IRS Addresses Income Inclusion and Tax Withholding for Stock-Settled Awards

In the Generic Legal Advice Memorandum (GLAM) 2020-004 dated May 22, 2020, the IRS discusses when employers should include stock-settled awards in employees’ income and when employers should withhold Federal Insurance Contribution Act (FICA) and federal income tax from stock-based compensation. In the IRS’s view, exercises of such stock-based awards result in income on the exercise date, so stock awards are often includible in income before the grantee receives the underlying shares. While the GLAM does not change the IRS’s existing positions on nonqualified stock options (NSO) and stock appreciation rights (SARs), it offers some additional insight into the timing of income inclusion for restricted stock units (RSUs).

Income Inclusion under Section 83

The GLAM states that the fair market value (FMV) of the underlying stock is includible in the employee’s gross income as compensation when the stock is considered transferred for purposes of Section 83 of the Internal Revenue Code. The transfer of the stock occurs when the employee exercises an NSO or a stock-settled SAR, or when the employer initiates payment under a stock-settled RSU. In the GLAM, the IRS says that an employer “initiates payment” under an RSU when it makes a request to its transfer agent to transfer shares underlying the award. So, the IRS has confirmed its position that (like NSOs and SARs) the value of the shares underlying an RSU is includible in the employee’s income before the date the employee actually receives the underlying shares.

FICA and Federal Income Tax Withholding

According to the GLAM, the grant of an NSO or a SAR does not constitute the deferral of compensation for purposes of Internal Revenue Code Section 3121(v)(2); thus the general timing rule under Treas. Reg. Section 31.3121(a)-2(a) applies. In other words, wages generally are subject to FICA tax when they are actually or constructively received. However, an RSU award is not a stock value right and therefore provides for the deferral of compensation for purposes of Section 3121(v)(2). Amounts paid pursuant to the settlement of an RSU award are nonqualified deferred compensation for FICA purposes and are subject to FICA taxes 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. For federal income tax withholding purposes, the income arising from any of these stock awards is considered wages paid to the employee when the amount is actually or constructively received.

Federal Tax Deposit Requirement

On the date the stock-based compensation is considered wages for FICA and federal income tax withholding purposes, the employer must collect the applicable amount from the employee and deposit the withheld taxes with the IRS in accordance with the prescribed monthly or semi-weekly deposit schedules. If the employer has accumulated $100,000 or more in withheld employment taxes, then the employer must deposit the employment taxes by the close of the next business day (this is often referred to as the “Next-Day Deposit Rule”). If the employer does not deposit such employment taxes by the close of the next business day, a Failure-To-Deposit (FTD) penalty may be assessed.
Employers often do not have enough time to determine the amount of tax to withhold or pay (for their share of FICA) before they must remit those taxes to the IRS under the Next-Day Deposit Rule. Employers may not even know that an employee has exercised an award until after the tax deposit deadline has passed. Plus, with cashless exercises, the employer often does not receive the proceeds from the sale of the shares intended to cover the taxes before the deposit deadline. As a result, employers could easily face late deposit penalties.

However, based on a 2003 IRS Field Directive and a 2012 IRS Administrative Waiver, employers that deposit within four days of the option exercise date may avoid the FTD penalty.