(This Item Posted April 2001)

Prepared by: Jeffrey R. Capwell

McGuireWoods LLP

Charlotte, North Carolina

Incentive stock options ("ISOs") and employee stock purchase plans that meet the requirements of Section 423 of the Internal Revenue Code ("ESPPs") permit employees to acquire employer stock on a tax-advantaged basis. Under these types of plans, an employee generally is not required to pay any income tax at the time of purchase even though the value of the stock exceeds the amount that he pays to purchase the stock. This favorable tax treatment is conditioned on the employee holding the acquired stock for at least one year from the date he purchased it, and two years from the date he was granted the ISO or became eligible to make the purchase under the ESPP. Any transfer before the end of these periods is referred to as a "disqualifying disposition" and will generally cause the employee to have taxable income at the time of the transfer.

Two significant tax withholding issues have arisen in recent years concerning ISOs and ESPPs. First, the IRS has begun to question whether FICA and FUTA taxes must be withheld at the time of purchase of stock under an ISO or ESPP. Second, the IRS has questioned whether an employer must withhold FICA, FUTA and income taxes when an employee makes a disqualifying disposition of stock purchased under an ISO or ESPP. Employers traditionally have not withheld taxes in either case, relying on a long-standing IRS ruling that applied to a type of statutory stock option that predated ISOs. The IRS has begun to question whether the ruling is applicable to ISOs and ESPPs, and has attempted to collect FICA, FUTA and income taxes in a number of recent audits of ESPPs.

In January the IRS announced a new position which resolves, at least temporarily, much of the uncertainty surrounding this issue. In Notice 2001-14, the IRS officially revoked the ruling that employers have been relying upon to support the position that no withholding is required at either time of purchase or when a disqualifying disposition occurs. In revoking the ruling, the IRS announced that it intends to publish new rules that will take the position that FICA and FUTA taxes do apply when shares are purchased under an ISO or an ESPP. The IRS has also announced that it may conclude, after further study, that income tax withholding is not required on a disqualifying disposition of shares.

This new position will not, however, become effective until January 1, 2003. Thus, employers may treat any purchase under an ISO or ESPP that occurs prior to January 1, 2003 as exempt from FICA and FUTA, and not subject to any withholding. In addition, employers may treat any disqualifying disposition of ISO or ESPP shares that occurs prior to January 1, 2003 as exempt from FICA, FUTA and income tax withholding. These interim rules have retroactive effect, and provide employers with authority to support a prior practice of not withholding FICA, FUTA or income taxes.

The announcement by the IRS of its intent to adopt these new positions has generated a great deal of interest among lobbying groups. A number of groups have begun to lobby Congress to enact clarifying legislation before the transition period expires at the end of 2002. In the meantime, employers should review the new interim rules and their current withholding practices, and be aware of the IRS’ intent to develop new rules in the next two years.