How to view Incentive Stock Options for 401(k) Comp Purposes

[401 Chaos]

We have a 401(k) plan which defines "compensation" generally using the safe harbor definition of

compensation under 1.415©-2(d)(4). That is to say, compensation is defined to include wages as defined in Code section 3401 plus all other payments of compensation to an employee required to be reported under sections 6041, 6051 and 6052.

I am confused as to how income from "disqualifying dispositions" of incentive stock options (ISOs) is handled under this definition. My understanding is that when an employee has a disqualifying disposition of an ISO, the employer is generally required to report the income associated with the disqualifying disposition in Box 1 of the employee's W-2 even though the employer is not required to withhold taxes on the income amount.

Under that interpretation, it seems these disqualifying disposition amounts should be counted as compensation under the safe harbor definition. That is to say, even though they are not wages subject to withholding under 3401, they are other amounts of compensation subject to reporting and seem to be squarely covered.

In looking through various 401(k) treatises, etc., however, I am finding conflicting information. In one, they appear to say that the income amounts from disqualifying dispositions of ISOs are to be included as compensation when using the "wages reported on W-2" safe harbor but should be excluded when using the "wages subject to withholding." That generall seems correct to my basic reading of the definition.

However, I have seen 2 or 3 other treatises and manuals basically say that "amounts realized from the sale, exchange, or other disposition of qualified stock options" are to be excluded from compensation under all the various Code Section 415 definitions / safe harbor definitions. That seems to me to suggest that disqualifying dispositions of ISOs are not counted for compensation purposes under our definition even though the employer may be required to report the income earned on the disposition on Form W-2.

Can anybody verify whether the exclusion of amounts from the disposition of incentive stock options from the general definition of 415© comp carries over to the safe-harbor definitions as well?

[Guest jhall]

I remember looking at a similar issue in the past and was also confused by various summaries or discussions of items in or out of the safe harbor definition. It seems to me though that the proper result is for the regulatory provisions excluding disposition of ISO shares to apply to the basic 6041 / W-2 reporting safe harbor definition rather than just to the primary 415 definition. If the company had to count disqualifying dispositions of ISOs as compensation under the 401(k) plan, it would be virtually impossible for the employer to collect proceeds from the employee's sale of the ISO shares in the marketplace to "fund" the elective deferrals. Seems the only choice would likely be to take more than the regular percentage from future payments to the employee rather than trying to have the employee actual return a portion of the sale proceeds to the company. Although employers may get notice that the ISO shares were sold in a disqualifying disposition (eventually) and thus may need to report the income from that, they really are outside the loop on the sale and actual money changing hands. Hope that helps.