Editor: Lori Anne Johnston, CPA, J.D.
Employers have various tools to attract and retain talent: cash, equity, fringe benefits, and others. Equity compensation has dual benefits of tying key employees' compensation to the company's performance while often offering such employees a tax deferral. Many employers may have looked to equity compensation during the COVID-19 crisis to retain valued employees who are vital in helping the company rebound from a downturn, while also benefiting the company's cash position.
Federal tax withholding overview
Federal taxation and withholding on equity compensation can often be overlooked at the employer's peril due to: (1) relative infrequency of, and unfamiliarity with, the reporting; (2) potentially very tight timing to make the employment tax deposit; and (3) harsh penalties. In general, the employer is required to withhold and remit to the IRS an employee's share of Federal Insurance Contributions Act (FICA) taxes from wages when actually or constructively paid to the employee and pay to the IRS the employer's share (Secs. 3101 and 3111).
Similarly, the employer is also required to collect income tax by withholding it from the employee's wages when actually or constructively paid (see Sec. 3402(a) and Regs. Sec. 31.3402(a)-1(b)). Employers are required to deduct and withhold payroll and income taxes regardless of whether the wages are paid in cash or something else, e.g., equity (Regs. Sec. 31.3402(a)-1(c)).
In May 2020 the IRS issued guidance confirming that the employer becomes liable for its share of employment taxes and must withhold the employee's taxes (income tax and employee share of FICA taxes) when a nonstatutory stock option (NSO) or stock appreciation right (SAR) settled in stock is exercised (see Generic Legal Advice Memorandum (GLAM) 2020-004, Sec. 3121(a), and Regs. Sec. 31.3121(a)-2(a)). A restricted stock unit (RSU) settled in stock is subject to withholding of FICA taxes on the later of the date on which: (1) the services creating the right to the amount are performed; or (2) the right to the amount is no longer subject to a substantial risk of forfeiture (id.). This treatment comports with Sec. 83, which provides the federal income tax treatment of property transferred in connection with services. Although an option without a readily ascertainable fair market value (FMV) itself is not property, Sec. 83 applies to the transfer of the property upon exercise of the option (Sec. 83(e)(3) and Regs. Sec. 1.83-7(a)). Accordingly, the FMV of the property less any amount paid for the property is includible in the employee's wages upon the exercise of NSOs and SARs or when the employer initiates payment of an RSU (Sec. 83(a)).
An employer generally deposits employment taxes either monthly or semiweekly based on the amount of employment taxes reported annually during the 12-month period ended on the prior June 30; however, if the employer has accumulated $100,000 or more of employment taxes during a period (which is not uncommon with equity awards), it must deposit the employment taxes on the next business day (the so-called next-day deposit rule; see Regs. Secs. 31.6302-1(b) and (c)). It may be difficult for many employers to react so quickly without having processes in place prior to the due date, besides needing to have the cash on hand to make the deposit. The employer risks incurring a penalty ranging from 2% to 15% of the underpayment if the deposit is not timely made (Sec. 6656).
It should be noted that a few days after the IRS issued the GLAM mentioned above, it added Section 18.104.22.168.2(5) to the Internal Revenue Manual, which refreshed an administrative waiver of the underpayment penalty if the deposit is not made timely. This may signal the IRS's increased focus on enforcement of withholding for equity compensation, which makes it all the more important for employers to understand the rules.
Further complexity with remote workers in multiple jurisdictions
State taxation of equity-based compensation involves layered complexities that employers must consider. An employee may be granted equity compensation while providing services in one state but may be working in another jurisdiction when the taxable event occurs. Residents of a particular state will generally be subject to the resident state taxes on their equity award. However, implementing nonresident withholding presents a daunting task to employers, as multiple state withholding rules exist. Specific guidance related to equity-based awards in general and the type and specific terms of an equity-based award can all complicate matters.
An employer's primary consideration is to determine the jurisdiction in which the equity compensation is subject to withholding. In the best of times, this can mean navigating a variety of state withholding approaches, depending upon each employee's work location and state of residence at different key testing dates. However, with the COVID-19 pandemic and ensuing shift to a more remote and mobile workforce, this determination has become much more difficult. Some states have withholding thresholds based on a minimum amount of wages or number of days worked in the state. For example, New York's 14-day rule provides that the employer is not required to withhold if the employee is expected to spend 14 days or fewer in the state (see New York Technical Memorandum TSB-M-12(5)I (July 5, 2012)). Similarly, Idaho withholding is not required for nonresidents if wages earned for the year are less than $1,000 (see Idaho Code §35.01.01.871(01)(b)).
While most states provide an allowance for taxes paid to other states as a credit to the employee, in other states, specific rules can lead to double taxation. Under such circumstances the employer must be cognizant of state rules and withhold for more than one state. For example, New York imposes the convenience-of-the-employer test. If a nonresident employee performs services both within and outside New York, then any allowance claimed for wages applicable to services performed outside the state must be for the necessity (not the convenience) of the employer (see New York TSB-M-06(5)I (May 15, 2006)).
In the absence of relief from states such as New York that impose the convenience-of-the-employer test, the employer has to withhold on nonresident remote employees who may not have set foot in New York during the year. At the same time, the employer may be required to withhold for the employee's resident state, depending on the resident state rules.
In contrast, some states' policies reduce or eliminate double taxation through reciprocal agreements. For instance, New Jersey and Pennsylvania have a reciprocal agreement by which a resident of either state who works in the other can be exempted from the work state taxation by affirming the primary state of residence on appropriate employee exemption forms.
Computing the amount of withholding in each state on equity awards can unleash its own challenges, as states do not necessarily use the same methodology to determine the sourcing of taxable income from an equity compensation award. For example, New York requires nonresidents and part-year residents who have been granted stock options, restricted stock, or SARs and who perform services within New York during the grant period (generally, the period from grant date to vesting date) to allocate a portion of the income to New York. The amount allocated to New York is the compensation income attributable to these items multiplied by the New York workday fraction (the number of days worked within New York State for the grantor during the grant period over all the days worked for the grantor during the grant period (see New York TSB-M-07(7)I (Oct. 4, 2007)). In contrast, nonresidents who become residents of Virginia during the year in which distributions are received are subject to tax on nonqualified distributions (see Virginia Public Document P.D. 14-79 (May 30, 2014)).
To make matters more complicated, states treat similar equity awards differently. In New York the allocation period for a stock option is from the date the option is granted to the date it is vested, while in California the allocation period is from grant date until the equity award becomes taxable (see California Employment Development Department Information Sheet DE 231SK). The state incidence of taxation can differ from that of federal tax in some states.
Thus, employers must be vigilant in keeping abreast of regulatory requirements and changes in each state in which they are required to withhold on equity-based awards. While this is difficult, given employee mobility in the current COVID-19 environment, instituting a system of tracking employee mobility in real time, or at least regularly, is critical. Further, tying employee mobility data to taxability and nexus considerations is equally important. Given the outlook of an increasingly remote workforce, this could be the only way to ensure compliance with ever-changing state laws and regulations.
New challenges amid COVID-19
Calculating the correct withholding amount on equity awards and making a timely deposit is challenging. Penalties for a late deposit up the ante, and the Service has recently signaled an increased focus on timely deposits for equity compensation. Now, in the time of COVID-19, where employers may increasingly turn to equity compensation to save on cash compensation expenses and employees are increasingly mobile, there is increased risk for employers.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.