Equity Compensation Withholding and Deposit Timing Rules Clarified
The IRS recently issued written advice clarifying the timing of the taxation and withholding of payroll taxes on certain stock-settled awards issued to employees.
Income and FICA tax withholding and deposit timing rules have always been an issue when an employee receives noncash compensation. For example, amounts may be taxable at a time when the employee has no cash from which to pay the withholding tax that needs to be deposited. Additionally, when dealing with publicly traded securities, there is often a settlement delay — a difference between the date of exercise and the date the stock is deposited in an individual’s brokerage account.
Previous Timeline Requirements
In 2003, the IRS issued a field directive establishing guidelines for IRS agents regarding the assertion of failure to deposit penalties with respect to the exercise of nonqualified stock options (NQSOs). Those guidelines directed agents not to challenge the timeliness of deposits if such deposits were made within one day of the settlement date, as long as such settlement date did not fall more than three days from the date of exercise.
This was based on a Securities and Exchange Commission (SEC) regulation, which allowed a three-day settlement cycle between option exercise and delivery of the shares to the option holder’s account or sale of the shares to cover the exercise price and withholding taxes. In 2017, the SEC changed that rule to two days, causing many to wonder if the IRS rule for the timing of withholding and tax deposits had changed.
Updated Rules
This year that issue was resolved. In a Generic Legal Advice Memorandum, GLAM 2020-004, IRS Chief Counsel described three fact situations, detailing the date for determining the taxable amount and the timing of withholding and payroll tax deposits for:
- Stock-settled NQSOs: An NQSO is a contractual right to purchase a specified number of shares for a specified price during a specified period.
- Stock appreciation rights (SARs): A stock-settled SAR is the right to receive an amount equal to the appreciation in value of a specified number of shares during a specified period.
- Restricted stock units (RSUs): A stock-settled RSU is the right to receive an amount equal to the value of the stock payable in stock.
In the case of stock-settled SARs and NQSOs, the date for determining the taxable amount and when withholding of income and employment taxes should occur is the exercise of the NQSO or SAR. In the case of stock-settled RSUs, withholding of income and employment taxes should occur when the employer initiates the transfer of shares of stock.
For example, if an NQSO is exercised on October 1, and the stock is deposited in the option holder’s brokerage account on October 3, the taxable amount is the value of the stock on October 1, because once the option is exercised the number of shares to be transferred is determined and the option holder bears the risk of price fluctuations.
Employment tax is due when amounts are paid or, in the case of deferred compensation, when services have been rendered and there is no substantial risk of forfeiture of the right to the amount. While NQSOs and SARs are not deferred compensation, an RSU is deferred compensation and thus subject to employment tax at vesting, which could be earlier than the initiation of the transfer of stock to the RSU holder’s brokerage account. If deferred compensation is paid in the year of vesting or within two and a half months after the end of the year, the employer can use the regular rule for withholding rather than the special rule for deferred compensation as long as it does so for all employees receiving RSUs and substantially similar awards.
In addition, there is a rule of administrative convenience that allows a taxpayer to use any value after the vesting date and before the end of the year to determine the taxable amount. This means that the income and employment tax withholding can be at the same time and for the same value.
Tax deposits are due by the close of the next business day for employers with at least $100,000 of employment taxes accumulated to be deposited, or at other specified dates depending on whether the employer is a monthly or semi-weekly depositor.
Waiver
In conjunction with issuing the GLAM, the IRS revised the Internal Revenue Manual to give an administrative waiver for failure to deposit penaltiesin the case of the exercise of NQSOs for employers subject to the requirement to deposit by the next business day. Under this waiver, the date the withholding liability is incurred as a result of the exercise of an NQSO is the settlement date, as long as that date is within three days of the exercise date. If the settlement date is not within three days of the settlement date, the third business day after the exercise is treated as the settlement date for this rule.
Conclusion
The clarification of the timing of taxation that the GLAM provides will be especially important for employers with individuals exercising NQSOs, SARs, or having payment initiated for an RSU at the end of the calendar year.
Note that the taxable event, and reporting of wages on Form W-2 and Form 941, could be earlier than the date stock is deposited in a brokerage account. In those cases, withholding and reporting may need to occur by year end in order to reflect the withholding for the individual’s current year W-2. Even though, in the case of the exercise of NQSO for taxpayers with $100,000 of employment taxes accumulated, the administrative waiver would prevent the assertion of penalties for failure to deposit taxes as long as the deposit occurred using the settlement date as the incurred liability date.
