Stock Options and 3121(v)

[Guest Mfcavo]

Can stock options qualify as porperty for the purposes of section 3121(v) if distributed from nonqualified plan.

[pjkoehler]

In Revenue Ruling 78-185, the Service addressed employment tax treatment of nonqualified stock options. It held that the spread between the exercise price and the FMV on the exercise date, including the value of a discount on the date of grant, is wages when the option is exercised. The Service's position in the context of incentive stock options is a little less clear, but seems to be that the spread between the exercise price and the FMV on the date of a "disqualifying disposition" is "wages" for FICA/FUTA purposes, although there is no withholding obligation. See also Reg. Sec. 31.3121(v)(2)-1(B)(3)(ii), which provides that neither the grant nor exercise of stock options is entitled to treatment under the special timing rule regarding deferrals under a nonqualified deferred compensation, because such arrangements do not result in the deferral of compensation. Thus, Sec. 3121(v) is not on point.

[This message has been edited by PJK (edited 04-14-2000).]

[KJohnson]

PJK--What is your read on FSA 199926034? Does this change your view on the FICA withholding requirement on disqualifying dispositions?

[Guest EAKarno]

I think the question that was actually asked is far more complex than the answer given realized.

I believe the question addresses a nonqualified deferred compensation plan that allows deferrals to be invested in, among other things, stock options. If so, in the case of a distribution in kind of a stock option, the question seems to be asking whether this is a new transfer of property subject to Section 3121(v). I think that the answer is that it is.

The initial deferral would be FICA taxed when vested, however, if the deferral is credited to a stock option and distributed in such form, I think the service will take the position that the transaction remained open and that the intial FICA was paid on the base purchase price of the option under the NQDC arrangement. When the option is later exercised, the spread less the basis will be subject again to FICA and income taxation. I cannot cite any authority except that this would be in keeping with the IRS position on nonqualified stock options in general, albeit, different than the position the Service announced in the Travelers ruling which dealt with the very different realm of a qualified plan. By the way, whatever happened to the Travelers plan, anyone know?

[pjkoehler]

KJohnson, I read FSA199926034 as limited to ESPP transactions, so it's not really directly on point with respect to NQSO transactions. Do you consider the scope of the advice memo to include NQSO transactions? Apparently, after issuing a number of inconsistent PLRs, the Service takes the position that the excess of FMV of ESPP stock on the exercise date over the option price is "wages" for FICA taxation purposes. But, this is consistent with the position take the Service takes with respect to NQSO transactions in Rev. Rul. 78-185, i.e. the ordinary income recognized upon exercise of a NQSO is subject to FICA/FUTA taxation as if paid in cash.

A note about ESPP transactions: I think it is still standard practice, notwithstanding the FSA, for employers to rely on the IRS's official guidance with respect to ISOs in Rev. Rul. 71-52 and Notice 87-49, which conclude that FICA/FUTA taxes are not due in connection with an ESPP grant, exercise or sale of ESPP stock, regardless of whether the sale constitutes a disqualifying disposition.

[IRC401]

1. It isn't clear what the initial question was. If you are asking about options inside of a NQDC program, the answer depends on what kind of option is being "purchased". If the option is publicly traded, the tax consequences are no different than if the underlying stock were "purchased". If the option does not have a readily ascertainable FMV (within the meaning of the section 83 regs), then the NQDC is being converted into an option, and taxation is governed under the section 83 regs. I would guess that at least three of the "big 5" accounting firms are out trying to convince big organizations to convert there NQDC into discounted options. As far as I know, the IRS has never objected to companies converting NQDC into options and vice-versa.

2. Rev Rul 71-52 doesn't deal with 423 plans (or ESPP plans). It deals with qualified stock options, a predecessor of ISOs. If you believe that the Rev. Rul was well reasoned, it is logical to extend it to section 423 plans. If you believe that the Rev Rul was a gift from the IRS, then accept the gift for what it is and realize that it doesn't apply to section 423 plans.

I think that the FSA was the IRS' way of attempting to limit the Rev. Rul. I don't know why it wouldn't be easier for the IRS to issue a new Rev Rul repealing the old one than to issue an FSA. Furthermore, I think that the IRS should be held in contempt for ignoring the Rev Rul with dealing with disqualifying dispositions of ISOs.

[Guest EAKarno]

IRC401,

Without clarification from Mfcavo I cannot be 100%certain, however I am fairly certain that what is going on is that one of the investment benchmarks within the NQDC plan is company stock options (with no readily ascertainable FMV). Although still rare, this is becoming a more popular technique. Typically the options are priced at the "Black-Scholes" value, though one client of ours simply uses a two for one pricing structure (probably an overvaluation of the option). The question that arises, however, is what to do if the NQDC plan participant terminates before exercising. If you simply cash out the participant at the current Black-Scholes value there is no problem. If, however, you make an in kind distribution of the option, as Mfcavo seems to be indicating, you have questions that arise regarding Section 83 and 3121(v) -- which I previously addressed.

This has nothing to do with Keysops or the like, it is simply an extension of the Travelers PLR that ok'd the use of company stock options within a 401(k) plan.

Regards,

Eric

[IRC401]

ERIC-

I have no better understanding of the facts than you do. Assuming that your explanation is correct, there is an issue whether the employee gets his FICA "basis" or loses it when the option is granted (and I know of no ruling on the subject). You have "fairness" on your side. On the other hand, the IRS could take the position that when you accept an option grant, you agree to play by the option rules, and you ignore any predecessor NQDC. As of a year or so ago (if my memory is correct), our favorite Big 5 firm was not giving an opinion on this issue.

Because the IRS is probably not thinking about this issue, it would obviously favor taxpayers to take your position.

I believe that the Travelers idea died because of prohibited transaction issues.

[KJohnson]

PJK, I don't think the FSA applies to NQO's but I was wondering how people were looking at this for disqualifying dispositions in ISOs. The FSA seems to take the position that there is no difference between an ISO and an ESPP for purposes of what is wages in a disqualifying disposition and that 71-52 is "discredited" and "nullified" by the Sun Micorsystems ruling.

[pjkoehler]

KJohnson, you've certainly spotted a central issue regarding the tax treatment of ESPP transactions. I think it is clear that an employer does not have to withhold in connection with an ESPP grant, exercise or qualifying stock sale. However, the guidance is murky with respect to whether an employer has to withhold in the event of a disqualifying disposition of ESPP stock. The IRS's official position in connection with the defunct Qualified Stock Options (and its progeny, ISOs) in Rev. Rul. 71-52 and Notice 87-49 is consistent with the position that the employer does not have a withholding obligation in the event of a disqualifying disposition. The FSA, of course, concludes to the contrary. An FSA does not trump a Revenue Ruling or Notice that have not been obsoleted or withdrawn, but the official guidance on its face does not apply to ESPPs, despite a very long industry practice that follows the official guidance. The Tax Court's decision in Sun Microsystems buttresses the IRS's position in the FSA, so I guess you would have to say that as of right now, employers are on thinner ice in continuing to apply the old practice of not withholding on disqualifying dispositions of ESPP stock.

Although I usually don't repeat rumors, I have heard through informal, but well-connected, channels that the Treasury has finalized the ESPP regs and they are sitting on Treasury Assistant Secretary for Tax Policy John Talisman's desk. Something tells me they are unlikely to be published until after the election. As the rumor goes, the regs do not require income tax withholding, but do require FICA withholding on the disqualying disposition of ESPP stock.

[KJohnson]

The IRS has just released its Notice 2001-14, which

(1) provides that, in the case of any statutory option exercised before January 1, 2003, the Service will not assess FICA tax or FUTA tax upon the exercise of the option and will not treat the disposition of stock acquired by an employee pursuant to the exercise of the option as subject

to income tax withholding;

(2) concludes that Rev. Rul. 71-52 is obsolete and that the holding of Rev. Rul. 71-52 does not apply to the exercise of statutory options or to the disposition of stock acquired pursuant to the exercise of statutory options;

and

(3) announces the intent to issue further administrative guidance to clarify current law with respect to FICA tax and FUTA tax on statutory options and to address the issue of whether the disposition of stock acquired by an

employee pursuant to the exercise of a statutory option will be subject to income tax withholding.