Last week, the IRS issued the final version of the new Section 1.83-3 regs that were proposed back in 2012.
Background: The Proposed Regs
Section 83 provides that property transferred in exchange for services is taxable when it is transferable or no longer subject to a substantial risk of forfeiture (whichever occurs first). As explained in the preamble to the proposed regs, the purpose of this revision was to clarify that, for a substantial risk of forfeiture to exist, there has to be 1) some reasonable possibility of forfeiture (e.g., a performance goal which is certain to be met would not give rise to a substantial risk of forfeiture) and 2) there has to be some likelihood that the forfeiture provision would be enforced.
Most of us always thought this was the case, so we were surprised to see the proposed regs. Some speculated that companies would now have to estimate the likelihood of forfeiture due to failure to meet the vesting requirements to determine if taxation is delayed under Section 83. During his session at the 2012 NASPP Conference, Stephen Tackney, of the Office of Chief Counsel, at the IRS explained that this wasn’t the IRS’s intention and that they were really only concerned about situations where the likelihood of forfeiture was so infinitesimally small as to be almost nonexistent. Apparently the IRS lost a couple of enforcement actions in court due to a misunderstanding about this concept, so they decided to make the rules a little clearer.
The proposed regs also clarified that lock-up restrictions and trading black-out periods don’t delay taxation under Section 83 and codified a prior Rev. Rul. clarifying when taxation is deferred as a result of the operation of Section 16(b) (for practical purposes, virtually never).
What’s New in the Final Regs
Well, not much, really. In response to the concerns that the regulations were perhaps raising the threshold for a substantial risk of forfeiture, the IRS explains in the preamble that the new regulations are not intended to depart from the historic position that the IRS has taken with respect to Section 83. The IRS also edited the language of the regs, I think with the intention of making this clearer.
The IRS added a sentence to the regs to further clarify that it must be likely that the forfeiture restrictions would be enforced for there to be a substantial risk of forfeiture. Here again, I don’t think this represents a change in position for the IRS.
Finally, the IRS added an example to clarify that, where a Section 16 insider engages in a non-exempt purchase in the six months before an otherwise taxable acquisition under a stock option or award, the non-exempt purchase doesn’t delay taxation of the option or award (even though it does delay when the insider can sell the shares acquired under the option/award). We had noticed there were some differences in opinion among practitioners as to whether this was the case and had asked for clarification. Although the situation probably doesn’t come up that often, when it does come up, we thought it important to know what the correct tax treatment is. And now we know (and I think it’s the answer most of us had been assuming all along).
Read more about the final regs, including our redline comparing the proposed and final regs, in the NASPP Alert “IRS Issues Final Regs Under Section 83.”
In today’s entry I highlight a few articles that are available on the NASPP website that I think are particularly valuable. Many of these articles are updated on an annual basis; together they comprise the core foundational knowledge necessary to be proficient in stock compensation.
Restricted Stock and Units: The article “Restricted Stock Plans” covers just about anything you could want to know about restricted stock and unit awards and is updated annually.
ESPPs: “Designing and Implementing an Employee Stock Purchase Plan” takes an in-depth look at the regulatory and design considerations that apply to ESPPs, particularly Section 423 plans. This is a reprint of my chapter in the NCEO’s book “Selected Issues in Equity Compensation” so it is updated annually.
Securities Law: Alan Dye and Peter Romeo’s outlines of Rule 144 and Section 16 provide great overviews of these areas of law and are also updated annually.
When all or a portion of a nonstatutory stock options is transferred to the former spouse of one of your employees subsequent to a divorce, there are no income reporting or tax withholding obligations on the transfer. However, the exercise of those option shares requires special handling by the company.
When an incentive stock option is transferred in a divorce settlement, it no longer qualifies for preferential tax treatment. Once the ISO has been transferred, the income reporting and tax withholding obligations are the same as for NSOs. However, if the transfer of the shares happens only at exercise, then the ISO shares maintain their preferential tax treatment. The transfer of the shares at exercise does not constitute a disqualifying disposition. The transferred shares are then subject to the same holding requirements from the date of grant and exercise to determine if the sale is a qualified or disqualified disposition.
Revenue Rulings
There are two important revenue rulings that govern the income reporting and tax withholding on options transferred pursuant to a divorce.
Revenue Ruling 2002-22 establishes that a transfer of nonstatutory stock options as part of a divorce settlement does not constitute an income event. For stock plan managers, this means that there is no need to establish the fair value of the option, report any income, or withhold any taxes on the date of transfer. It also establishes that the former spouse realizes income on the exercise of those option shares.
Revenue Ruling 2004-60 clarifies the withholding and reporting obligations for an exercise made by the non-employee former spouse of options that were transferred in a divorce settlement.
Withholding and Reporting at Exercise
So, we know from Revenue Ruling 2004-60 that the former spouse realizes income at the exercise of options transferred pursuant to a divorce. What’s more, FICA and FUTA are both applied to the income at exercise. But, don’t worry; you won’t need to collect a Form W-4 from the former spouse. The income and FICA tax rates are applied based on the employee’s supplemental income and the Social Security tax she or he paid in that tax year as of the exercise date.
When the former spouse exercises the option, the company withholds income, Social Security, and Medicare from the exercise proceeds based on the employee’s withholding rates. The income tax withholding is attributed to the former spouse, but the FICA taxes are attributed to the employee even though they are paid by the former spouse. The income (i.e.; spread at exercise) and the income taxes withheld are reported on a Form 1099-MISC to the former spouse. That same income amount is reported to the employee as Social Security and Medicare wages on Form W-2. Additionally, the Social Security (if applicable) and Medicare withheld are reported on the employee’s Form W-2. For a great example of this, see our Tax Withholding on Option Exercises Subsequent to Divorce alert. You can also find more information in these recorded webcasts: Death and Divorce: The Lighter Side of Equity Compensation and The 2nd Annual NASPP Webcast on Tax Reporting.
Last Chance for Special Conference Rates
Registrations for our 18th Annual NASPP Conference are pouring in! If you haven’t already registered, don’t miss out on the special $200 discount on registration fees. This special rate is only available through tomorrow, May 14th!