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What is the issue? Longstanding Treasury policy held that statutory stock options -- incentive stock options (ISOs) and employee stock purchase plans (ESPPs) -- were not subject to payroll tax withholding. The Treasury and IRS reversed this policy in 2001 by issuing proposed rules that would impose payroll tax withholding on the exercise of these options beginning in 2003. The Stop Higher Payroll Taxes Coalition was formed to advocate against these proposed rules. As a result of the coalition's efforts, the Treasury Department issued in May of 2002 an indefinite moratorium on implementing these proposed rules. Legislation to clarify that statutory stock options are not subject to payroll taxes was introduced and - as a result of the indefinite moratorium - scored by the Joint Committee on Taxation as having a "negligible" revenue effect.
Coalition goal for 2003 -- The goal is to enact legislation clarifying that statutory stock options are NOT subject to payroll taxes.
Why do companies need legislation if the Treasury issued an indefinite moratorium in implementing these rules? In conversations with the Treasury staff it is clear that "indefinite" does not mean never. The Treasury intends to put this issue in its business plan to be issued in June of 2003. Moreover, there is great concern that the JCT score will correspondingly rise as a result of this action (an old JCT estimate indicates the cost could be as high as $23B over 10 years). Legislation needs to pass this year while "indefinite" is still meaningful for scoring purposes.
What are ISOs and ESPPs? ISO plans and ESPPs provide tax-favored opportunities to obtain employer stock. There is no taxable event when an option under either program is granted to or exercised by the employee. If the employee holds the shares of stock purchased through either plan for the appropriate time periods, proceeds from the sale are taxed at capital gains rates rather than as ordinary income. ESPPs allow workers to purchase stock, usually through payroll deduction, at a discount of up to 15%, and ESPPs generally are available to all employees. ISOs are options given to workers, who typically must wait a specified period of time before they can exercise the ISOs to purchase shares. While not discussed here, ISOs and ESPPs also have their own specific limits and restrictions on the value of options or shares that may be provided to employees at any particular time.
What is the impact on companies and employees? ISOs and ESPPs are widely used by both entrepreneurial and established U.S. companies. A recent survey by the National Center for Employee Ownership (NCEO) revealed that 82% of venture-backed companies offer ISOs and 62% provide only ISOs. A separate NCEO survey indicated that 44% of all surveyed companies offered ISOs to all employees. The same survey revealed that approximately sixty-five percent of public companies offer ESPP plans, which generally cover all employees.
In 2003, workers will pay 6.2% in Social Security taxes on the first $87,000 they earn. There is no cap on Medicare, which taxes 1.45% of all wages. Companies pay an equal amount on their workers' behalf, bringing the total up to 15.3%. In addition to the direct costs in taxes, employers will face new and heavy administrative costs in implementing the new IRS policy.
- Why should the Congress exclude statutory options from payroll tax withholding?
- Imposing payroll tax withholding will result in a tax increase on worker incomes below the Social Security wage base and is contrary to 30 years of accepted tax policy without legislative approval;
- ISOs and ESPPs are qualified for special tax treatment and are not subject to income tax at exercise. Imposing employment tax withholding at exercise is inconsistent with this premise;
- Assessing employment taxes at exercise per the IRS proposed guidelines will be administratively difficult if not impossible since, e.g., employees may have long since left the company at the time that they exercise; and
- ISOs and ESPPs are extremely valuable tools for companies of all sizes to recruit, retain and incentivize employees. The IRS proposed policy will greatly undermine their effectiveness and may lead some companies to significantly curtail their use given the administrative difficulties and costs that will arise.
The Stop Higher Payroll Taxes Coalition 
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