- General
We believe that it is inappropriate for the Service to modify its position in Rev. Rul.
71-52 ruling though the use of a field service advice memorandum. If any such modification
is made, it should be done only after a higher level of review has been completed. The
more formal review is appropriate because of the policy issues discussed below. A more
formal review is also consistent with procedure specified in Notice 87-49, which indicates
that no change will be made with respect to an employer's income tax withholding
obligation on a disqualifying dispositions of ISO stock until the application of Rev. Rul.
71-52 has been reconsidered. The Notice indicates that imposition of a withholding
obligation will be prospective. The FSA distinguishes the subject of Notice 87-49 from the
subject of the FSA by stating:
Notice 87-49 cannot reasonably be relied upon because it does not address whether FICA
tax is owed upon the exercise of an employer-granted stock option; but rather addresses
only whether the compensatory amount is deductible by the employer.
Of course, Notice 87-49 addresses the interaction of deductibility and withholding of
income taxes. We believe that from both a technical and policy perspective, the income tax
withholding issues are closely related to the FICA and FUTA tax issues, and it would be
inappropriate for the Service to address them on a piecemeal basis.
The FSA concludes that Rev. Rul. 71-52 was revoked at the time of the Sun
Microsystems decision, and that case itself put employers on notice of this
revocation. As discussed above, we do not view the Sun Microsystems decision as
reversing or discrediting Rev. Rul. 71-52, and we do not believe that such a case
constitutes adequate notice of the revocation of a revenue ruling, especially when the
acquiescence by the Service was not issued for more than 2-½ years after the decision, in
an announcement that makes no mention of FICA taxes.
The need for adequate notice is particularly important in connection with employment
taxes. In Central Illinois Public Service Co. v. United States, 435 U.S. 21, 31-32
(1978), the Court stated:
Because employer is in a secondary position as to liability for any tax of the
employee, it is a matter of obvious concern that, absent further specific congressional
action, the employer's obligation to withhold be precise and not speculative. [Citations
omitted.]
The court in American Airlines v. United States, 98-1 U.S.T.C. para. 50,323,
citing the foregoing language from Central Illinois Public Service, stated:
A duty to withhold income taxes on payments made to its employees should not be imposed
retroactively on an employer unless there was adequate notice (from relevant statues,
regulations, and IRS pronouncements) to the employer at the time of the payments that such
a withholding obligation existed. [Citations omitted.]
The concern arises because the employer's role with respect to employment taxes
includes the collection of taxes on the income of its employees. If there is uncertainty
about the employer's obligations, and the employer resolves the uncertainty by withholding
on the amounts in question, the employer is likely to have employee relations problems,
and is likely to also have competitive concerns if other employers do not withhold on
comparable types of compensation. If there is uncertainty about of the employer's
obligations, and the employer resolves the uncertainty by not withholding on the amounts
in question, the employer may not only become liable for interest and penalties, but also
may be required to pay from its own assets amounts that would otherwise have been due from
the employee. Further, Code § 6672 provides that, under certain circumstances, the
individual responsible for collecting the employment taxes may be personally liable for
payment of that tax to the Treasury. We believe that the informal manner apparently being
used to address these issues, and the uncertainty resulting from this approach, is
inconsistent with the sound administration of the tax laws.
We believe that the considerations that initially led to the issuance of Rev. Rul.
71-52 are also present today. While the amount of compensation currently escaping FICA and
FUTA taxes under ISOs and ESPP options may be greater now than the amount that would have
escaped such taxes when Rev. Rul. 71-52 was issued, and although concerns about Social
Security solvency may be greater today than in 1971, we do not believe that either
consideration justifies the use of informal procedures to modify the employment tax rules.
We believe that if Rev. Rul. 71-52 is to be revoked, it should be done by an announcement
by the Service expressly providing for the revocation. We believe that a higher level of
review should be given to the issue of whether FICA and FUTA taxes are applicable to ISOs
and ESPP options, and that the Service should consider holding public hearings on the
matter.
- Policy Reasons Also Support Exemption from FICA and FUTA for ISOs and
ESPP Options
There are strong policy considerations for exemption of ISO and ESPP options from FICA
and FUTA taxes. The Code provides favorable tax treatment for ISOs and ESPP options, and
previously provided favorable treatment for QSOs. One of the main benefits provided for
these options, all of which are subject to § 421, is that taxable income is not
recognized by the employee at the time of exercise. This treatment limits the
out-of-pocket cost associated with the exercise, making it less financially burdensome for
the employee to retain rather than sell the stock after exercise. The reduction of the
financial burden is particularly important for employees who are not among an employer's
most highly paid. Because of the coverage requirements applicable to ESPPs, and the
$100,000 limit applicable to ISOs, such employees make up a significant portion of the
recipients of these types of options.
For shares acquired pursuant to the exercise of an option of the type covered by § 421
(including ISOs, ESPP options and, previously, QSOs), the Code provides incentives for
employees to retain the shares by providing meaningful tax benefits for shares retained
for a specified holding period after exercise. Similarly, many employers want their
employees to hold shares of the employer's stock, in order to align the interests of the
employees with those of the employer's other shareholders. Such employers frequently use
ISOs, ESPPs, or both to encourage employees to retain employer stock. Despite the tax
benefits provided when such shares are retained after exercise, and other incentives that
are sometimes provided by an employer to encourage such retention, employers often find
that successfully encouraging such share retention is a difficult challenge. The
imposition of employment taxes at the time an ISO or ESPP option is exercised would create
another significant obstacle to achieving such retention, and would be contrary to the
policy of encouraging retention of employer stock by employees.
- Application of FICA Taxes to ISOs and ESPP Options Should Not Be
Retroactive
The perspective expressed by the FSA appears to be that, since the Sun Microsystems
decision, taxpayers have been on notice that the exercise of discount ESPP options results
in payment of FICA wages. As discussed above, we believe that this conclusion is not
appropriate, and that it does not follow from the decision. Contrary to the suggestion in
the FSA, we do not agree that a stipulation by the Service in a Tax Court memorandum
decision should be treated as sufficient notice to taxpayers of a change in the Service's
position on this matter. When the Service was contemplating a revision to the principles
of Rev. Rul. 71-52 in connection with ISOs, it provided, in Notice 87-49, that such
application would be prospective. We believe that the Service should continue to follow
this approach with respect to any change in the employment tax treatment for ISOs or ESPP
options.