The NASPP Blog

Your outside directors should be making estimated tax payments to the IRS on compensation they receive from your company in exchange for their services as an outside director. This includes income realized from equity compensation. Sometimes companies are tempted to withhold taxes on outside director stock transaction. At face value, this may appear to be simple common sense–we know that they will owe taxes, why not facilitate a sell-to-cover or withhold shares to cover those tax payments? The truth is that withholding taxes on outside director transactions is something that your company really should not be doing.

Why not withhold shares?

There has recently been a lot of focus on the accounting consequences of withholding shares above the statutory minimum, because this triggers liability accounting under FAS123(R) (see Paragraph 35). Many companies are struggling with this issue when it comes to share withholding on restricted stock in locations where there is no flat statutory tax rate associated with stock transactions. In the case of non-employees, any taxes withheld will be above the statutory minimum. Therefore, if you withhold shares on a transaction made by an outside director, then the entire grant would be classified and accounted for as a liability. Even worse, if you establish a pattern of allowing shares to be withheld above the minimum statutory required tax obligation, then it is possible that you will trigger liability accounting for the entire plan.

Why not withhold FIT?

So, what about facilitating a sale of shares to help the outside director cover taxes due? As attractive as that may sound, this also is a problem for both the company and the outside director. In addition to the general issues surrounding excess tax payments, reporting the income and tax withholding will prove to be a challenge. Payments for services made to non-employees must be reported on a Form 1099-MISC. You can’t properly report that federal tax payment on a 1099-MISC. This is because there is no provision in the tax regulations for withholding taxes on payments made to non-employees. Additionally, if you withhold federal income tax, then the IRS may determine that FICA and FUTA should also have been withheld, which could result in penalties for the company.

Why not withhold FICA?

This is a bad idea all around–bad for the company and bad for the director. The outside director will need to pay both the income taxes and the self-employment taxes on his or her equity compensation from your company. Self-employment tax includes both the FICA payment and what would be the company’s matching payment. If you withhold FICA at the time of the transaction, it won’t exempt the outside director from also having to pay the self-employment tax on that same income. For the company, if FICA is withheld, then the IRS is going to expect to see a matching company payment. Failing to make that matching payment could result in penalties for the company.

Why not just report everything on a W-2?

Reporting payments made to a non-employee on a W-2 goes against Regulation §1.6041-2(a)(2), which specifically states that the W-2 is for reporting payments made to an employee. Additionally, failing to report the income on a Form 1099 puts the company’s tax deduction in jeopardy–the company would need to prove that the outside director had properly reported the income and paid the income taxes and self-employment taxes on it in order to receive the corporate tax deduction.

Ah, but there is an exception.

If your outside director received a stock grant as an employee (before becoming an outside director), then the some or all of the income from a transaction on that grant may be subject to tax withholding and be reported on a W-2.

We have several great resources on the NASPP site to help you deal with your company’s tax withholding and reporting obligations. Our best resource is the NASPP Tax Withholding and Reporting portal. You can also go back and review our annual webcasts on Tax Withholding and Reporting–the 2008 Webcast has fantastic points on dealing with non-employees! Also, don’t forget about the NASPP Discussion Forum. Take advantage of the key word search to find questions other members have submitted; you might find that the answer to your question is already available.

-Rachel