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.
For today’s entry, I have several follow-up items relating to a few of my recent blog entries.
Your Favorite Words 10 pts. to Sheila Jan of Life Technologies for accepting my challenge in “Holiday Fun” (December 18, 2012) and submitting her own favorite word with an example of how it might be used at a holiday gathering. Sheila’s submission:
Tranche: I’m going to help myself to a second tranche of the mashed potatoes!
A Little More on Excess Withholding Susan Eichen of Mercer reminded me that allowing employees to use share withholding to cover more than just the statutorily minimum required tax payment will trigger liability treatment under ASC 718, even if the proscribed W-4 procedures are followed (see my blog entry from last week, “Supplemental Withholding“). If the difficulty of the W-4 withholding process wasn’t enough, this makes one more reason to prohibit excess withholding for restricted stock and units (for NQSOs, where shares are generally sold on the open market, rather than withheld, to cover taxes, this is less of a concern).
Proposed Regs on New Medicare Tax The IRS has issued proposed regs on withholding the additional 0.9% Medicare tax that applies to wages in excess of $200,000 for individuals/$250,000 if married filing jointly. No surprises here, the procedures are as I described them back in August (“The Supreme Court and Stock Compensation“):
The company withholds the additional 0.9% tax on any wages in excess of $200,000 that are subject to Medicare, regardless of the employee’s filing status or wages paid to his/her spouse.
Any overpayments or underpayments as a result of the employee’s filing status/spousal income will be sorted out on the employee’s tax return. The company has no obligations here.
Employees can’t request that the company withhold additional Medicare tax (for example, if they have received wages of less than $200,000 but know that their wages, when combined with their spouse’s wages, will exceed $250,000). In this case, employees should submit a new Form W-4 to increase their withholding for federal income tax purposes. This will then offset the deficit in Medicare withholding when they file their tax returns.
Follow-up on Lawsuits Targeting Stock Plan Proposals On November 6 (“Martha Steward and Your Proxy Statement“), I blogged about a new type of shareholder lawsuit that seeks to extract plaintiffs’ attorney fees from companies by alleging that the disclosures in connection with their stock plan proposals (e.g., adopting a new stock plan or allocating shares to an existing plan) are inadequate. There now have been over 30 of these suits filed, with no end in sight as proxy season ramps up. We’ve posted a new alert, “Shareholder Lawsuits Target Stock Plan Proposals,” that collects several law firm memos on the suits as well as a interesting commentary on them from Stanford (“Shareholder Lawsuits: Where Is the Line Between Legitimate and Frivolous?“). It’s worth your time to catch up on this issue.
This week, I have a couple of updates on the tax rates and procedures for withholding federal income taxes on supplemental payments.
2013 Supplemental Withholding Rates When Jenn blogged about the American Taxpayer Relief Act last week, the ink was still wet on President Obama’s signature on the Act and we were all still trying to figure out exactly what it meant in terms of tax withholding in 2013. It now seems clear that the flat rate that applies to supplemental payments of $1 million or less per year will remain at 25% and the flat rate that applies to supplemental payments of more than $1 million has increased to 39.6%.
ADP has confirmed these rates and, while that isn’t quite the same thing as the IRS confirming them, my sense is that ADP knows what they are talking about, their confirmation agrees with my understanding of how these rates work, and it agrees with what I’ve heard from other practitioners (e.g., Baker & McKenzie), so I’m considering this issue put to rest.
No Other Rate is Allowed While we’re on the topic of supplemental rates, a question I get frequently is whether companies can permit employees to request that taxes on their stock plan transactions be withheld at a higher rate than the prescribed flat rate. This was a topic of two of my earliest blog entries (“Excess Tax Withholding,” December 1, 2008 and “Excess Tax Withholding – Part 2,” December 9, 2008).
In September of last year, the IRS issued Information Letter 2012-0063 confirming that when you are using the flat rate (regardless of whether you are choosing to use the flat rate over the employee’s W-4 rate on an optional basis or the employee has received over $1 million in supplemental payments for the year and you are required to withhold at the maximum rate), you are required to withhold at the specified rate (25% for optional flat rate withholding, 39.6% for mandatory flat rate withholding). From the IRS’s discussion of optional flat rate withholding:
“If the employer is using the optional flat rate withholding method, the employer must withhold at the optional flat rate and cannot take into account requests by the employee that the rate be increased or lowered. Only one rate applies for purposes of optional flat rate withholding on supplemental wages.”
Where employees have received more than $1 million in supplemental payments, you have to withhold federal income tax at 39.6% on their stock plan transactions–no other rate (either higher or lower) is permissible.
Where employees have recieved $1 million or less in supplemental payments, the only way to withhold federal income tax at a rate of other than 25% is to use the employee’s W-4 rate (which the IRS refers to as the “aggregate procedure”). In that case, you could have the employee complete a new W-4 requesting the higher rate for federal income tax purposes just prior to his/her stock plan transaction and then complete another W-4 resetting the FIT rate back to the prior rate after the stock plan transaction is concluded (without the second W-4, the higher rate will apply to all of the employee’s regular pay). But then you’d have to figure out the W-4 rate–good luck with that.
Where you don’t want to deal with the hassle of figuring out W-4 rates, you can offer employees two other alternatives when they are worried that the withholding on their stock plan transactions isn’t sufficient:
Increase the withholding on their regular pay (which does require a new W-4, but at least you don’t have to be involved).
Make estimated payments to the IRS.
The information letter doesn’t provide any information on what the penalties would be if you do withhold at a different rate without following the W-4 procedure or whether those penalties would apply to the company or the employee. For now, those mysteries remain unsolved.
On New Year’s Eve, as I was watching the various countdowns and celebrations on TV, I couldn’t help but notice the volume of interruptions and the stark contrast of “serious” reporting going on about the fiscal cliff negotiations. It was like watching two different television shows at once: celebrate, fiscal cliff, celebrate, fiscal cliff. All that reporting did lead to somewhere this time – a deal was eventually reached and passed shortly thereafter (formally known as “The American Taxpayer Relief Act 89-8”). Sorting through the outcomes has become the next challenge at hand. In today’s blog I’ll attempt to provide the current lay of the land for tax withholding in 2013.
For Many, A Reprieve
One of the big stories of the fiscal cliff doom scenario was that not only were some tax cuts expiring, but that there were so many of them slated to change all at once. The Bush Era income tax rates were set to expire and revert upward. The Social Security payroll tax holiday was coming to an end. New medicare rates were set to be introduced in 2013 for high earners and on certain types of income. So what’s the bottom line? What changed and what didn’t? The good news for many taxpayers is that it’s not as bad as it could have been, though some taxes will still increase. Higher earners will be impacted more, with increased federal rates.
Federal Withholding Rates: The American Taxpayer Relief Act effectively maintains the reduced income tax rates adopted in 2001 and 2003 for individuals earning up to $400,000 and families earning less than $450,000. Income above those levels will be taxed at 39.6%, up from 35%.
Social Security: The end of the road has come for the Payroll tax holiday of 2011 that was eventually extended through 2012. That means the 4.2% employee withholding rate that’s been in effect for the past two years has returned to 6.2% effective January 1, 2013. Employers have until February 15, 2013 to implement the new rate and until March 31, 2013 to make any adjustments related to rate implementation post effective date.
Medicare: The new medicare tax rate previously enacted remains in force and unchanged. Essentially, for income over a certain threshold, an additional 0.9% in medicare tax is withheld beginning with tax years after December 31, 2012. For more details, click here or visit our Tax Withholding and Reporting Portal.
Supplemental Income Withholding Rates: At this point, our eyes are looking for additional guidance from the Treasury Department on the status of supplemental income withholding rates. Our current thought is that the rate for supplemental payments below $1 million will stay at 25%, since this is tied to the third highest individual tax rate (which didn’t change), but that the rate for supplemental payments in excess of $1 million will increase to 39.6%, since this is tied to the highest individual tax rate. This interpretation is not based on any guidance from the Treasury, and we’ll have to wait until they release more information to confirm this component.
Timeframe to Implement
Companies have until February 15, 2013 to make the changes to withholding rates. It may make sense to move forward in making changes to known rates (like social security and medicare) as quickly as possible, and wait a bit longer to change other rates until the Treasury has issued further guidance on how the supplemental (and other) rate(s) will be affected. The IRS did release Notice 1036, which is essentially contains the rate tables to guide withholding for 2013, but that was on New Year’s Eve, before the Act was passed. As a result, their 2013 tables will need to be updated to reflect the withholding rates that are now in effect.
The NASPP is Hiring!
On a completely separate note, the NASPP is hiring! Check out our job listing in the NASPP Career Center for additional information.
I wish everyone a happy, healthy and prosperous new year!
For equity compensation transactions that are subject to U.S. federal income tax withholdings, companies can choose to withhold at either the employee’s W-4 amount or the supplemental wage flat rate of 25% for the first $1,000,000 of supplemental wages paid to the employee within a calendar year. As Barbara mentioned in her entry on Excess Tax Withholding, most companies choose to withhold at the flat rate for supplemental wages simply because it is easier than tracking employees’ W-4 rate and applying it. A definition of supplemental wages, the withholding requirements, and examples can all be found in IRC Regulation §31.3402(g)-1.
The Difference $1 Million Makes
In the context of U.S. income tax withholding on equity compensation, $1 million within a calendar year is a threshold for how employers should withhold on supplemental income. Below that amount, a company can choose to withhold at the 25% flat rate or the employee’s W-4 rate. After that amount, a company must withhold at the 35% flat rate.
This means that cumulatively, all supplemental wage payments made in the same calendar year are combined to determine the total supplemental wage payments made to each employee. After an individual reaches $1 million, the flat rate changes from 25% to 35% and the choice to withhold at the employee’s W-4 rate is no longer available. Because equity compensation is considered supplemental wages, stock plan management teams need to be prepared to withhold at the higher level once an employee crosses this threshold.
Supplemental Wages
So, exactly what are supplemental wages? While there are a number of examples specific listed in the Code, many are not. The definition of supplemental wages is “all wages paid by an employer that are not regular wages.” I know, not a lot of help, right? Fortunately, the most common types of supplemental wages are given as examples including cash bonuses, noncash fringe benefits, equity compensation, and commissions. It’s a good idea for stock plan managers to meet with their payroll contacts to confirm that the cumulative year-to-date supplemental wage amount for each employee is being correctly calculated and communicated to the stock plan management team.
Remind Me Again When I Need to Do This?
It sounds pretty simple, right? If a company has paid $500,000 in supplemental wages to an employee, and that employee realizes income from an option exercise in the same calendar year for another $500,000, then the stock plan management team must be prepared to withhold at the 35% flat rate for any additional equity compensation income in that year.
But, what happens if that option exercise is $700,000 instead of $500,000? The IRS has offered companies two methods to handle that situation. If one particular payment (e.g.; one specific option exercise) straddles the $1 million threshold, companies may either withhold at the 35% flat rate for the entire payment or withhold at 35% for only the portion of the payment that exceeds $1 million. So, in my (very simplified) example, the company could withhold on the entire $700,000 RSU vest at 35% or apply the 35% withholding rate to only the $200,000 that exceeds the first $1 million.
As a stock plan manager, make sure you know how your company wants to withhold on single transactions that straddle the $1 million supplemental wage threshold. Also, get a solid understanding of how your stock plan administration software handles this situation.
For more information on tax withholding on equity compensation, visit our Tax Withholding and Reporting portal on the NASPP site.
If you missed the early-bird rates, it’s not too late to get a discount. We are now offering a $200 discount on registration through May 14th. You can even get an additional 10% discount by participating in the 2010 Domestic Stock Plan Design Survey before our final extended deadline tomorrow, April 23rd.