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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.

National Perspective:

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 of employees.

Massachusetts Perspective:

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.

Governmental Activity:
  • 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 taxes.
  • 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.
Software Council Position:

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 options.

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.

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