On May 22, 2020, the IRS released an Office of Chief Counsel Memorandum that addresses (i) the date that fair market value is determined and when gross income and federal income tax withholding liability arises for stock-settled awards and (ii) the timing for remitting FICA taxes for such awards. This question comes up frequently and has not always had a clear answer, and so the memo provides important guidance for employers who sponsor equity award plans.
The memo provides that gross income is recognized for income tax withholding purposes on the date nonqualified stock options (NSOs) and stock appreciation rights (SARs) are exercised and on the date the employer initiates settlement of restricted stock units (RSUs), regardless of whether shares ultimately are delivered at a later date. The amount recognized is equal to the fair market value of the shares underlying the award on such date. If awards are settled upon vesting, that would mean that FICA tax withholding liability also arises on the exercise date for NSOs and SARs, and the date the employer initiates settlement of shares for RSUs. Further, the memo held that employers subject to the $100,000 next-day deposit rule must deposit the employment taxes related to the awards within one day of the exercise or settlement initiation date. These holdings are significant, and they also need to be understood in the context of the FICA withholding regulations under IRC Section 3121(v)(2) in order to appreciate them fully. These details are explained in more detail below.
When does income recognition and withholding obligations arise?
As background, participants who receive stock-settled awards typically experience a delay between the exercise of their NSOs or SARs (or the vesting of their RSUs) and the delivery of shares to them (often in the form of a deposit into their brokerage account). Under Securities and Exchange Commission (SEC) rules, the process may take up to two business days. When markets are volatile, there can be a substantial change in the price of the shares underlying an award from the date of exercise or vesting and the date of deposit into the employee’s brokerage account. That makes the question of when income and FICA tax recognition arises important. Should it be on the date of vesting or exercise (the date the transfer process begins), or the date of delivery of the shares?
The IRS had nearly an identical analysis to answer that question for each of the NSOs, stock-settled SARs, and stock-settled RSUs. The IRS explained that a participant acquired a “beneficial” interest in the shares on the date of exercise of the NSOs and SARs, and the date of vesting of the RSUs. On that date, the participant incurs the risk and reward of the stock declining or increasing in value and becomes the legal shareholder who has dividend and voting rights and the right to sell, transfer, and pledge the shares.
The treatment of RSUs, however, requires additional discussion. That is because RSUs often are treated as nonqualified deferred compensation. NQDC amounts generally are recognized in taxable income when paid, not at vesting. In fact, the IRS acknowledged that RSUs typically are treated as nonqualified deferred compensation (subject to potential exceptions), while NSOs and SARs are not, but it still applied the same type of analysis to the RSUs as it did to NSOs and SARs. Yet, a closer reading of the facts of the Memo suggest that the IRS did not change the law. In the example in the memo, the RSUs were settled on the same day as vesting, and so those particular RSUs were not deferred compensation under the FICA tax regulations (or Code Section 409A for that matter).
So, while not entirely clear, the memo’s reasoning, combined with application of the FICA tax regulations under IRC Section 3121(v)(2), suggests the following results for income recognition and tax withholding for stock-settled awards:
- For stock-settled NSOs and SARs, the employee is considered the beneficial owner of the shares on the exercise date, not the share delivery date. Accordingly, gross income recognition, federal income tax withholding, and FICA tax withholding arise on the exercise date. The amount taken into account for employment tax withholding, and the amount of gross income recognized, is equal to the fair market value of the shares on the exercise date.
- For stock-settled RSUs that are not considered nonqualified deferred compensation (because they are settled at vesting or within the applicable short-term deferral period), gross income recognition, federal income tax withholding, and FICA tax withholding arise on the date the employer initiates settlement of the shares. In the memo, that date happened to take place on the vesting date, but it is possible that settlement may commence on a later date.
- For stock-settled RSUs that are considered nonqualified deferred compensation (because they are settled (i.e., the shares are delivered) beyond the applicable short-term deferral period), FICA tax withholding arises on the vesting date, and the amount taken into account for FICA wages is the fair market value of the shares on the vesting date. That is consistent with the regulations under IRC Section 3121(v)(2), and nothing in the Memo suggested that the analysis has changed. In some cases, the regulations may allow FICA wages and withholding to occur on a later date, such as under the rule of administrative convenience. Gross income recognition and federal income tax withholding, however, arise on the date that the employer initiates settlement of shares (not the share delivery date).
When employers must remit income and FICA tax withholdings
Understanding when withholding obligations arise leads to a related question of when the employer must remit its tax withholding obligations. Applicable regulations provide that once employers must remit employment taxes to the IRS within one business day after an employer accumulates $100,000 or more of employment taxes on any given day. In the memo, the IRS held that when this rule is triggered from the exercise or vesting (or share settlement initiation date) of stock-settled awards, the employer must remit the employment taxes within one business day of such date, not the date the shares actually are delivered. In other words, the employer may be required to remit employment taxes to the IRS before the shares are deposited in the participant’s brokerage account.
Unfortunately, this holding raises a couple of practical questions. One is whether a company that normally sells the shares to cover the tax withholding obligation would have the cash necessary to pay the employment taxes. Another question is whether the payment of employment taxes before actual withholding could be considered a personal loan form the company to the participant. If the participant is an executive officer, such a loan could violate applicable securities laws.
Interestingly, several years ago, the IRS issued a directive in which it said that it would not challenge the timeliness of employment tax remittances with respect to NSOs so long as the remittances were (i) made within one business day of settlement and (ii) still occurred within three business days of exercise. The memo is not entirely clear on whether the IRS will still abide by that directive (let alone expand its application to SARs and RSUs), or whether the Memo effectively reverses that directive.
Next steps for employers
The memo provides important guidance and requires employers to make the following decisions:
- Are stock-settled RSUs deferred compensation or not?
- When do income and FICA tax withholding obligations arise with respect to stock-settled awards?
- What amount should be recognized in gross income (and taken into account as wages) on the date that the employment tax obligations arise?
- When must the employer remit its withholding obligations?
Employers should consult with legal counsel to determine the position it will take with respect to the timeliness of employment tax remittances for these awards.