Payroll Taxes on Incentive Stock Options
Updated: October 22, 2003
Technology companies use Incentive Stock Options (ISOs) to attract
and retain their employees. A recent proposal by the IRS to make the
exercise of stock options subject to payroll tax withholding would
impose a tax on employees' unrealized gains, discouraging many of
them from participating in stock option plans. In addition, companies
would have to pay additional matching payroll taxes, discouraging
them from offering these incentives to their employees.
A survey by the National Center for Employee Ownership revealed that
82% of venture-backed companies offer ISOs and that 62% of these companies
provide only ISOs. A separate NCEO survey indicated that, among technology
companies, 52% offer only ISOs in new hire grants to non-management
employees and 50% offer only ISOs in ongoing grants to this same group
A survey conducted by the Council of its membership indicated that thirty-four of the forty responding companies
grant ISOs to more than eighty percent of their employees.
Software Council Position:
- Longstanding US Treasury policy has been that the exercise
of ISOs are not subject to payroll tax withholding. However, an
IRS field service memorandum in 1999 reversed this policy and
concluded that FICA and FUTA taxes must be collected when ISOs
are exercised, thus creating payroll tax withholding liabilities.
- In January 2001, the IRS published a proposed rule saying that
ISOs exercised after January 1, 2003 would be subject to payroll
- On June 25, 2002 the Treasury Department announced that it was
postponing indefinitely any further action on the proposed rule.
- Legislation has been filed in Congress that would prohibit the
IRS from implementing this rule.
Allowing the exercise of ISOs to be subject to payroll taxes would
be costly to employees, discouraging many of them from participating
in stock option plans; this would be a disincentive for companies
to offer these incentives to their employees, because companies
would pay additional payroll taxes.
Moreover, allowing ISOs to be subject to payroll tax withholding
would encourage the IRS to require the withholding of income taxes
on ISOs and to impose payroll and income tax withholding on non-qualified
Software Council Activity:
- The Council is a member of a national coalition of trade associations,
including the National Venture Capital Association, the Financial
Executives Institute and TechNet, supporting enactment of legislation
that would the IRS from implementing this rule.
- The Council successfully urged the coalition to request former
Treasury Secretary Paul O'Neill to reconsider the proposed rule,
expressing concern that the rule would discourage employee participation
in an incentive that companies have used to spur productivity,
enhance employee morale and provide savings benefits.
- The coalition obtained support from key Members of Congress,
including Senator John Kerry, in requesting Secretary O'Neill
to reconsider the rule.