Many employers offer some form of stock-based compensation to employees. In AM-2020-004[1] the IRS has issued guidance related to the computation of payroll and withholding taxes on certain types of such compensation, as well as the timing of payroll tax deposits related to such compensation.

The guidance deals with three different programs:

Nonqualified stock options
Stock-settled stock appreciation rights (SARs)
Stock-settled restricted stock unit (RSU)

The ruling poses an example situation for each of these types of compensation, and looks to resolve the following issue:

When does (i) income inclusion and application of FICA taxes and federal income tax withholding and (ii) the employer's obligation to deposit withheld employment taxes occur with respect to each of the following stock-settled awards?[2]

The memorandum does caution that it is not addressing the impact of the deferral of employer OASDI under CARES Act §2302 for the period from March 27, 2020 through December 31, 2020.

A key complication in dealing with these programs is the inherent short delay between the time an employee exercises the right or, in the case of RSUs, vests in the shares and when the shares are deposited into the employee’s brokerage account. Especially in times when the market is volatile, there can be a substantial difference in the value of the underlying stock between the date the employee exercises the option or vests, and the date the stock is deposited into the brokerage account established to hold the stock.

As the memorandum notes:

When a service provider exercises a stock award (such as a stock option or a stock-settled SAR) or the service recipient initiates payment under a stock award (such as a stock-settled RSU), the service recipient or a securities broker (broker) makes a request to the service recipient’s transfer agent to transfer shares held in the service recipient’s account with the transfer agent to the broker’s account with the transfer agent. The broker then holds the shares on behalf of the service provider until the service provider decides to sell the shares. If, at the time of exercise, the service provider elects to sell shares to pay the exercise price or satisfy the tax withholding obligations, then the broker instructs the transfer agent to sell those shares.

Due to Securities and Exchange Commission (SEC) regulations that apply to transfer agents and securities brokers, there is generally a short delay (settlement cycle) between the exercise of the option and settlement of the option exercise (delivery of the shares to the service provider’s brokerage account or sale of the shares to cover the exercise price/withholding taxes). This same settlement cycle applies to the exercise of a stock-settled SAR as well as the payment under a stock-settled RSU. With respect to a stock-settled RSU, the short delay occurs between initiation of payment by the service recipient and delivery of the shares to the service provider’s brokerage account. Prior to September 5, 2017, the settlement cycle could not exceed three days. On March 22, 2017, the SEC amended the settlement cycle regulations to provide that the settlement cycle could not exceed two days effective September 5, 2017. 17 C.F.R. § 240.15c6-1(a).

Nonqualified Stock Options

The memorandum gives the following definition of a stock option for purposes of this ruling:

A stock option is a contractual right to purchase one or more shares of stock from a corporation by virtue of an offer of the corporation continuing for a stated period of time, whether or not irrevocable, to sell such stock at a specified price.[3]

The fact situation posed in the memorandum for the stock option is as follows:

On January 2, 2020, Employer (a publicly traded corporation) grants Employee a nonstatutory stock option to purchase 10 shares of Employer stock. The exercise price is $10 per share, which is the fair market value of each share on the date of grant. On the date of grant, the stock option has no readily ascertainable fair market value as defined in Treas. Reg. § 1.83-7(b). The stock option does not provide for a deferral of compensation under I.R.C. § 409A and Treas. Reg. § 1.409A-1(b)(5)(i)(A). The stock option vests and becomes exercisable with respect to all 10 shares of Employer on January 2, 2021. Employee can exercise the stock option at any time from January 2, 2021 through January 2, 2024. The shares delivered upon exercise of the option are substantially vested as defined in Treas. Reg. § 1.83-3(b). On December 29, 2021, Employee exercises the option to purchase the shares. On the date of exercise, the fair market value of each share is $15. On December 31, 2021, the shares are delivered to Employee's brokerage account. On the delivery date, the fair market value of each share is $14.[4]

The memorandum holds that the employee obtains ownership via beneficial interest on the date the option is exercised, even if the actual delivery is not the same day. The memorandum states:

An employee acquires a beneficial interest in the underlying shares of stock upon exercising a stock option. For example, in Walter, the Tax Court ruled that, upon the exercise of a stock option, the employee became the beneficial owner of the underlying stock because, upon exercise, the employee incurred the risk that the value of the stock would decline. Walter, TC Memo 2007-2, at 7. Rev. Rul. 70-335, 1970-1 C.B. 111, holds that stock is considered transferred on the date the employee delivers to the grantor corporation written notice of the stock option exercise with full payment even though the plan provides that the employee has no interest in the stock until issuance of the stock certificates. In both Walter and Rev. Rul. 70-335, the employee incurred the risk that the value of the stock would decline and thus acquired beneficial ownership of the stock upon exercise of the stock option. When the employee exercises a stock option (thus initiating the process pursuant to which the employer transfers the stock), the number of shares and fair market value of the stock received by the employee are fixed and determinable, even though the value of the stock may decrease or increase prior to actual delivery of the shares (for example, during the period of delay between exercise and delivery of the shares to the employee’s brokerage account). The employee’s ability to (1) pledge the stock as collateral for a loan to exercise the option, and (2) direct the sale of shares to repay the loan or to satisfy the tax withholding obligation upon exercising the stock award are also indications of beneficial ownership. Accordingly, for purposes of I.R.C. § 83, the transfer of shares of stock occurs on December 29, 2021, the date on which Employee exercises the stock option.[5]

In a footnote, the memorandum expands on the reasoning the court used in Walter to determine there was beneficial ownership at the exercise date:

In concluding that an employee acquired a beneficial ownership of shares of stock on the date of exercising the stock options, the court in Walter also explained that the employee’s exercise of the stock options constituted an “unconditional acceptance of [the employer’s] offer under the stock option grants and created a contract between [the employer] and petitioner for the sale of the exercised shares of stock.” Walter, TC Memo 2007-2, at 6. In other words, an employee acquires a beneficial ownership in stock under a stock option when the employee is contractually obligated to purchase the underlying shares. This is consistent with the definition of transfer in Treas. Reg. § 1.83-3(a) and the Ninth Circuit’s description of Theophilos in Pahl.[6]

The taxation of the stock option is governed by IRC §83. The IRS continues the analysis in the memorandum to determine the amount of the income inclusion:

When an employee exercises a stock option, I.R.C. § 83 applies to the transfer of stock pursuant to the exercise and compensation is realized upon such transfer at the time and in the amount determined under I.R.C. § 83(a). See Treas. Reg. § 1.83-7(a). To determine the amount of compensation realized, I.R.C. § 83(a) provides, in relevant part, that the excess of the fair market value of the transferred property over the amount (if any) paid for such property shall be included in the gross income of the person who performed such services. In other words, the amount of compensation realized is the excess of the fair market value of the stock on the date of exercise over the exercise price. In accordance with Treas. Reg. § 1.83-7(a), such compensation is included in gross income upon exercise of the option because that is when the transfer of the underlying stock occurs for purposes of I.R.C. § 83. Accordingly, on December 29, 2021, $50 [10 shares x ($15 FMV on date of exercise – $10 exercise price)] is includible in Employee’s gross income.[7]

The IRS cites to additional authority in a footnote to this analysis which provides:

See also Rev. Rul. 67-257, 1967-2 C.B. 359, which holds that because the employees have an unconditional right to receive stock upon payment of the exercise price, the excess of the fair market value of the stock on the date of exercise over the option price is compensation includible in the employee’s gross income at the time the option is exercised.[8]

Finally, the IRS concludes that the option is valued based on the higher value at the date of exercise, providing:

Even though the fair market value of each share is $14 on December 31, 2021 when the shares are delivered to Employee's brokerage account, the value of the shares on the delivery date is not taken into account in determining the amount of compensation income includible under I.R.C. § 83 nor the wage amount subject to FICA taxes or federal income tax withholding. At the time Employee exercised the stock option on December 29, 2021, when the fair market value of the stock was $15 per share, Employee incurred the risk that the value of the stock would decline.

On December 29, 2021, when Employee exercises the option to purchase the shares, Employee has beneficial ownership of the stock. Furthermore, when Employee exercises the option, the stock was made available to the Employee without any substantial limitation or restriction and was available to be used by the Employee at any time. Therefore, on December 29, 2021, the $50 stock payment constitutes wages that have actually or constructively been received by the Employee and is subject to FICA taxes and federal income tax withholding at that time.[9]

In a footnote, the IRS also references Rev. Rul. 67-257. Cf. Rev. Rul. 78-185 and Rev. Rul. 79-305 in support of the position that the exercise makes the stock available to the employee.[10]

The analysis concludes by looking at the payroll tax deposit date implications of this transaction—and, again, the date of exercise governs when the employer treats the payroll tax liability as having been incurred (and thus the date by which a deposit must be made). The memorandum states:

If, in conjunction with other wage payments, Employer has accumulated $100,000 or more in employment taxes upon the $50 stock payment date of December 29, 2021, then pursuant to the One-Day rule, Employer has an obligation to deposit such employment taxes by the close of the next day, December 30, 2021. If the Employer does not deposit such employment taxes by December 30, 2021, then under the Code the IRS may impose an FTD penalty upon the Employer unless it is shown that such failure is due to reasonable cause and not due to willful neglect.[11]

Stock-Settled Stock Appreciation Rights (SARs)

In the memorandum the IRS defines a stock-settled SAR as:

A stock-settled SAR is a right to stock based on the appreciation in value of a specified number of shares of stock during a specified period (such as a period beginning on the date of grant or some other specified date and the date of exercise of such right). Although less typical, the terms of the SAR may also provide that the stock will be paid on a specified date and not require the service provider to exercise the SAR. These facts do not contemplate or address the situation in which the SAR is settled only in cash.[12]

As the explanation notes, most often such rights are not settled in stock and, thus, the analysis does not apply to the more typical situation where the SAR is settled in cash.

The facts in the situation to be discussed in this memorandum are as follows:

On January 2, 2020, Employer (a publicly traded corporation) grants Employee 10 stock-settled SAR’s. The 10 stock-settled SAR’s vest and become exercisable on January 2, 2021. Employee can exercise the SAR’s at any time from January 2, 2021 through January 2, 2024. Each SAR entitles Employee to receive upon exercise a number of shares of the common stock of Employer equal to the excess of the fair market value of a share of Employer common stock on the date Employee exercises the SAR over the fair market value of a share of such stock on the date of grant, divided by the fair market value of a share of such stock on the date of exercise. The SAR’s do not provide for a deferral of compensation under I.R.C. § 409A and Treas. Reg. § 1.409A1(b)(5)(i)(B). The shares received upon exercise of the SAR are substantially vested as defined in Treas. Reg. § 1.83-3(b). On January 2, 2020, the fair market value per share of the Employer common stock was $10. On December 29, 2021, when the fair market value of each share of Employer stock is $25, Employee exercises all of the SAR’s. On December 31, 2021, the shares are delivered to Employee’s brokerage account. On the delivery date, the fair market value of each share is $24.[13]

In this case, the analysis is similar to that of the stock option:

A stock-settled SAR is, in substance, a stock option without an exercise price. Upon exercising the stock-settled SAR, an employee acquires a beneficial ownership in the underlying shares of stock because the employee incurs the risk that the value of the stock would decline. Accordingly, the transfer of shares of stock occurs on December 29, 2021, the date on which Employee exercises the stock-settled SAR. Therefore, on December 29, 2021, $150 [10 SAR’s x ($25 FMV per share on date of exercise — $10 FMV per share on date of grant)], which is the fair market value of 6 shares on the date of exercise ($150 total FMV/$25 FMV per share on date of exercise = 6 shares), is includible in Employee’s gross income.

Even though the fair market value of each share is $24 on December 31, 2021 when the shares are delivered to Employee’s brokerage account, the value of the shares on the delivery date is not taken into account in determining the amount of compensation income includible under I.R.C. § 83 nor the wage amount subject to FICA taxes or federal income tax withholding. At the time Employee exercised the stock option on December 29, 2021, when the fair market value of the stock was $25 per share, Employee incurred the risk that the value of the stock would decline.[14]

The result for the employee is much the same as it was for the stock option:

On December 29, 2021, when Employee exercises the stock settled SAR, Employee has beneficial ownership of the stock. Furthermore, when Employee exercises the option, the stock was made available to the Employee without any substantial limitation or restriction and was available to be used by the Employee at any time. Therefore, on December 29, 2021, the $150 stock payment constitutes wages that have been actually or constructively received by the Employee and is subject to FICA taxes and federal income tax withholding at that time.[15]

As well, the payroll tax deposit rules are similar to the result for the stock option:

If, in conjunction with other wage payments, Employer has accumulated $100,000 or more in employment taxes upon the $150 stock payment date of December 29, 2021, then pursuant to the One-Day rule, Employer has an obligation to deposit such employment taxes by the close of the next day, December 30, 2021. If the Employer does not deposit such employment taxes by December 30, 2021, then under the Code the IRS may impose an FTD penalty upon the Employer unless it is shown that such failure is due to reasonable cause and not due to willful neglect.[16]

Stock Settled Restricted Stock Unit (RSU)

The memorandum describes a stock-settled RSU as follows:

A stock-settled RSU is an unsecured and unfunded promise by the service recipient to pay one or more shares of stock to the service provider at a future date following a specified vesting condition. The terms of a RSU typically provide that the payment of the stock will occur upon or within a short period of time following the satisfaction of the vesting condition. If payment occurs no later than two and a half months after the end of the taxable year in which the vesting condition was satisfied, then the payment is not considered deferred compensation. See Treas. Reg. § 1.409A-1(b)(4). If the payment occurs more than two and a half months after the end of the taxable year in which the vesting condition was satisfied, then the RSU provides for a deferral compensation and is subject to the requirements of I.R.C. § 409A. See Treas. Reg. § 1.409A-1(b)(1). These facts do not contemplate or address the situation in which the RSU is settled only in cash.[17]

As the description notes, unlike the first two structures mentioned, most often RSUs are considered deferred compensation, subjecting them to the special rules for determining when the value is subject to payroll taxes, as well as potentially running into §409A issues (though those are not really relevant to the memorandum).

The facts in this example are as follows:

On January 2, 2020, Employer (a publicly traded corporation) grants Employee a stock-settled RSU that entitles Employee to 10 shares of Employer’s common stock if Employee continues to provide services to Employer until December 29, 2021. The terms of the RSU provide that payment of the shares will occur on the date the vesting condition is satisfied. The shares received upon payment of the RSU are not subject to a substantial risk of forfeiture. On December 29, 2021, Employee satisfies the vesting condition and Employer initiates payment of the 10 shares of stock. The fair market value of each share of stock is $25 on December 29, 2021. On December 31, 2021, the shares are delivered to Employee’s brokerage account. On the delivery date, the fair market value of each share is $24.

However, despite being a deferred compensation program in most cases, the final result is similar to the result for the other programs. The applicable law is discussed in the memorandum as the memo states:

When the employer initiates payment under the RSU, the employee acquires a beneficial ownership in the underlying stock. When the employer initiates payment, the number of shares of stock to be transferred and the fair market value of the stock become fixed and determinable. At this time, the employee incurs the risk that the stock’s fair market value may decrease or increase prior to actual delivery of the shares (for example, during the period of delay between the time the employer initiates payment and delivery of the shares to the employee’s brokerage account). The employee’s ability to direct the sale of stock to satisfy the tax withholding obligation is another indication of beneficial ownership. Thus, upon initiation of the payment, the employee is considered a beneficial owner of the stock and the stock is considered transferred for purposes of I.R.C. § 83. Accordingly, the transfer of shares of stock occurs on December 29, 2021, the date on which Employer initiates payment of the 10 shares of stock.

I.R.C. § 83(a) determines the amount of compensation realized upon the transfer and provides, in relevant part, that the excess of the fair market value of the transferred property over the amount (if any) paid for such property shall be included in the gross income of the person who performed such services. If the employee did not pay for the stock issued under the RSU, then the amount of compensation included in the employee’s gross income is the fair market value of the stock on the date that the employer or broker initiates the payment. Accordingly, because Employee paid nothing for the shares, on December 29, 2021, $250 (10 shares x $25 FMV on date of transfer) is includible in Employee’s gross income.[18]

The result for the employee is also very similar to the result in the case of the stock option and stock-settled SAR:

Even though the fair market value of each share is $24 on December 31, 2021, when the shares are delivered to Employee’s brokerage account, the value of the shares on the delivery date is not taken into account in determining the amount of compensation income includible under I.R.C. § 83. At the time Employer initiated payment on December 29, 2021, when the fair market value of the stock was $25 per share, Employee incurred the risk that the value of the stock would decline.[19]

However, since this is a deferred compensation program, the explanation for the result for the employer and payroll tax deposits is different, though it arrives at much the same result:

I.R.C. § 3121(v)(2) determines the FICA tax treatment of NQDC plans. A RSU award is not a stock value right and therefore provides for the deferral of compensation. Amounts paid pursuant to the settlement of an RSU award are NQDC for FICA purposes and are subject to FICA taxes as of the later of (1) the date on which the services creating the right to the amount are performed, or (2) the date on which the right to the amount is no longer subject to a substantial risk of forfeiture. On December 29, 2021, when Employer initiates payment, the Employee’s right to the shares of stock transferred is no longer subject to a substantial risk of forfeiture. Thus, the fair market value of the shares of stock transferred in the amount of $250 is an amount paid subject to FICA taxes at that time.

As stated above, on December 29, 2021, when Employer initiates payment, Employee has beneficial ownership of the stock. Furthermore, when Employer initiates payment, the stock is made available to the Employee without any substantial limitation or restriction and was available to be used by the Employee at any time. Therefore, on December 29, 2021, the $250 stock payment constitutes wages that have been actually or constructively received by the Employee and is subject to federal income tax withholding at that time.

If, in conjunction with other wage payments, Employer has accumulated $100,000 or more in employment taxes upon the $250 stock payment date of December 29, 2021, then pursuant to the One-Day rule, Employer has an obligation to deposit such employment taxes by the close of the next day, December 30, 2021. If the Employer does not deposit such employment taxes by December 30, 2021, then under the Code the IRS may impose an FTD penalty upon the Employer unless it is shown that such failure is due to reasonable cause and not due to willful neglect.[20]

[1] AM-2020-004, May 22, 2020, https://www.irs.gov/pub/lanoa/am-2020-004.pdf (retrieved May 22, 2020)

[2] AM-2020-004, p. 1

[3] AM-2020-004, p. 1

[4] AM-2020-004, pp. 1-2

[5] AM-2020-004, pp. 12-13

[6] AM-2020-004, p. 12

[7] AM-2020-004, p. 13

[8] AM-2020-004, p. 13

[9] AM-2020-004, p. 13

[10] AM-2020-004, p. 13

[11] AM-2020-004, p. 13-14

[12] AM-2020-004, p. 2

[13] AM-2020-004, p. 2

[14] AM-2020-004, p. 14

[15] AM-2020-004, p. 14

[16] AM-2020-004, p. 14

[17] AM-2020-004, p. 3

[18] AM-2020-004, p. 15

[19] AM-2020-004, p. 15

[20] AM-2020-004, p. 16