The NASPP Blog

December 9, 2008

Excess Tax Withholding – Part 2

Last week, I discussed the reasons companies might want to withhold federal income tax at a rate higher than 25% on stock plan transactions and the accounting consequences of doing so.  This week I take a look at whether or not a higher withholding rate is permitted under U.S. federal income tax regulations.

Having discussed this issue with a number of tax practitioners and with staff at the IRS and Treasury, I don’t believe that, where an employee has received less than $1 million in supplemental payments, it is permissible to withhold at any rate other than the employee’s W-4 rate or the flat rate applicable to supplemental payments (currently 25%).

The final regulations for withholding on supplemental payments (which include payments pursuant to stock compensation arrangements) allow only two withholding methods:  1) the W-4 rate or 2) the flat rate applicable to supplemental payments.  The regulations make no provisions for withholding at any other rate.  IRS Publication 15 (Circular E) Employer’s Tax Guide takes this one step further, expressly stating, on page 14, that no other rate is permitted.

But, you ask, why wouldn’t the IRS want to receive extra withholding? The answer is that the IRS doesn’t want employees to use the supplement tax withholding procedures as a way of avoiding having the proper amount of withholding deducted from their regular pay or of avoiding the estimated tax payment system.  For example, a situation that I’ve encountered is an executive that purposely set his W-4 withholding rate too low, with the knowledge that if he didn’t somehow make up the shortfall in his tax withholding by the end of the year, he would owe underpayment penalties to the IRS.  Then, at the end of the year, the executive exercises his stock option and has the company collect federal income tax on the exercise at a rate much higher than 25%–sometimes even as high as 100% of the option proceeds.  Even better if the exercise is a same-day sale, so that the executive isn’t out-of-pocket for all of this tax withholding.  This is exactly the situation the IRS wants to prohibit. In the U.S., employees are supposed to pay an estimate of their taxes as they are compensated; they aren’t supposed to save up all their tax payments until the end of the year and then make a big payment all at once (allowing them, rather than the IRS, to earn interest on the funds until then).

Employees that are concerned that the withholding on their stock plan transactions will be too low have two alternatives to remedy this:

  1. Increase their W-4 withholding rate. This will increase the withholding on their salary and other compensation that isn’t subject to the flat rate. If they increase their W-4 withholding rate by the right amount, they should be able to make up for the shortfall in withholding on their stock plan transaction.
  2. Make estimated tax payments to the IRS. 

Another important thing to remember is that not everyone is subject to the underpayment penalties. As I mentioned last week, those employees whose withholding for the current year is at least equal to their tax liability for the prior year will not be subject to the underpayment penalties, regardless of how much additional tax they owe when they file their tax return.  

Now, I know what you’re thinking: you’re wondering what the penalties are for withholding at a rate greater than 25%.  Here’s where things get a little fuzzy.  None of the tax practitioners I’ve spoken with have been able to give me a clear sense of the penalties that would apply.  It’s going to come down to the facts and circumstances involved. In the example I gave above, the executive is clearly trying to manipulate the tax withholding system and may even be committing outright fraud.  But I can think of other examples where everyone involved has only the purest of intentions.  For example, let’s say that an executive does have an appropriate rate selected on her Form W-4, engages in a stock plan transaction early in the year–maybe even in January, and requests that only a minimal amount of excess withholding be collected (say, 35%, rather than 100% of the gain on exercise).  This situation seems a lot less likely to involve manipulation; with an appropriate W-4 rate, the transaction occurring early in the year, and the executive limiting the excess tax withholding to a reasonable rate, the executive appears to be legitimately attempting to cover only the tax liability generated by her stock plan transaction, rather than trying to make up for shortfalls in withholding on her other compensation. I would expect that the penalties would be comensurate with the facts involved, so I would expect there to be greater penalties for my first example than the second scenario.  Moreover, in either scenario, it isn’t clear to me that the penalties, if any, would apply to the company. It’s possible that only the employee would be penalized. 

As a general rule, I don’t like to see companies offer excess withholding in any sort of broad, systematic manner.  But if you have a one-off transaction where you withhold a little extra federal income tax, well, I can’t sanction this but I can think of worse crimes to commit when it comes to tax withholding. 

Deadline Extended to Participate in the International Stock Plan Design and Administration Survey

Due to overwhelming demand, we’ve extended the deadline to participate in our International Stock Plan Design and Administration Survey until December 19. But don’t put this off any longer–we will not be able to extend the deadline again.  As an added incentive, one person from every company that completes the survey is entitled to $100 off any of the NASPP’s online courses (including our newly updated Restricted Stock Essentials course).   

Reason #5 to Renew Your NASPP Membership:  The NASPP’s Stock Plan Design and Administration Survey

While we’re on the subject of the NASPP’s Stock Plan Design and Administration Survey, I’d like to point out that the data we provide in the survey report is easily worth the cost of your NASPP membership.  The 2007 domestic survey report was over 130 pages long with over 400 respondents.  This is by far the industry’s most comprehensive survey on trends in stock plan design and practices.  We ask the questions on one else asks and provide more robust data for those questions that are covered by other surveys.  Not only that, but we’ve been conducting the survey since 1996–that’s more than a decade of data and trends.  I expect that you’d pay well over the cost of your NASPP membership to get this extensive of a report from any other source.  But, here at the NASPP, we provide it free of charge to all our members.   

2nd Annual NASPP Webcast on Tax Reporting

Later today, Robyn Shutak, the NASPP’s Education Director, and I will present our annual webcast on tax reporting, where we answer the tax-related questions you’ve been asking all year long in the NASPP discussion forum.  Former employees, consultants, outside directors, death, divorce…we’re going to cover it all, complete with sample Forms W-2 and 1099.    

NASPP “To Do” List

We have so much going on here at the NASPP, it can be hard to keep track of it all, so I’m going to keep an ongoing “to do” list for you here in my blogs. 

– Barbara