Comments Concerning FSA 199926034: FICA Liability for ESPPs

The purpose of this comment is to address certain issues arising from Field Service Advice Memorandum 199926034 (April 7, 1999, released July 2, 1999) (the "FSA"). The FSA addresses the application of the "FICA taxes" imposed by §§ 3101 and 3111 of the Internal Revenue Code (the "Code") to the exercise of options granted under an employee stock purchase plan that satisfies the requirements of Code § 423 (an "ESPP"), and having an exercise price less than the fair market value of the stock on the date of exercise. The FSA concludes that (i) on the exercise date of the ESPP 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 decision in Sun Microsystems, Inc. v. Commissioner, T.C.M. 1995-69, acq. AOD CC-1997-010 (November 4, 1997). By way of background, we are providing a summary of the pertinent guidance applicable to the issues raised by the FSA.

1.  Income Tax Treatment of Options

1. NSOs

2. Generally, under Code § 83, the grant to an employee of an option that does not satisfy the requirements of Code §§ 422 or 423 (a non-statutory stock option or "NSO") will not result in the recognition of income by the employee, provided that, at the time of grant, the option does not have a readily ascertainable fair market value. Generally, under Code § 83 and Treas. Reg. § 1.83-7, upon exercise of the NSO for stock that is nonforfeitable, the employee will recognize ordinary income equal to the excess of the then fair market value of the stock over the exercise price, and the employer will be entitled to a corresponding deduction.

3. ISOs

4. The grant of an option that satisfies the requirements of Code § 422 (an incentive stock option or "ISO") will not result in taxable income to the employee. Pursuant to Code § 421(a), the exercise of an ISO will not result in taxable income to the optionee, provided that the optionee was an employee of the employer or certain related companies during the period beginning on the date of the grant of the option and ending on the date three months prior to the date of exercise (subject to exceptions for death or disability).

   If the employee does not sell or otherwise dispose of the stock within two years from the date of the grant of the ISO or within one year after the transfer of such stock, then, upon disposition of such shares, any amount realized in excess of the exercise price will be taxed to the employee as capital gain, and the employer will not be entitled to a deduction for Federal income tax purposes.

   Under Code § 421(b), if ISO stock is disposed of prior to satisfaction of the foregoing holding period requirements (a "disqualifying disposition"), then, at the time of the disposition of the shares, the employee will generally recognize ordinary income, and a corresponding deduction will be allowed to the employer in an amount equal to the lesser of: (i) the excess of the fair market value of the shares on the date of exercise over the exercise price, and (ii) the excess, if any, of the amount realized upon disposition of the shares over the exercise price. If the amount realized exceeds the fair market value of the shares on the date of exercise, the additional amount will be capital gain. If the amount realized is less than the exercise price, the employee will recognize no income, and will recognize a capital loss equal to the excess of the exercise price over the amount realized upon the disposition of the shares.

5. ESPPs

6. The grant of an ESPP option will not result in taxable income to the employee. Pursuant to Code § 421(a), the exercise of an ESPP option will not result in taxable income to the optionee, provided that the optionee was an employee of the employer or certain related companies during the period beginning on the date of the grant of the option and ending on the date three months prior to the date of exercise (subject to exceptions for death and disability).

   If the employee does not sell or otherwise dispose of the stock within two years from the date of the grant of the ESPP option or within one year after the transfer of such stock, then, upon disposition of the ESPP shares (a "qualifying disposition"), the employee will recognize ordinary income equal to the lesser of: (i) the excess of the fair market value of the shares at the time of such disposition over the option price, or (ii) the excess of the fair market value of the shares at the time the option was granted over the option price. Code § 423(c). Any remaining gain is capital gain. The employer is not entitled to any deduction upon the qualifying disposition of stock acquired pursuant to an option granted under an ESPP.

   Under Code § 421(b), if ESPP stock is disposed of prior to satisfaction of the foregoing holding period requirements (a "disqualifying disposition"), then, at the time of disposition of the shares, the employee will recognize ordinary income equal to the excess of the fair market value of the stock on the date of exercise over the option exercise price. Any remaining gain or loss shall be a capital gain or loss. The employer will also have a deduction (which may be less than the ordinary income recognized by the employee), provided that the disqualifying disposition is timely reported.

   Although the tax treatment of ISOs and the tax treatment of ESPP options are both governed by Code § 421, the treatment differs in one respect. Under § 423(c), if a share of stock is purchased pursuant to an ESPP option for a price between 85% and 100% of its fair market value as of the date the option is granted, a qualifying disposition will result in recognition of ordinary income up to the amount of the discount from fair market value at the time the option is granted. The exercise price of an ISO cannot be less than 100% of the fair market value of the stock at the time the option is granted, and so there is no corresponding provision addressing such discount.