Earlier today, the IRS issued Notice 1036, which updates the tax tables and withholding rates for 2018 to reflect the new marginal income tax rates implemented under the Tax Cuts and Jobs Act.
The flat rates that apply to supplemental payments are updated as follows:
For employees who have received $1 million or less in supplemental payments during the calendar year, the flat rate is 22% (the third lowest income tax rate).
For employees who have received more than $1 million in supplemental payments during the calendar year, the flat rate is 37% (the maximum individual tax rate).
As under prior rules, for employees who have received $1 million or less in supplemental payments, the company can choose to withhold at either the flat rate or the W-4 rate (which also changes as a result of Notice 1036). Where employees have received more than $1 million in supplemental payments, this choice is not available; the company must withhold at the specified flat rate (now 37%).
While companies have until February 15 to implement the new rate tables, the IRS encourages companies to implement them as soon as possible and I expect that many companies will switch to the new flat rates immediately. Where shares are being withheld to cover taxes, withholding at greater than 37% could now trigger liability accounting.
– Barbara
P.S. Thanks to Andrew Schwartz of Computershare for alerting me to the IRS’s announcement.
On Wednesday, the final version of the tax reform bill was passed in both the House and Senate. There were a few small changes to the bill at the last minute, but none of them impact what I wrote about on Tuesday. Since the bill changes individual tax rates, some of you may be wondering if you need to update your withholding rates on January 1.
It’s Still Just a Bill, Sitting There on Capital Hill
Hold your horses, there, buckaroo. If you are old enough to remember Schoolhouse Rock’s I’m Just a Bill, you know that the passage of a bill by Congress doesn’t make legislation a law (unless the bill has already been vetoed by the president and two-thirds of Congress votes for it). The legislation still has to be signed by the president. Although Trump’s signature seems like a formality with the tax bill, it still has to happen (rules are rules); moreover, there is speculation that the bill won’t be signed until January (“It’s Unclear When Trump Will Actually Sign the Tax Bill,” Bloomberg.com).
Tax Withholding Rates for 2018
Most of the provisions in the bill, including the new individual tax rates, are effective as of January 1, 2018. This does not mean that you have to rush to update tax withholding rates, however (especially if the bill hasn’t been signed into law as of January 1). The IRS has to issue guidance updating the tax rate tables and withholding procedures before you can withhold at the new rates. Of course, the IRS can’t issue any guidance until the bill becomes law (and if the looming government shutdown happens, this could impact how quickly the IRS can issue its guidance). The following announcement is posted to the IRS website:
The IRS is continuing to closely monitor the pending legislation in Congress, and we are taking the initial steps to prepare guidance on withholding for 2018. We anticipate issuing the initial withholding guidance (Notice 1036) in January reflecting the new legislation, which would allow taxpayers to begin seeing the benefits of the change as early as February. The IRS will be working closely with the nation’s payroll and tax professional community during this process.
Your payroll provider should be a great resource when tax withholding rates change, since this will impact all compensation subject to withholding, not just stock compensation. An announcement on the ADP website notes that companies should continue to apply 2017 withholding rates until the IRS issues new guidance (“Federal Tax Reform Legislation May Be Imminent: Impact to 2018 Payroll Calculations May Be Delayed“)
Thanks to Marlene Zobayan for bring this concern to our attention.
Transactions on December 31, 2017
As a reminder, transactions that occur on December 31, 2017 are still occurring in the 2017 tax year, even if the FMV for these transactions isn’t known until market close on December 31 (market close does not mark the end of the tax year) and even if the transactions aren’t settled until 2018 or the shares acquired under the transactions aren’t issued until 2018. Most companies have to complete a special payroll run in the first week of 2018 to add late December transactions to Forms W-2.
With tax rates changing for 2018, it is especially important to include transactions in the correct tax year. Failure to do so could cause employees to underpay or overpay taxes due on the transaction and underpayments could be subject to penalties. (Remember that even though the withholding rate may not change until February, withholding is only an estimate of employees’ tax liability. Their actual liability will be based on the rate in effect at the time of their transaction; any excess withholding will be refunded to them when they file their tax return.)
This is a good reason to avoid scheduling vesting dates for December 31; see the November-December 2016 NASPP Advisor for nine more reasons to avoid December 31.
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.
For today’s blog, I feature five trends in tax withholding practices for restricted stock and units, from the 2016 Domestic Stock Plan Design Survey (co-sponsored by the NASPP and Deloitte Consulting):
Share Withholding Dominates; Sell-to-Cover Is a Distant Second. The majority (79% of respondents for executive transactions, 77% for non-executive transactions) report that share withholding is used to fund the tax payments the majority (greater than 75%) of award transactions. Most of the remaining respondents (17% of respondents for executive transactions, 18% for non-executive transactions) report that sell-to-cover is used to pay the taxes due on the majority of award transactions.
Rounding Up Is the Way to Go. Where shares are withheld to cover taxes, 75% of respondents report that the shares withheld are rounded up to the nearest whole share. Most respondents (62% overall) include the excess with employees’ tax payments; only 13% refund the excess to employees.
FMV Is Usually the Close or Average. The overwhelming majority (87%) of respondents use the close or average stock price on the vesting date to determine taxable income. Only 12% look to the prior day’s value to determine taxable income, despite the fact that this approach provides an additional 24 hours to determine, collect, and deposit the tax withholding due as a result of the vesting event (see “Need More Time? Consider Using Prior Day Close“).
Form 1099-B Is Rare for Share Withholding. Although share withholding can be considered the equivalent of a sale of stock to the company, only 21% of respondents issue a Form 1099-B to employees for the shares withheld.
Companies Are Split on Collecting FICA from Retirement Eligible Employees. Where awards provide for accelerated or continued vesting upon retirement, practices with respect to the collection of FICA taxes are largely split between share withholding and collecting the tax from employees’ other compensation (41% of respondents in each case).
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 Social Security Administration has announced that the maximum wages subject to Social Security will remain at $118,500 for 2016. The rate will remain at 6.2% (changing the tax rate requires an act of Congress, literally), so the maximum Social Security withholding for the year will remain at $7,347.
As noted in the SSA’s press release, increases in the Social Security wage cap are tied to the increase in inflation as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers. The Bureau of Labor Statistics found no increase in inflation over the past year based on this index, so there are no cost of living adjustments to Social Security benefits or the wage cap.
For those of you keeping score, the last time the Social Security wage base remained the same for a two years in a row was 2010 to 2011 (see “Social Security Wage Base Will Not Increase for 2011“), but in that year the Social Security tax rate was temporarily reduced.
A few other things that currently are not scheduled to change for next year:
The Medicare tax rates remain the same and there’s still no cap on Medicare. The wage threshold at which the additional Medicare tax must be withheld is still $200,000.
The flat supplemental rate is still 25% and the maximum individual tax rate is still 39.6%.
The threshold at which supplemental wages become subject to withholding at the maximum individual tax rate is still $1,000,000.
The compensation threshold at which an employee is considered highly compensated for purposes of Section 423 will remain $120,000.
Note that all of the above items can be changed by Congress and Congress has been known to sometimes make changes to next year’s tax rates very late in the year (e.g., see the 2011 alert noted above). But as things stand now, you have one less thing to worry about on your year-end checklist (but don’t forget that you still need to reset year-to-date wages/withholding back to $0 after December 31).
Last week, I covered the basic rules that apply for tax purposes when options are exercised or awards pay out after an individual has changed status from employee to non-employee or vice versa. Today I discuss a few more questions related to employment status changes.
Is it necessary that the consulting services be substantive?
When employees change to consultant status an important consideration is whether the consulting services are truly substantive. Sometimes the “consulting services” former employees are providing are a little (or a lot) loosey goosey (to use a technical term). For example, sometimes employees are allowed to continue vesting in exchange for simply being available to answer questions or for not working for a competitor. It this case, it’s questionable whether the award is truly payment for consulting services.
A few questions to ask to assess the nature of the consulting services former employees are performing include whether the former employee has any actual deliverables, who is monitoring the former employee’s performance and how will this be tracked, and will the award be forfeited if the services are not performed.
If the services aren’t substantive, it’s likely that all of the compensation paid under the award would be attributable to services performed as an employee (even if vesting continues after the employee’s termination) and subject to withholding/Form W-2 reporting.
Is the treatment different for an executive who becomes a non-employee director?
Nope. The same basic rules that I discussed last week still apply. The only difference is that I think it’s safe to presume that the services performed as an outside director will be substantive (unless the director position is merely ceremonial).
What about an outside director who is hired on as an executive?
The same basic rules still apply, except in reverse. For options and awards that fully vested while the individual was an outside director, you would not need to withhold taxes and you would report the income on Form 1099-MISC, even if the option/award is settled after the individual’s hire date.
For options and awards granted prior to the individual’s hire date but that vest afterwards, you’d use the same income allocation method that I described last week. As I noted, there are several reasonable approaches to this allocation; make sure the approach you use is consistent with what you would do for an employee changing to consultant status.
What about a situation where we hire one of our consultants?
This often doesn’t come up in that situation, because a lot of companies don’t grant options or awards to consultants. But if the consultant had been granted an option or award, this would be handled in the same manner as an outside director that is hired (see the prior question).
What if several years have elapsed since the individual was an employee?
Still the same; the rules don’t change regardless of how much time has elapsed since the individual was an employee. The IRS doesn’t care how long it takes you to pay former employees; if the payment is for services they performed as employees, it is subject to withholding and has to be reported on a Form W-2.
So even if several years have elapsed since the change in status, you still have to assess how much of the option/award payout is attributable to services performed as an employee and withhold/report appropriately.
What if the individual is subject to tax outside the United States?
This is a question for your global stock plan advisors. The tax laws outside the United States that apply to non-employees can be very different than the laws that apply in the United States. Moreover, they can vary from country to country. Hopefully the change in status doesn’t also involve a change in tax jurisdiction; that situation is complexity squared.
Finally, When In Doubt
If you aren’t sure of the correct treatment, the conservative approach (in the United States—I really can’t address the non-US tax considerations) is probably going to be to treat the income as compensation for services performed as an employee (in other words, to withhold taxes and report it on Form W-2).
What is the US tax reg cite for all of this?
My understanding is that none of this is actually specified in the tax regs—not even the basic rules I reviewed last week. This is a practice that has developed over time based on what seems like a reasonable approach.
For today’s blog entry, I discuss how stock plan transactions are taxed when they occur after the award holder has changed employment status (either from employee to non-employee or vice versa). This is a question that I am asked quite frequently; often enough that I’d like to have a handy blog entry that I can point to that explains the answer.
The basic rule here is that the treatment is tied to the services that were performed to earn the compensation paid under the award. If the vesting in the award is attributable to services performed as an employee, the income paid under it is subject to withholding and reportable on Form W-2. Likewise, if vesting is attributable to services performed as a non-employee, the income is not subject to withholding and is reportable on Form 1099-MISC.
Where an award continues vesting after a change in status, the income recognized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is allocated based on the portion of the vesting period that elapsed prior to the change in status.
For example, say that an employee is granted an award of RSUs that vests in one year. After nine months, the employee changes to consultant status. The award is paid out at a value of $10,000 on the vest date. Because the change in status occurred after three-fourths of the vesting period had elapsed, 75% of the income, or $7,500, is subject to tax withholding and is reportable on the employee’s Form W-2. The remaining $2,500 of income is not subject to withholding and is reportable on Form 1099-MISC.
What if the award is fully vested at the time of the change in status?
In this case, the tax treatment doesn’t change; it is based on the award holder’s status when the award vested. For example, say an employee fully vests in a award and then later terminates and becomes a consultant. Because the award fully vested while the individual was an employee, the award was earned entirely for services performed as an employee and all of the income realized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is subject to withholding and is reportable on Form W-2.
This is true no matter how long (days, months, years) elapse before the settlement. Under Treas. Reg. §31.3401(a)-1(a)(5), payments for services performed while an employee are considered wages (and are subject to withholding, etc.) regardless of whether or not the employment relationship exists at the time the payments are made.
What is the precise formula used to allocate the income?
There isn’t a precise formula for this. We asked Stephen Tackney, Deputy Associate Chief Counsel of the IRS, about this at the NASPP Conference a couple of years ago. He thought that any reasonable method would be acceptable, provided the company applies it consistently.
The example I used above is straight-forward; awards with incremental vesting are trickier. For example, say an employee is granted an NQSO that vests in three annual installments. 15 months later, the employee changes to consultant status.
The first vesting tranche is easy: that tranche fully vested while the individual was an employee, so when those shares are exercised, the entire gain is subject to withholding and reportable on Form W-2.
There’s some room for interpretation with respect to the second and third tranches, however. One approach is to treat each tranche as a separate award (this is akin to the accelerated attribution method under ASC 718). Under this approach, the second tranche is considered to vest over a 24-month period. The employee changed status 15 months into that 24-month period, so 62.5% (15 months divided by 24 months) of that tranche is attributable to services performed as an employee. If this tranche is exercised at a gain of $10,000, $6,250 is subject to withholding and reported on Form W-2. The remaining $3,750 is reported on Form 1099-MISC and is not subject to withholding. The same process applies to the third tranche, except that this tranche vests over a 36-month period, so only 41.7% of this tranche is attributable to services performed as an employee.
This is probably the most conservative approach; it is used in other areas of the tax regulation (e.g., mobile employees) and is also used in the accounting literature applicable to stock compensation. But it isn’t the only reasonable approach (just as there are other reasonable approaches when recording expense for awards under ASC 718) and it isn’t very practical for awards with monthly or quarterly vesting. It might also be reasonable to view each tranche as starting to vest only after the prior tranche has finished vesting. In this approach, each tranche in my example covers only 12 months of service. Again, the first tranche would be fully attributable to service as an employee. Only 25% of the second tranche would be attributable to services as an employee (three months divided by 12 months). And the third tranche would be fully attributable to services performed as a consultant.
These are just two approaches, there might be other approaches that are reasonable as well. Whatever approach you decide to use, be consistent about it (for both employees going to consultant status as well as consultants changing to employee status).
Read “Employment Status Changes, Part II” to learn about additional considerations and complexities relating to changes in employment status.
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.
As the year draws to a close, now is the time to ensure the tax withholding ducks are all in a row. It’s far more challenging to correct tax withholding mistakes after year-end than before, so if there are any areas that need audit or attention, this is the moment of truth – you may still have a pay period to make those corrections. Along those lines, the IRS recently released additional clarification on procedures related to the additional medicare tax withholding that was implemented this year. In today’s blog I’ll highlight some highlights from the IRS’s Q&A.
A Quick Recap
To recap in a nutshell – we should all be aware by now that beginning January 1, 2013, an “additional” Medicare withholding tax went into effect for high earners. Essentially, employers need to collect an additional 0.9% of Medicare tax on wages in excess of $200,000. Ultimately the threshold for the tax to kick in is $250,000 of income for a married couple and $200,000 for individuals, but employers are not required to gather any information to determine the employee’s true liability. That at least keeps it easy – anything over $200,000 in wages will incur the additional tax from an employer perspective. That recapped, there are some nuances you’ll want to make sure you’ve accurately interpreted this year.
Employees can’t voluntarily increase their medicare withholdings
The IRS’s Q&A clarified that employees can’t request to increase their Medicare withholdings. Why would this be a question? I could see a family where two earners each make $150,000 in wages, but neither exceeds the individual $200,000 income amount that would trigger additional withholding by their employer. Together they make $300,000, so they would owe 0.9% in additional medicare taxes on $50,000 of income. One or both employees may consider approaching their employer close to year end to request additional Medicare taxes be withheld to satisfy the higher obligation they will have on their last $50,000 of combined income. The IRS has nixed the ability to do this. However, there may be a solution – employees can complete a W-4 Form to increase their income tax withholdings. They just can’t specifically request to withhold additional Medicare.
The definition of wages includes non-cash fringe benefits
Ensuring year-to-date income amounts are contemplated in withholding has long been a balancing act. The additional medicare becomes another tax where an income threshold must be monitored and considered. One important piece to remember is that non-cash fringe benefits are also included in the year-to-date wage threshold, so those components need to be included in any year-to-date income calculations. It may be worth checking with Payroll to ensure those fringe benefits have been included in year-to-date figures.
Employees will have to file Form 8959 with the IRS if additional Medicare tax is withheld
Even though employers will be reporting the Additional Medicare Tax on the employee’s Form W-2, employees will still need to file Form 8959 with the IRS to essentially reconcile their Medicare tax liability. This is where they would determine any additional amounts due, or any overpayments made. This is probably news to most employees, who probably haven’t considered that they will need to file any type of form reporting Medicare payments to the IRS.
Employers can’t stop withholding the additional Medicare tax once the $200,000 income threshold has been reached and withholding is required.
Once the additional Medicare tax kicks in, the employer cannot stop withholding that tax for the remainder of the calendar year. A likely scenario would be where an employee’s combined income with their spouse won’t exceed the $250,000 income amount for couples, but the individual employee’s income will exceed $200,000 and withholding of the additional tax is required for the spouse that will exceed $200,000. The employee may present a case that their combined income won’t trigger the tax, but employers will still have to withhold based on the employee’s individual income situation. The employee will need to complete Form 8959 to get a credit back for the additional Medicare withholdings. As far as I can tell, Form 8959 is still in draft form and the final hasn’t been released (please, someone correct me if that’s not the case).
Now is the time to ensure your withholdings are in order before the end of the year. You may also consider including some of the above points and examples in your year-end employee communications.