On May 22, 2020, the IRS released a Generic Legal Advice Memorandum, GLAM 2020-004, which addresses the timing of the taxation and withholding of payroll taxes on certain stock-settled awards issued to employees. Specifically, the GLAM focuses on the treatment of stock options, stock-settled stock appreciation rights (SARs), and stock-settled restricted stock units (RSUs).
Employers should be aware that the GLAM does not appear to alter the Service’s existing position with respect to such awards — the fair market value of the stock underlying the award is includible in gross income when the stock is deemed transferred to the employee. However, the GLAM does appear to offer some additional insight into the timing of income inclusion with respect to RSUs. Perhaps most importantly, the GLAM reiterates the IRS’s 2003 administrative position regarding the application of late deposit penalties to payroll tax deposits due on the exercise of nonqualified stock options. A question had arisen regarding whether SEC guidance shortening the standard settlement cycle for securities transactions to two business days had the effect of shortening the period for depositing payroll taxes. Deposits owed with respect to option exercises will continue to be deemed timely if deposited within one day of settlement, so long as settlement occurs within three days of the exercise date.
The GLAM restates existing IRS guidance with respect to the timing of income inclusion for stock options, stock-settled SARs, and stock-settled RSUs—the fair market value of the stock underlying the award is includible in gross income when the stock is transferred for purposes of section 83 of the Internal Revenue Code (the Code). For stock options or stock-settled SARs, the IRS takes the position that the date of transfer is the date when the employee exercises the award because the employee obtains beneficial ownership of the underlying stock on such date. In contrast, the stock underlying an RSU is deemed transferred when the employer “initiates payment” under the stock award.
Under SEC regulations applicable to stock transfer agents and securities brokers, there is a short settlement cycle between the exercise or payment of an award and receipt of the underlying stock. On September 5, 2017, the SEC shortened this settlement cycle from three business days (T+3) to two business days (T+2). Because of the IRS’s position that the exercise of the option results in income on the exercise date, stock awards are often includible in income prior to the date the underlying shares are received by the grantee.
Under the Next-Day Deposit Rule applicable to the timely electronic deposit of payroll taxes, the administration of stock awards and collection of payroll taxes can create administrative issues for employers. The “Next-Day Deposit Rule” requires employers that have “accumulated” $100,000 or more in employment taxes on a given day to deposit those taxes through electronic funds transfer by the close of the following business day. (Employment taxes required to be withheld from employee wages are generally accumulated when the employee withholds the amount.) Failure to timely deposit accumulated withholding taxes and the employer’s share of FICA taxes results in the imposition of a harsh late-deposit penalty that ranges from 2% to 15% of the applicable tax, unless the employer can show that the failure was due to reasonable cause and not willful neglect.
In the case of stock-settled awards, employers often have little time to determine the amount of tax required to be withheld (or paid by the employer, in the case of employer FICA taxes) before the Next-Day Deposit Rule may require the employer to remit employment taxes to the IRS. Depending upon plan design, an employer may not even be aware that an employee has exercised an option or SAR on the exercise date that the IRS asserts triggers a deposit liability as early as the next business day. In many cases, the deposit may be required before settlement of the underlying award. If the underlying award provides for cashless exercise and withholding, the employer may not have received the proceeds from the sale of the shares intended to cover the required taxes before the deposit deadline. As a result, employers may find themselves facing late deposit penalties in connection with such exercises. The IRS asserted a number of such penalties against employers during the dot-com boom of the late 1990s and early 2000s.
After significant pressure and countless trips to IRS Appeals, the Service provided administrative relief to employers in the form of the 2003 Field Directive and Internal Revenue Manual (IRM) 184.108.40.206.2. The directive instructs examiners not to challenge the timeliness of an employment tax deposit related to the exercise of stock options if the taxes are deposited within one day of settlement, so long as settlement occurs within three days of the exercise date (T+3). If the settlement occurs more than three days after exercise, which may happen in the case of a private company, examiners should not challenge the timeliness of the deposit so long as the liability is treated as incurred no later than the third business day after the exercise date.
Timing of Income Inclusion for RSUs
Although the GLAM largely restates existing guidance, it does suggest the date that employers should use for determining the settlement date of stock-settled RSUs, as compared to nonqualified stock options and stock-settled SARs. In a discussion on page three of the GLAM, the IRS suggests that an employer “initiates payment” under an RSU when it makes a request to its transfer agent to transfer shares underlying the award. As with nonqualified stock options and stock-settled RSUs, this suggests that the IRS takes the position that the value of the shares underlying an RSU become includible in the employee’s gross income before the date on which the employee actually receives the shares in settlement of the award.
Many employers likely treat the date on which the employee receives the shares as the liability date. Employers should consider whether their existing payroll practice includes the value of RSUs in income on the date that the GLAM would seem to require. Employers should also keep in mind that RSUs may be subject to the special timing rule under section 3121(v)(2) of the Code. As a result, the liability date for FICA taxes may be before the date of income inclusion based on the vesting date of the RSU rather than the date on which the employer makes a request to transfer shares to the employee. If the RSUs are designed, as is common, to avoid the application of section 409A, and are settled in the same year that they vest, the employer may use the rule of administrative convenience to align the FICA tax liability date under section 3121(v)(2) and the income tax withholding liability date.
Although the GLAM provides some guidance on the timing of income inclusion with respect to RSU settlements, it does not address the valuation of the shares transferred in settlement of the RSU. Based on existing guidance, employers have some flexibility when determining the value of the underlying shares on the required date of inclusion. The Code does not mandate any particular method for determining the fair market value of shares of the stock underlying an RSU. For publicly traded companies, any number of potential values could be used for determining the amount of income inclusion (and consequently, the amount of payroll taxes), including the opening price, closing price, or the average of the opening and closing prices. The Code does prescribe some rules governing the valuation of publicly traded shares for purposes of determining the strike price for statutory stock options and for options under 409A, which employers offering RSUs have often looked to when valuing RSUs. In both cases, the guidance provides some degree of flexibility. Employers may look to those rules for guidance regarding how to determine the amount of income to include when RSUs are settled.
Administrative Waiver for Payroll Tax Deposits is Unchanged
Although not obvious from reading the GLAM’s conclusions, the administrative waiver included in the 2003 Field Directive and the IRM survives the GLAM. In its conclusion, the GLAM states that the IRS may assert late deposit penalties “[i]f the employer does not deposit such employment taxes by the close of the next business day” following the exercise date of a stock option or SAR or the date on which the employer initiates payment under a stock-settled RSU, if the Next-Day Deposit Rule applies. At first glance, this would suggest that the IRS is abandoning the administrative waiver and intending to assert late deposit penalties for deposits that would not have incurred penalties in the past.
Fortunately, the Service indicates in its discussion of the administrative waiver that the GLAM “does not affect application of the administrative waiver” with respect to the deemed timeliness of employment tax deposits. Accordingly, the existing administrative waiver period continues to apply, and deposits are treated as timely if deposited within one day of settlement, so long as settlement occurs within three days of the exercise date (T+3). This appears to be the case even though the SEC shortened the settlement cycle to T+2. For publicly traded companies, the change in the SEC settlement cycle may still result in earlier deposit requirements (and may have done so since the settlement cycle was changed in 2017) because settlement will generally occur at T+2 rather than T+3. In other words, an employer subject to the Next-Day Deposit Rule should deposit the accumulated taxes with the U.S. Treasury the day after the liability date.
This clarification is welcome, as some practitioners had speculated that the period of the administrative waiver was shortened by recent SEC guidance. Unfortunately, the GLAM fails to take the opportunity to explicitly extend the administrative waiver to other forms of equity compensation. It is unclear from IRS guidance, including the GLAM, whether this waiver applies to stock-settled SARs and RSUs, which are also subject to a delay in settlement. The GLAM states that stock-settled SARs are “in substance, a stock option without an exercise price.” Although some might quibble with the IRS’s description, the statement suggests that the administrative waiver should apply equally to stock-settled SARs. Although it is far less certain that the waiver applies to stock-settled RSUs, employers would appear to have more control over the timing of employment tax deposits given that the employer’s instruction to transfer shares to the employee seems to trigger the deposit liability. Coupled with the flexibility regarding the determination of the value of the shares underlying the RSU, an employer may be able to better anticipate its required deposits and avoid late deposit penalties in connection with RSU settlements.