New IRS rules may diminish stock perks

Tech workers and employers alike could wind up paying more U.S. taxes next year under a plan to impose new taxes on certain stock incentive programs widely used in the high-tech industry.

Under the plan, the Internal Revenue Service would impose payroll taxes, including Social Security and Medicare taxes, on incentive stock options and employee stock purchase plans beginning Jan. 1, 2003. Those taxes already apply to some stock plans, but this rule would extend the taxes to ESPPs and other plans currently exempt.

But critics say new taxes will discourage employees and companies from participating in what are some of the most widely used benefits to both attract and retain workers, particularly in the hard-hit technology industry.

"This is silliness," said Bartlett Cleland, a vice president and tax lobbyist for the Information Technology Association of America (ITAA), a trade association with more than 500 member companies. "We should be looking for ways to inspire workers, not take away their economic capabilities."

The regulations would have the greatest impact on ESPPs, said Corey Rosen, executive director of The National Center for Employee Ownership, a nonprofit research organization that focuses on compensation issues. Under an ESPP, a company takes a portion of a participant's after-tax wages and uses it to purchase company stock at a discounted rate, typically 10 percent to 15 percent below the market price. The employee can then decide whether to sell it immediately or hold on to it.

Under the new regulation, the IRS would tax that "discount" spread of 10 percent to 15 percent. Unless workers were to sell the stock the same day they exercised it, they would owe taxes on earnings they had yet to receive. And employers would be required to pay the IRS a matching amount.

Because the tax is due immediately on that spread, it creates a confusing scenario for both workers and employers. The companies would be expected to withhold payroll taxes, even though they wouldn't have an actual payment from which to withhold them. Workers might have to sell at least some of their stock to cover the cost of the tax. If they sold the stock that quickly, they would be subject to still higher taxes at the end of the year because they would no longer qualify for the less-hefty capital-gains tax.

Tech industry balks at new tax proposals Harris Miller, president, Information Technology Association of America ="" onclick="window.open('http://www.cnet.com/radio/radio_load.html?showType=ondmd,sid=nws,asset=0429harrisN','radioplayer','toolbar=no,location=no,directories=no,status=no,top=no,scrollbars=no,resizable=no,width=295,height=175,left=200,screenX=200,top=100,screenY=100');" rel="follow" target="_self">Play clip

Although the regulation would apply to all workers, the already struggling tech industry would be particularly hard-hit. Stock-based incentive programs have long been a staple of the highly competitive workplace. Extra perks, such as quick turnaround stock incentives like ESPPs, have become even more important as the tech downturn has dampened worker enthusiasm for traditional stock grants, which vest over a long period.

And tech companies, increasingly frugal, are likely to balk at paying taxes on something now considered to be a financially painless way to reward employees.

"If the IRS proposal does go through, then a lot of companies are at least going to reconsider whether or not they want to offer these plans," Rosen said. "It could have a significant impact on the prevalence of these plans, and they're certainly a good benefit for typical employees."

Round 2
The tax previously went into effect early last year, when the IRS declared a ban on payroll taxes on certain stocks as obsolete. But the IRS immediately declared a moratorium on the change until it could clarify its potential effect. In November 2001 the IRS unveiled the new regulation, which spells out the changes, saying it would take effect Jan. 1, 2003.

The backlash was immediate, with some members of the Senate Finance Committee condemning the change and several tech-lobbying groups lining up against the plan. Several congressional representatives have proposed legislation to block the regulation from taking effect, and the IRS will hold a public hearing on the matter May 14. A congressional tax committee estimates that the change would result in the IRS collecting an additional $23 billion over the next decade.

If the IRS rule isn't stopped from going through this time, some workers said they would choose not to participate in their companies' ESPPs.

"You would have to sell most of the stock as soon as you get it to pay for the tax bill," said Doug Santry, a computer scientist at storage maker Network Appliance. "What's the point?"

The regulation would also apply to certain types of stock grants, typically given to new employees or as an annual allotment. Some are taxed when they are exercised--known as non-qualified options--and some are not taxed. If the new regulation goes into effect, the currently exempt stock options will be subject to payroll taxes when the employee exercises the options.

According to several high-tech industry associations, the change would undermine a growing trend of broad employee ownership in the workplace, which has helped businesses motivate and attract workers, not to mention keeping some labor costs off the balance sheet. Among the groups opposing the change are TechNet, the ITAA and the American Electronics Association (AEA).

"It is up to Congress to determine what is subject to federal taxes," said Caroline Graves Hurley, tax counsel at the AEA. "This is a regular tax increase by the IRS, which has just changed their position and decided these taxes are owed."

Sen. Pat Roberts, R-Kan., and Sen. Hillary Clinton, D-N.Y., have drafted a bill that would overturn the regulation, as would another bill sponsored by Rep. Amo Houghton, R-N.Y., that passed a House vote earlier this month. The bills clarify present tax law surrounding ESPPs and incentive stock options, explicitly exempting them from payroll taxes.

"The IRS is saying this is compensation. This is not compensation; this is a benefit," said Christopher Hogin, a tax legislation assistant to Roberts. "That's the distinguishing factor. There is no income that's been gained until you sell the stock, and IRS cannot tax income that has not yet been gained."

Deja vu?
Yet that's exactly what the IRS did last year, when many workers were saddled with enormous tax bills for exercising shares that they never cashed in and had since sunk below their exercise price. Under IRS rules, people who exercise certain types of stock options are required to pay the so-called Alternative Minimum Tax based on the stock price on the day of their exercise, even if they hold the stock and never actually pocket the money.

The uproar over the AMT tax issue led to legislation aimed at modifying the tax code.

Critics also say the rule would unfairly targets rank-and-file workers because the IRS only collects the 6.2 percent Social Security tax on the first $84,900 in earnings. So an employee earning more than that would not pay any more Social Security taxes on their stock transactions. A 1.45 percent Medicare tax would still apply to all employees on the stock transactions.

Despite the pressure from high-tech industry associations, tax experts say the IRS is unlikely to budge on the issue unless new legislation requires it. Yet few are optimistic that such legislation will be passed this year by the slow-moving, narrowly divided Senate, particularly against the backdrop of hundreds of Enron employees losing life savings that were invested in the company's stock.

"Lawmakers are thinking, 'Maybe we shouldn't promote the idea of stock options so much. We just had a bunch of people really stung in this whole Enron deal,'" said Michael Gray, a San Jose, Calif., certified public accountant and founder of the Employee Stock Option Advisors Association. "But they may be killing the goose that lays the golden egg. For businesses that are trying to get off the ground, options are a form of currency."