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.
This week’s NASPP webcast on Understanding Payroll Administration Related to Equity Compensation drew a great turnout, which suggests that the relationship between stock administration and Payroll is something that stock professionals aren’t taking lightly. In today’s blog I offer a few tips for enhancing the synergy between the two functions.
1. Replace ad hoc transaction reporting of option exercises with a routine, fail safe process. How often do you communicate exercises to Payroll? Consider a daily process that will let Payroll know with certainty whether actionable activity occurred or not. Communicating even when “not” provides a confirmation that no action is needed for that day. One best practice includes dropping a daily “transaction” file to a shared network folder, rather than simply emailing it to a designated contact. This is the fail safe part of the process. Sending an email to someone creates more possibility that transactions may be overlooked if the email recipient is absent from the office. Having a secure location accessible by all backup personnel will help avoid oversights or missed activity.
2. Send as much as possible to Payroll before year-end. Year-end is Payroll’s crunch time. Even though stock transactions can occur right up through 12/31, most activity for the year can be reported to Payroll far earlier. Take advantage of Payroll down times to send information and perform reconciliation, rather than attempt a big batch process in January. Payroll will thank you.
3. Watch out for close proximity transactions. If you have multiple transactions occurring in the same time frame, be sure any transaction data sent to Payroll provides clear guidance on the order in which the data is to be entered to Payroll’s system. For example, if a person has a stock option exercise and RSU vest within days of each other, be sure that Payroll knows which to enter first, and replicates the data in the stock system. Absent this guidance, assumptions could be made on the Payroll side that result in entries that do not match up to the stock system.
4. Follow up with former employees routinely to capture address changes. The company’s obligation to report stock plan related income to the IRS doesn’t cease with employment. Reportable ordinary income for former employees is captured on a Form W-2 at year-end, just like active employees. One challenge with this requirement is that former employees not only may need to be reactivated in the Payroll system (particularly if the transaction occurs in a calendar year where they had no other income from the company), but may forget to inform the company of address changes. Don’t wait until year-end to track down former employees – build a process to follow up periodically so that Payroll has plenty of time to ensure the person’s record is active and accurate. Placing a reminder message on the employee section of your vendor web site may be an option (explore this with your service provider) – when the former employee logs in, they see a message reminding them to keep their address information current with the company.
The materials and transcript from this webcast will be available soon (consider this blog a preview if you missed the webcast). As a reminder, our monthly webcasts are free to all NASPP members. Next month’s webcast (March 20th) will delve into one of the more complicated aspects of accounting for stock plans – journal entries and the general ledger.
The upcoming tax season is shaping up to be a confusing one for your plan participants. They will be receiving new bits of information regarding their equity transactions, all intended to be helpful. The problem with information is that it’s only helpful if you can understand it. As your company gears up for your Section 6039 reporting, don’t push cost basis reporting off as an issue that can wait until 2011 year end.
As Barbara pointed out in her June 2nd blog entry, requirements for cost basis reporting come in phases and 2011 marks the first phase. For regular stock sales, this will be very helpful. For equity compensation, however, this first phase actually provides misleading information. The cost basis that is required to be in Box 3 of the new Form 1099-B is only the purchase price of the shares, not the actual cost basis. While it is permissible for brokers to go above and beyond the requirement ahead of schedule, I doubt that it will be feasible for, especially for sales of ESPP shares, to put processes in place to capture and incorporate the necessary information to report the true cost basis for all sales in 2011.
Tower of Babel
What the communication quagmire boils down to is that employees are receiving an increasing number of communications with numbers that represent some piece of their tax puzzle, but not all the numbers will match or even be relevant. The message to your seasoned employees can be simple and clear: There is absolutely no change in the way you need to report your income or capital gains. This is true for both the Section 6039 information statements that employees may receive for this upcoming tax season as well as the changes to 2011 Forms 1099-B. Your new employees or those who still haven’t fully grasped the concepts behind tax reporting, on the other hand, will need to be given the resources to avoid making costly mistakes.
Double Trouble
Just to review, let’s talk about an NQSO exercise. At exercise, the employee realizes income on the difference between the exercise price and the FMV on the exercise date. For example, if 100 shares of an option were exercised for $10 per share when the FMV is $15 per share, the employee would pay an exercise price of $1,000 and realize ordinary income of $500. The new cost basis for these 100 shares is the exercise price plus the income, which is $1500 or $15 per share.
If the exercise in this example takes place in 2011 and the employee sells 11 shares to cover the taxes due, she or he will receive a Form 1099-B from the broker for the 11 shares showing a cost basis of $10 per share. Leaving the fees and commission on the sale out of the conversation, this means that the employee could easily misunderstand and pay capital gains taxes on that same $5 per share that is reported as income on his or her W-2–effectively paying taxes twice.
The Broker Connection
Brokers are making changes to their back-end systems and the user interfaces to accommodate lot ID for sales of shares. Some brokers already have electronic lot selection for some or all brokerage accounts, but the functionality may not yet apply to shares from employer equity plans. You will want to work closely with your broker(s) to understand what any changes will look like for employees, especially if there will be enhanced modeling features. Get educated on how the broker will determine which lot of shares is being sold through employee accounts and if or how employees can designate specific lot sales when selling online.
Now is also a perfect time to provide information to employees on the acceptable methods for determining cost basis of shares and how to plan for tax filing before they engage in a sale. Many brokers have information and FAQs already available that you can leverage to educate your employees.
Because cost basis reporting is only required for sales of shares that were acquired on or after January 1, 2011, you’ll also want to know what your broker is planning to do about reporting for shares purchased prior to 2011.
Break it Down
If possible, provide your employees with an FAQ that illustrates the cost basis of shares sold from each type of equity award that you offer this year so that next year’s conversation won’t mean starting from scratch. If you need a refresher in any of these, the Conference session, “IRS Cost-Basis Reporting: Are Your Stock Plans Ready?” includes a great list. By working to get employees familiar with the term “cost basis” right now, you help them with their tax reporting for this year, making next year’s conversation easier. If you issue ISOs or have an ESPP, any discussion of cost basis must include a refresher on qualifying vs. disqualifying dispositions, which works perfectly into any plans you have in place for educating employees on the Section 6039 information statements they’ll be receiving.
Last month I wrote about divorce and stock plan management, and today I’m going to tackle the other big “d”…death. Although (thankfully) the death of an employee is a relatively unlikely scenario, it’s one that warrants preparation. None of the issues surrounding the death of an employee can be addressed without an underlying consideration for what the decedent’s family will coping with. Not only is the death of a family member an emotional period, there is also a pretty intense amount of paperwork to be completed.
When it comes to handling equity compensation after the death of an employee, there are issues that are straightforward and those that are subject to interpretation and company policy. This week, I’m only going to cover the tax withholding and reporting since the IRS has made this relatively clear.
ISO and ESPP
For both ISOs and 423 ESPP shares transferred to the estate or beneficiary upon the death of an employee, the statutory holding periods for preferential tax treatment no longer apply. When it comes to tax withholding, this means the company is off the hook. However, there remains a reporting obligation both to comply with Section 6039 and to report ordinary income on discounted ESPP. The transfer of ESPP shares is considered a qualifying disposition. The compensation income, which is the lesser of the discount at purchase or the actual gain at the disposition, is reported on the employee’s final Form W-2. For ISOs, because any sale of shares by the estate or beneficiary is treated as a qualified disposition, the company generally has no income reporting or tax withholding obligation.
Section 6039 Considerations
The exercise of an ISO triggers the 6039 reporting obligations regardless of whether the exercise is made by the employee or by the employee’s estate or beneficiary. This means that the company should still furnish an information statement. In addition, for any exercises beginning in 2010, the company must file Form 3921 with the IRS. (Catch up on the latest regarding Forms 3921 and 3922 in Barbara’s post from Tuesday.)
For ESPP, however, the 6039 considerations hinge on how the company issues ESPP shares at purchase as well as the company’s policy regarding the current offering period both come into play. According to the final regulations, if the purchased shares are immediately deposited into the employee’s brokerage account, this is considered the “first transfer of legal title”. Since this is the prevalent practice for ESPP shares, many companies will provide 6039 information statements to employees and file a Form 3022 (for purchase beginning in 2010) to the IRS subsequent to each purchase. In addition, most companies do not permit the estate or beneficiary to purchase shares in the current offering period, refunding accumulated contributions instead.
This means that for most situations involving the death of an employee, the event that triggers 6039 reporting obligations on ESPP shares has already taken place. If, however, the ESPP shares are issued in certificate form or otherwise held in the employee’s name, or if the employee is not automatically withdrawn from the current offering upon death, the company may still have outstanding 6039 reporting obligations when it comes to ESPP shares.
NQSOs
For NQSOs, the company’s withholding and reporting obligations differ depending on whether the exercise by the estate or beneficiary takes place in the same year as the death of the participant or not. In either case, the company’s obligation to withhold income tax no longer applies. If the exercise takes place in a subsequent year, the company generally has no withholding obligation and reports the income on a Form 1099-MISC issued to the employee’s estate or beneficiary. However, if the exercise takes place in the year of the employee’s death, then the company withholds FICA taxes (but no FIT) on the exercise and reports the income and FICA withholding on the employee’s final Form W-2.
If diving into the latest updates on tax withholding and reporting is on your list, then you won’t want to miss the session, “The IRS and Treasury Speak: Hot Tax Topics and Updates” . In fact, we’ve got all the hottest topics lined up for you this year. If you haven’t already, register today! If you’re already registered, don’t forget to let us know which sessions you’ll be attending.
-Rachel
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.
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Employee equity compensation income is reported on a W-2, and non-employee equity compensation income is reported on a 1099-MISC. But, what happens when a person has been both during the vesting period of the grant?
Fully Vested Grants
When an employee terminates his or her employment relationship with the company, but continues to be a service provider, the income reporting and tax withholding requirements change. If the individual does holds only fully vested grants at the point of the status change, then the income reporting and tax withholding is straightforward. Any income from exercises on grants that vested while the individual was an employee is reported on a W-2 and subject to income tax and FICA withholding, even if the exercise is executed when the individual is a non-employee. Likewise, any income from grants that vest after the employment relationship terminated is reported on a 1099-MISC and is not subject to income tax or FICA withholding.
Partially Vested Grants
If that same employee held unvested grants that continue vest after he or she has become a non-employee, then the income should be allocated pro-rata between employee and non-employee income. Any income from shares that are attributable to the period of time when the individual was an employee should be treated as employee wages, while shares that vest after the individual became a non-employee service provider will be treated as non-employee compensation.
Let’s take the example of an employee who becomes a consultant for the company after 600 shares of an option for 1,000 shares have vested, and the option continues to vest while the individual is a consultant. If the individual exercises all 1,000 shares after the option is fully vested, then income from 600 shares is reported as wages on a W-2 and income from the remaining 400 shares is reported as income on a 1099-MISC. If the individual instead exercised only 800 shares, then the company could use the “first-in, first-out” (FIFO) method to attribute the income, allocating 600 shares as earned under the employee relationship and 200 as earned under the consultant relationship.
Your outside directors should be making estimated tax payments to the IRS on compensation they receive from your company in exchange for their services as an outside director. This includes income realized from equity compensation. Sometimes companies are tempted to withhold taxes on outside director stock transaction. At face value, this may appear to be simple common sense–we know that they will owe taxes, why not facilitate a sell-to-cover or withhold shares to cover those tax payments? The truth is that withholding taxes on outside director transactions is something that your company really should not be doing.
Why not withhold shares?
There has recently been a lot of focus on the accounting consequences of withholding shares above the statutory minimum, because this triggers liability accounting under FAS123(R) (see Paragraph 35). Many companies are struggling with this issue when it comes to share withholding on restricted stock in locations where there is no flat statutory tax rate associated with stock transactions. In the case of non-employees, any taxes withheld will be above the statutory minimum. Therefore, if you withhold shares on a transaction made by an outside director, then the entire grant would be classified and accounted for as a liability. Even worse, if you establish a pattern of allowing shares to be withheld above the minimum statutory required tax obligation, then it is possible that you will trigger liability accounting for the entire plan.
Why not withhold FIT?
So, what about facilitating a sale of shares to help the outside director cover taxes due? As attractive as that may sound, this also is a problem for both the company and the outside director. In addition to the general issues surrounding excess tax payments, reporting the income and tax withholding will prove to be a challenge. Payments for services made to non-employees must be reported on a Form 1099-MISC. You can’t properly report that federal tax payment on a 1099-MISC. This is because there is no provision in the tax regulations for withholding taxes on payments made to non-employees. Additionally, if you withhold federal income tax, then the IRS may determine that FICA and FUTA should also have been withheld, which could result in penalties for the company.
Why not withhold FICA?
This is a bad idea all around–bad for the company and bad for the director. The outside director will need to pay both the income taxes and the self-employment taxes on his or her equity compensation from your company. Self-employment tax includes both the FICA payment and what would be the company’s matching payment. If you withhold FICA at the time of the transaction, it won’t exempt the outside director from also having to pay the self-employment tax on that same income. For the company, if FICA is withheld, then the IRS is going to expect to see a matching company payment. Failing to make that matching payment could result in penalties for the company.
Why not just report everything on a W-2?
Reporting payments made to a non-employee on a W-2 goes against Regulation §1.6041-2(a)(2), which specifically states that the W-2 is for reporting payments made to an employee. Additionally, failing to report the income on a Form 1099 puts the company’s tax deduction in jeopardy–the company would need to prove that the outside director had properly reported the income and paid the income taxes and self-employment taxes on it in order to receive the corporate tax deduction.
Ah, but there is an exception.
If your outside director received a stock grant as an employee (before becoming an outside director), then the some or all of the income from a transaction on that grant may be subject to tax withholding and be reported on a W-2.
We have several great resources on the NASPP site to help you deal with your company’s tax withholding and reporting obligations. Our best resource is the NASPP Tax Withholding and Reporting portal. You can also go back and review our annual webcasts on Tax Withholding and Reporting–the 2008 Webcast has fantastic points on dealing with non-employees! Also, don’t forget about the NASPP Discussion Forum. Take advantage of the key word search to find questions other members have submitted; you might find that the answer to your question is already available.