The Internal Revenue Service (“IRS”) released two informal updates to guidance on income inclusion timing, and withholding and deposit rules, for stock options and for stock-settled stock appreciation rights (“SARS”) and restricted stock units (“RSUs”). First, the IRS released Generic Legal Advice Memorandum 2020-004 (the “GLAM”) on May 22, 2020, which outlines the views of the IRS Office of Chief Counsel with respect to the timing of income inclusion and the application of Federal Insurance Contribution Act (“FICA”) and Federal income tax (“FIT”) withholding and deposit obligations for three types of stock-settled equity awards. Second, the IRS updated Section 126.96.36.199.2 of the Internal Review Manual (“IRM Update”) on May 26, 2020, to expand the categories of equity awards eligible for certain administrative relief from the penalties of the Next-Day Deposit Rule (described below), while slightly tightening the conditions for such relief.
The application of the income inclusion and FICA and FIT withholding and deposit rules for stock awards are complicated by the fact that there is typically a short delay between the exercise of an option or stock appreciation right (“SAR”) and settlement of the award limited by Securities and Exchange Commission (“SEC”) regulations that apply to transfer agents and securities brokers. (SEC rules historically required settlement within three days, but this period was shortened to two days in 2017.) Similarly, in the case of stock-settled RSUs, there is usually a short delay between the initiation of the transfer of shares, and the actual delivery of those shares to the employee’s brokerage account, in settlement of the RSU, and the SEC requires that this delay be no more than two days. This delay in timing can be especially significant during times in which the market is volatile and the value of the shares can vary dramatically from day to day.
In the case of stock-settled RSUs, IRS guidance to date has left some uncertainty as to whether the date of income inclusion is the date the transfer of stock is initiated or settled. Further, for all three types of awards, the IRS has not previously expressly addressed the issue of the date the employer’s FIT and FICA withholding liability arises (the “liability incurred date”), although the IRS position has been understood to be the date of exercise in the case of stock options. The IRS position with respect to stock options has posed considerable logistical challenges to employers in satisfying the various withholding deposit deadlines, including the “One-Day” rule (also often referred to as the “Next-Day Deposit Rule”), which generally requires an employer, who as of a date within a deposit period has accumulated $100,000 or more of employment tax withholding liability for that deposit period, to remit those taxes by electronic fund transfer to an authorized financial institution by the close of the next business day. Penalties for a failure to deposit (“FTD penalties”) can range from 2% to 15% of the applicable tax, depending on when the deposit is eventually made. These penalties can become substantial when applied to large numbers of stock awards over a number of years even it any one delinquency is not significant.
On account of the logistical difficulties entailed in complying with the One-Day rule, the IRS issued a 2003 Field Directive, which, while not ruling on the issue, states that in the case of nonqualified stock options, agents should not challenge the timeliness of deposits required under the One-Day rule, if such deposits are made within one day of the settlement date, as long as such settlement date does not fall more than three days from date of exercise.” Prior to the issuance of the new 2020 guidance, Internal Revenue Manual (IRM) 29,1,4,26.2 (issued in 2012) provided for an administrative waiver of the FTD penalties by allowing the settlement date to be used as the liability incurred date for purposes of the One-Day rule, so long as the settlement was within three days of exercise. If the settlement date was more than three days from the date of exercise, the third day from exercise was treated as the liability incurred date for purposes of calculating the FTD penalties.
The 2003 IRS Field Directive and IRM have applied by their terms to options only; they have not purported to apply to other stock-based compensation such as RSUs. Nevertheless, some taxpayers have taken the position that the same relief should apply to other stock-based compensation by analogy because the timing concerns are similar. In addition, some have contended that under principles found in various Code sections and Treasury Regulations generally, the FIT tax withholding obligation for RSUs does not arise in any event until the settlement date (as opposed to the date transfer is initiated), because the employee does not receive the stock until the settlement date.
In the GLAM, the IRS examines three situations in which stock-settled awards are granted to employees of a publicly traded corporation and identifies when the awards are (i) included in income under Internal Revenue Code Section 83 (which governs the transfer of property in connection with the performance of services), (ii) subject to FICA taxes, and (iii) subject to FIT withholding. The Memo also discusses the application of the FICA and FIT withholding deposit rules, including the One-Day rule.
- Situation 1 involves a grant to an employee of nonstatutory stock options with no ascertainable fair market value on the date of grant. The IRS reaffirms its long held position that the fair market value (minus the exercise price) of shares of stock transferred to an employee pursuant to a stock option are includible in income under Code Section 83 on the date that the employee exercises the option. In addition, based on inferences drawn from prior revenue rulings, the GLAM takes the position that this amount is treated as wages paid to the employee on the exercise date, triggering the employer’s FICA and FIT wage withholding obligations on that date, even though the shares in settlement of such stock option may not be deposited in the employee’s brokerage account for two days. If, when combined with other wage payments, the employer has accumulated, on the date of exercise, $100,000 or more in employment taxes for the applicable deposit period, the employer must deposit those taxes by the close of the next business day after the date of exercise, again even if the shares have not been settled at that point. The fair market value of the shares on the date of settlement is not relevant for purposes of measuring the employee’s income inclusion or the employer’s withholding obligations.
- Situation 2 relates to a grant of stock-settled SARs to the employee. Under the facts of the GLAM, upon exercise of an SAR, an employee is entitled to the number of shares of employer stock equal to the difference between the fair market value of a share of such stock on the date of exercise over its fair market value on the date of grant, divided by the fair market value of a share of such stock on the date of exercise. The fair market value of the shares received on the date of exercise is includible in income by the employee and constitutes wages paid subject FICA and FIT. Similar to the options, the date of exercise is the liability incurred date, i.e., the date that triggers the requirement for the employer to remit FICA and FIT with respect to such exercise (even though the shares in settlement of such stock option may not be deposited in the employee’s brokerage account for two days). If, when combined with other wage payments, the employer has accumulated as of the date of exercise, $100,000 or more in employment taxes for the applicable deposit period, the One-Day rule requires that the employer deposit those taxes by the close of the next business day after the date of exercise, again even if the shares have not been settled at that point. The fair market value of the shares on the date of settlement is not relevant for purposes of measuring the employee’s income inclusion or the employer’s withholding obligations.
- Situation 3 analyzes a grant of stock-settled RSUs to the employee. The employee’s income inclusion is triggered on the date that the shares are transferred (within the meaning of Section 83 of the Code). The GLAM takes the position that the transfer of shares for purposes of Section 83 occurs when the employer initiates the transfer of shares, even though it may take up to two days for the shares to be deposited in the employee’s brokerage account pursuant to the same SEC rules noted above. The fair market value of the shares on such date constitutes wages subject to FICA and FIT withholding, and the date that the employer initiates the transfer triggers the requirements for the employer to remit FICA and FIT with respect to such transfer (even though shares in settlement of such RSUs may not be deposited in the employee’s brokerage account for two days). If, when combined with other wage payments, the employer has accumulated as of the date transfer is initiated, $100,000 or more in employment taxes, for the applicable deposit period, the employer must deposit those taxes by the close of the next business day after the date that the employer initiates the transfer. As in the case of stock options and SARs, the fair market value of the shares on the date of settlement is not relevant for purposes of measuring the employee’s income inclusion or the employer’s withholding obligations.
Administrative Relief. The GLAM references the administrative waiver issued in 2012 in Section 188.8.131.52.2 of the IRM that provides for the calculation of the FTD penalties, with respect to the transfer of shares pursuant to nonqualified stock options, based on the date of settlement of the shares in the brokerage account rather than the date of exercise of the option. The GLAM states specifically that the GLAM is not updating or expanding such rule to address stock-settled SARs or RSUs, or to modify the waiver to reflect the change in SEC rules to require settlement in two days. Nevertheless, within a week of issuing the GLAM, the IRS issued an “IRM Update” that specifically revises 184.108.40.206.2 to extend the same administrative waiver applicable to stock options to stock-settled SARS and RSUs. In addition, the updated IRM reflects the change in the SEC rules regarding a two, rather than three, day settlement period. Hence, under the new guidance in the case of stock options and SARs, the settlement date rather than the exercise date of the award will be treated as the liability incurred date for purposes of calculating FTD penalties under the One-Day rule, provided that the settlement date is within two days of the exercise date. Similarly, in the case of RSUs, the settlement date rather than the transfer initiation date will be treated as the liability incurred date for penalty purposes, again, provided that the settlement date is within two days of the transfer initiation date. If the settlement date is more than two days after the exercise date or transfer initiation date, as applicable, the liability incurred date is the second day after the exercise date or transfer initiation date, as applicable.
Although the GLAM does not reference the IRM Update, it seems clear that the issuance of the two was coordinated. The intent of the GLAM appears to be to shore up the integrity and consistent application of the rules governing income inclusion, and the FICA and FIT withholding and deposit obligations to the various types of equity awards discussed. The intent of the IRM in turn appears to be to mitigate the practical, logistical challenges employers face in the context of a pristine application of those rules and provide administrative relief subject to the satisfaction of certain conditions.
Finally, please note that the application of the income inclusion and FICA and FIT withholding and deposit rules can vary depending on the specific terms and conditions of the equity award grants. The GLAM explicitly excludes discussions of any nuances not addressed by the simple fact patterns selected for the stock option grant, SAR grant, and RSU grant discussed in the memo. For example, the GLAM does not address the income tax treatment of, and the timing of FIT and FICA withholding on, awards that constitute nonqualified deferred compensation under Section 409A. Further, the deposit obligation rules (and related FTD penalties) are significantly more complex than the One-Day rule discussed in the new guidance. To ensure compliance with the FIT and FICA withholding and deposit rules as applied to more complicated equity awards, and to avoid the application of FTD penalties on equity awards generally, we recommend that companies consult with their executive compensation and employee benefits advisors.