One of the hottest questions I am hearing these days is whether to allow US employees to request additional federal tax withholding on their restricted stock, RSU, and performance awards. So, last week, we conducted a quick survey to find out what NASPP members are doing. Here are the results, in a nifty infographic:
P.S. NASPP members are awesome! We launched this survey on Thursday and by Saturday I had enough responses to close the survey and finalize the results. Thanks to all of you who participated so quickly! You rock! Check out the full survey results.
I’ve been getting a lot of questions about what tax withholding rate can be used for federal income tax purposes, now that the FASB’s update to ASC 718 is final and companies are free to adopt it. So I thought I’d take a blog entry to clarify what’s changed and what hasn’t.
Who’s the Decider on Tax Withholding Procedures
One thing that a lot of folks seem to have forgotten is that the FASB doesn’t determine tax withholding procedures; they just determine how you account for situations in which tax is withheld. The ultimate authority on how much tax you should (and can) withhold in the United States is the IRS, not the FASB.
Tax Withholding for Supplemental Payments
I’ve blogged about the rules for withholding on supplemental payments, which include stock plan transactions, quite a bit (search on the term “Excess Withholding” in the NASPP Blog). There are two choices when it comes to withholding taxes on stock plan transactions for employees who have received less than $1 million in supplemental payments for the year:
Withhold at the flat rate (currently 25%). No other rate is permissible.
Withhold at the employee’s W-4 rate. Here again, no other rate is permissible.
If employees want you to withhold additional FIT, they have to submit a new W-4 requesting the withholding (as a flat dollar amount, not a percentage) and you have to agree to withhold at the W-4 rate. This is stated in IRS Publication 15 and even more emphatically in IRS Information Letter 2012-0063. Whether you are using method 1 or 2, you can’t arbitrarily select a withholding rate.
Where Does the FASB Come Into This?
The FASB has no authority over these requirements and they didn’t amend ASC 718 to make is easier for you to ignore the IRS requirements. They amended ASC 718 to make it easier for companies that grant awards to non-US employees to allow those employees to use share withholding. Other countries don’t have a flat rate, making it challenging for the US stock plan administration group to figure out the correct withholding rate for non-US employees. This would allow companies to withhold at the maximum rate in other countries and refund the excess to employees through local payroll (who is more easily able to figure out the correct withholding rate).
The only change for US tax withholding procedures is that if you want to use the W-4 rate to withhold excess FIT, withholding shares for the excess payment will no longer trigger liability treatment once you adopt the update to ASC 718. But if you want to withhold excess FIT, you still have to follow the IRS procedures to do so. Previously, even if you had followed the IRS W-4 procedures, withholding shares for an excess tax payment would have triggered liability treatment.
Why Not Use the W-4 Rate?
No one wants to use the W-4 rate because it is impossible to figure out. You have to aggregate the income from the stock plan transaction with the employee’s other income for the payroll period, which the stock plan administration group doesn’t have any visibility to. The rate varies depending on the number of exemptions the employee claims on Form W-4. And the rate is complicated to figure out. I count at least seven official methods of figuring out this rate and companies can make up their own method (but if they make up a method, they have to apply it consistently, the stock plan administration group can’t make up a method that is different than the method the payroll group uses).
The upshot is that you literally can’t figure it out. You would have to run the income through your payroll system to figure out what the tax withholding should be. And that’s a problem because your stock plan administration system is designed to figure out the withholding and tell payroll what it is, not the other way around.
What’s the Penalty?
Members often ask me what the penalty is for withholding extra FIT without following the IRS procedures. Generally there isn’t a penalty to the company for overwithholding, provided there’s no intent to defraud the IRS (if you don’t understand how overwithholding could involve tax fraud, see “Excess Withholding, Part 2“) and the withholding is at the request of the employee. Doing this on a one-off basis, at the occasional request of an employee, probably won’t result in substantial penalties to the company, especially if the employee has appropriately completed Form W-4 for his/her tax situation. (Note, however, that I’m not a tax advisor. You should consult your own advisors to assess the risk of penalty to your company.)
But I’ve encountered a number of companies that want to create a system to automate electing a higher withholding rate without following the W-4 procedures (in some cases, for all of their award holders). I think that it could be problematic to create an automated system that circumvents the W-4 process, especially in light of Information Letter 2012-0063. That system is likely to be noticed if the company is audited, and I think it could have negative ramifications.
The Financial Accounting Foundation has completed their post-implementation review of FAS 123(R) (see my August 27, 2013 blog entry, “FAF to Review FAS 123(R)“) and the upshot is that they think the standard (now known as ASC 718) needs to be simplified. In response the FASB has proposed some very significant amendments to the standard. In addition to the summary I provide here, be sure to listen to our newest Equity Expert podcast, in which Jenn Namazi discusses the proposed amendments with Ken Stoler and Nicole Berman of PwC.
Share Withholding
Currently, ASC 718 provides that withholding for taxes in excess of the statutorily required rate triggers liability treatment. This has been a problem because of rounding considerations (if companies round the shares withheld up to the nearest whole share, does that constitute withholding in excess of the required rate) and, more significantly in jurisdictions (e.g., US states and other countries) that don’t have a flat withholding rate. The FASB proposal would change the standard to allow share withholding up to the maximum tax rate in the applicable jurisdiction, regardless of the individual’s actual tax rate.
This is obviously great news and would make share withholding a lot more feasible for non-US employees. There is still the question of rounding, however. It also isn’t clear how this would apply in the case of mobile employees. Finally, don’t forget that, here in the US, the IRS still opposes excess withholding at the federal level (see my January 9, 2013 blog entry “Supplemental Withholding“).
Estimated Forfeitures
Estimating forfeitures is one of the most complicated aspects of ASC 718—I’ve seen multiple presentations of over an hour in length on just this topic. The FASB has proposed to dispense with this altogether and allow companies to simply recognize the effect of forfeitures as they occur. Companies would be required to make a policy decision as to how they want to recognize forfeitures that would apply to all awards they grant. I assume that this would apply only to forfeitures due to service-related vesting conditions, but I don’t know this for certain.
Tax Accounting
Another area of the standard that has provided a wealth of material for NASPP webcasts and Conference sessions is how companies account for the tax deductions resulting from stock awards. FASB’s proposal would change the standard to require that all tax savings and all shortfalls flow through the income statement. If an award results in a deduction in excess of the expense recognized for it, the excess savings would reduce tax expense (currently, the excess is recorded to APIC). Likewise, shortfalls would always increase tax expense (currently, shortfalls are deducted from the company’s APIC balance to the extent possible, before reducing tax expense).
With this change, companies would no longer need to track what portion of APIC is attributable to excess tax deductions from stock plan transactions. But this would introduce significant variability into the income statement (which is the reason FASB decided against this approach ten years ago). This approach gets us closer to convergence with IFRS 2, but is still not completely aligned with that standard (in IFRS 2, all excess deductions run through APIC and all shortfalls run through the P&L). But this makes me wonder if companies will simply record the windfall/shortfall tax deductions as they occur, or would they have to estimate the potential outcome and adjust tax expense each period until the deduction is finalized (as under IFRS 2)?
Now? Now They Figure This Out?!
All of these changes will eventually make life under ASC 718 a heck of a lot simpler than it is now. That’s the good news. The bad news is that it’s really too bad the FASB couldn’t have figured this out ten years ago. Not to say “I told you so” but I’m sure there were comment letters on the exposure draft that warned the FASB that the requirements in at least two of these areas were too complicated (I’m sure of this because I drafted one of them).
If you are already thinking wistfully about how much more productively you could have used all that time you spent learning about estimated forfeitures and tax accounting, imagine how your administrative providers must feel. They’ve spent the last ten years (and a lot of resources) developing functionality to help you comply with these requirements; now they’ll have to develop new functionality to comply with the new simpler requirements.
More Info
I’ll have more thoughts on this and some of the FASB’s other decisions—yes, there’s more!—next week. For now, check out the PwC and Mercer alerts that we posted to the NASPP website (under “More Information” in our alert, “FASB Proposes Amendments to ASC 718“). And listen to our Equity Expert podcast on the proposed amendments with Ken Stoler and Nicole Berman of PwC.
As is often the case at this time of the year, a lot of tax related questions have been popping up in the NASPP Q&A Discussion Forum lately. For today’s blog entry, I try to quickly answer some of the questions I’ve seen the most frequently.
Former Employees You have to withhold taxes on option exercises by and award payouts to former employees and report the income for these stock plan transactions on a Form W-2, no matter how long it has been since they were employed by the company. The only exceptions are:
ISOs exercised within three months of termination (12 months for termination due to disability).
RSAs paid out on or after retirement (because these awards will have already been taxed for both income tax and FICA purposes when the award holders became eligible to retire). Likewise, RSUs paid out on or after retirement that have already been subject to FICA are subject to income tax only.
If the former employees did not receive regular wages from the company in the current year or the prior calendar year, US tax regs require you to withhold at their W-4 rate, not the supplemental rate. In my experience, however, few companies are aware of this and most withhold at the supplemental rate because the W-4 rate is too hard to figure out.
Changes in Employment Status Where an individual changes status from employee to non-employee (or vice versa) and holds options or awards that continue to vest after the change in status, when the option/award is exercised/paid out, you can apportion the income for the transaction based on years of service under each status. Withhold taxes on the income attributable to service as an employee (and report this income on Form W-2). No withholding is necessary for the income attributable to service as a non-employee (and this income is reported on Form 1099-MISC).
Any reasonable method of allocating the income is acceptable, so long as you are consistent about it.
Excess Withholding I know it’s hard to believe, but if you are withholding at the flat supplemental rate, the IRS doesn’t want you to withhold at a higher rate at the request of the employee. They care about this so much, they issued an information letter on it (see my blog entry “Supplemental Withholding,” January 8, 2013). If employees want you to withhold at a higher rate, you have to withhold at their W-4 rate and they have to submit a new W-4 that specifies the amount of additional withholding they want.
Also, withholding shares to cover excess tax withholding triggers liability treatment for accounting purposes (on the grant in question, at a minimum, and possibly for the entire plan). Selling shares on the open market to cover excess tax withholding does not have any accounting consequence, however.
ISOs and Form 3921 Same-day sales of ISOs have to be reported on Form 3921 even though this is a disqualifying disposition. It’s still an exercise of an ISO and the tax code says that all ISO exercises have to be reported.
On the other hand, if an ISO is exercised more than three months after termination of employment (12 months for termination due to disability), it’s no longer an ISO, it’s an NQSO. The good news is that because it’s an NQSO, you don’t have to report the exercise on Form 3921. The bad news is that you have to withhold taxes on it and report it on a Form W-2 (and, depending on how much time has elapsed, it might have been easier to report the exercise on Form 3921).
FICA, RSUs, and Retirement Eligible Employees This topic could easily be a blog entry in and of itself, but it doesn’t have to be because we published an in-depth article on it in the Jan-Feb 2014 issue of The NASPP Advisor (“Administrators’ Corner: FICA, RSUs, and Retirement“). All your questions about what rules you can rely on to delay collecting FICA for retirement eligible employees, what FMV to use to calculate the FICA income, and strategies for collecting the taxes are covered in this article.