Under § 3402 of the Code (relating to income tax collected at the source on wages), an
employer is required to withhold income taxes on "wages" (as defined in Code §
3401) paid to an employee. Code § 3101 imposes a tax on the income of an individual
received with respect to employment for Old-Age, Survivors, and Disability Insurance and
for Hospital Insurance (together referred to as the "FICA" tax). Under Code §
3102, an employer is required to withhold FICA taxes on "wages" (as defined in
Code § 3121) paid to an employee and, under Code § 3111, the employer is required to pay
a corresponding additional FICA tax. Under Code § 3301, which reflects the Federal
Unemployment Tax Act, an employer is required to pay taxes on "wages" (as
defined in Code § 3306) paid to an employee ("FUTA taxes").
The term “wages” for all these purposes generally means all remuneration from
employment, including the cash value of all remuneration (including benefits) paid in any
medium other than cash. Although the Code lists a number of specific exceptions under each
of these definitions, NSOs, ISOs, or ESPPs are not expressly listed. Moreover, there is no
indication under the respective Code sections that NSOs, ISOs, or ESPPs should be treated
any differently for purposes of FICA and FUTA withholding than for purposes of income tax
withholding.
Generally, income realized in connection with NSOs granted to employees is treated as
"wages" subject to FICA and FUTA taxes and income tax withholding at the time of
exercise of the option. See, e.g., Rev. Rul. 78-185, 1978-1 C.B. 304. However, the
determination of "wages" has, in the past, been covered by different rules when
the tax treatment of the option has been subject to Code § 421.
- ISOs and ESPPs
The tax treatment of an option that satisfied the requirements of Code § 422 and
which, generally, was granted on or before May 20, 1976 (a "qualified stock
option" or "QSO") was to be determined in accordance with Code § 421. Rev.
Rul. 71-52, 1971-1 C.B. 278, held that if an employer sells its stock to an employee
pursuant to a QSO, then, for purposes of FICA and FUTA taxes, and collection of income tax
at the source on wages, the acquisition of the stock does not result in the payment of
"wages" by the employer, and a disqualifying disposition of such stock does not
result in the payment of "wages" by the employer or the receipt of
"wages" by the employee. The revenue ruling does not set forth a specific
rationale for its conclusions.
Prop. Treas. Reg. § 1.422A-1(b), by reference to the regulations under § 83
(including, specifically, Treas. Reg. § 1.83-6(a)(2), as in effect on the date the
proposed regulations were issued), required employers to withhold income tax on a
disqualifying disposition of ISO stock as a condition of obtaining a deduction. In Notice
87-49, 1987-2 C.B. 355, the Service stated:
[The position stated in the proposed ISO regulations] conflicts with the rule
articulated in Revenue Ruling 71-52, 1971-1 C.B. 278, in which the Service ruled that the
disqualifying disposition of stock acquired by the exercise of a qualified stock option
described in section 422(b) of the Code did not result in the receipt of wages for Federal
employment tax purposes.
Notice 87-49 announced that the deduction on a disqualifying disposition of ISO stock
would not depend on whether taxes were withheld. The Notice also stated that:
The Internal Revenue Service is reconsidering Rev. Rul. 71-52. Until the results of
such reconsideration are announced, the principles of that revenue ruling will apply to a
disqualifying disposition of stock acquired by the exercise of an ISO. Pursuant to section
7805(b) of the Code, any determination that the gross income resulting from such a
disqualifying disposition is wages for Federal employment tax purposes will be given
prospective effect only.
- Sun Microsystems
The amount of "wages" paid by an employer is taken into account in
determining the research credit available under Code § 41. Code § 41(b)(2)(D)(i)
provides that, for purposes of § 41, the term "wages" has the definition used
in § 3401(a). (As noted above, this is the definition used for purposes of determining
the amounts subject to income tax withholding.) In Sun Microsystems, the court
considered whether, for purposes of Code § 41, the term "wages" included the
income realized from the disqualifying disposition of stock purchased through the exercise
of ISOs. The Service sought to have such amounts excluded from wages for purposes of
determining the research credit, and in support of this position cited Rev. Rul. 71-52 and
Notice 87-49. The court, holding against the Service, stated that:
[The Service's] position as expounded in Rev. Rul. 71-52…, and Notice
87-49…is totally unpersuasive. In the first place, each of these pronouncements was
issued for the specific purposes of administrative convenience not related to the issue
before us herein. In the second place, and more importantly, revenue rulings, to say
nothing of lesser pronouncements such as notices, represent "merely the opinion of a
lawyer in the agency and must be accepted as such," and are "not binding on the
* * * courts."… Accordingly, "a ruling or other interpretation by the
Commissioner is only as persuasive as her reasoning and the precedents upon which she
relies."… [The Service's] interpretation of section 3401 is in conflict with the
statute and the regulations thereunder…. We hold that the ISO spread income
constitutes "wages" under section 3401(a) and that, therefore, the ISO spread
constitutes "wages" for the purposes of section 41. [Citations omitted.]
- Field Service Advice Memorandum
As indicated above, the FSA addresses the application of FICA taxes to the exercise of
an option granted under an ESPP, and having a price less than the fair market value of the
stock on the date of exercise. The FSA concludes that (i) at the time of exercise of the
option, the excess of the then fair market value of ESPP stock over the option price is
FICA wages, (ii) the exercise of an ESPP option constitutes a payment of wages, and (iii)
the employer is not excused from withholding and payment of FICA taxes for periods after
the Sun Microsystems decision.
The basis of the first conclusion of the FSA is largely contained in the following
paragraph from the FSA:
The court [in Sun Microsystems] made three points which are instructive in
determining the correct employment tax treatment of ESPP options. First, the court's
analogy to [Apple Computer, Inc. v. Commissioner, 98 T.C. 232 (1992)] is
significant because Apple Computer involved the employment tax treatment of
nonstatutory stock options. As stated, the compensatory amount with respect to
nonstatutory stock options is subject to employment taxes on exercise. Rev. Rul. 78-185;
Rev. Rul. 67-257. Second, the court completely discredited Rev. Rul. 71-52; therefore even
assuming for the sake of argument that this ruling applies to ESPPs, the [court] opinion
nullifies any [effect] the ruling had. Third, the court found ISOs and ESPPs to be
indistinguishable with respect to whether the compensatory amount is wages. Therefore,
given the court's holding that the compensatory amount with respect to ISOs is wages, it
follows that the compensatory amount with respect to ESPP options is wages for employment
tax purposes.
The FSA, in discussing its second conclusion, notes that, upon the exercise of an ESPP
option, the discount below the fair market value of the stock at the time of exercise is
not then includible in income by reason of Code § 421. The FSA states that this raises
the issue of whether the discount on the ESPP stock should be subject to FICA wages. The
FSA reviews the legislative history of the Social Security Amendments Act of 1983, and the
rule that, under some circumstances, FICA taxes are due with respect to income that is not
recognized for income tax purposes until a later date, and concludes that "in
determining the correct FICA tax treatment, the income tax withholding treatment is
irrelevant." The FSA reasons that, because employment taxes are due in connection
with the exercise of an NSO, and the income tax treatment of an ESPP option is irrelevant
in determining FICA tax treatment, the employment tax treatment applicable to NSOs should
also apply to ESPP options.
The final conclusion of the FSA is that the first and second conclusions should be
retroactively applied to the date of the Sun Microsystems decision. The basis for
this conclusion is that a taxpayer's reliance on Rev. Rul. 71-52 and Notice 87-49 would
have been unreasonable after that date, because the ruling and the notice were discredited
in Sun Microsystems, and because Notice 87-49 addresses only whether the
compensatory amount of an ISO is deductible by an employer, but does not address the FICA
tax obligation. It also states that:
In Sun Microsystems, the Service stipulated that the compensatory amount in the
context of ESPP options is wages; therefore, despite the loss in Sun Microsystems,
the Service's position with respect to ESPPs was clear. Assuming for the sake of argument
that the Service's position prior to Sun Microsystems was ambiguous based upon Rev.
Rul. 71-52, as a result of Sun Microsystems, [the taxpayer] was put on notice
regarding its duty to withhold FICA tax.