A new Internal Revenue Service filing requirement, affecting firms that have transferred shares of stock through an incentive stock option (ISO) or employee stock purchase program (ESPP) in the last year, is just now grabbing CFOs’ attention. “In the last week or two companies are getting a heads up, and realize that they need to do this right now,” says Peter Klinger, partner in the compensation and benefits area with BDO.
Both forms are purely informational. But they are one more tool the IRS can use to identify taxable sources of revenue that otherwise might escape their notice.
For ISO exercises, companies now are required to send IRS Form 3921 to both the employee exercising the options, and to the IRS. Previously, companies were supposed to make most of this information available to employees, although the IRS didn’t specify the format.
“The form is new, but the requirement to provide this information to the employee isn’t,” says David Kaplan, a Philadelphia-based attorney with Pepper Hamilton, and co-chair of its benefits and compensation practice group.
Similarly, Form 3922, which also is to be made available to both the IRS and employees, now comes into play with some purchases made through employee stock purchase plans. Its use is required on the “first transfer of shares after the purchase” — that is, a transfer to someone other than an employee in the program, such as to a brokerage account, Klinger says. In addition, either the exercise price has to have been less than the value of the stock on the date the option was granted, or the value of the stock on the date of the grant was not fixed or determinable.
The federal taxman’s search for new taxation avenues has been on some minds. “The IRS’ focus is, Where are we not collecting revenue?” says Mary Samsa, a Chicago-based attorney and member of the employee benefits and executive compensation group with Polsinelli Shughart. That is, they want to determine whether some holders of incentive stock options or participants in employee stock purchase plans are avoiding taxes. “This is another check or control for the IRS.”
Samsa notes that ISOs and ESPPs enjoy favorable tax treatment, but only if a number of requirements are met. For instance, with ISOs, the exercise price has to equal the fair market value on the date of the grant. Assuming this and other requirements are met, when the employee exercises the option and holds it for the required amount of time, the compensation component of the transaction can be taxed at the long-term capital gain rate, which tends to be “quite favorable,” Samsa says.
Also figuring into the IRS’ thinking is the Alternative Minimum Tax, Kaplan says. That’s because the bargain element inherent in an ISO when it’s exercised — that is, the difference between the option exercise price and value of the shares at the time of the exercise — is added back to taxpayers’ income in order to determine their tax liabilities under the AMT. While this requirement isn’t new, the form provides the IRS with information that may allow them to identify people likely to owe additional taxes under the AMT.
This is important, as “the amount of Federal revenue from the AMT has grown substantially in recent years, making it now worth the enforcement funds to pursue these dollars,” Kaplan says. Tax receipts from the AMT rose from about $9 billion in 2001 to $32 billion in 2009, according to a 2010 report from the Congressional Budget Office.
At the same time, the forms don’t provide all the information the IRS will need to determine a taxpayer’s obligation, Klinger notes. Form 3921, for instance, shows the exercise of an option, but doesn’t tell if or when the stock later was sold, or for what price. The IRS still would need to obtain that information. It’s impossible to predict whether the new forms will lead to greater numbers of audits, Klinger says.
Employers were supposed to have sent these forms to their employees by January 31. The deadline to submit them to the IRS is February 28 for paper forms, or March 31 for organizations that file electronically. Companies that file more than 250 forms are required to file them electronically. Each form covers one exercise event per person.
To be sure, this new requirement will add to CFOs’ already full To-Do lists. However, companies with solid record-keeping systems should have the required data, although they will need to put it into the IRS’ format, Klinger notes.
In addition, the requirement to file these forms comes with an upside, Samsa notes. That’s this: the forms let the IRS know that a stock option or purchase transaction has occurred, which could result in a favorable tax treatment, and that the shares involved have moved outside the company’s control. “This give the IRS a mechanism to track it themselves,” Samsa adds.
While the new requirements may have caught some companies by surprise, CFOs will want to “take this seriously and be prepared to remit the information on a timely manner,” Kaplan says.”