Comments to the IRS on Proposed Regulation on Stock Option Withholding

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Sarah Hall Ingram, Esq.
Associate Chief Counsel
(Tax Exempt and Government Entities)
CC:TEGE
ATTN: Employment Taxes and Statutory Options
Internal Revenue Service
1111 Constitution Avenue, N.W., Room 5214
Washington, D.C. 20224

Dear Ms. Ingram:

     This letter is written on behalf of Biotechnology Industry Organization ("BIO") and its member organizations to request that the Internal Revenue Service ("IRS") rescind Notice 2001-14, which will require employers to withhold FICA taxes on the exercise of incentive stock options and on purchases under employee stock purchase plans. As you know, Revenue Ruling 71-52 held that income recognized by employees and former employees from a disqualifying disposition of stock acquired under a qualified stock option is not "wages," and therefore the employer is not required to withhold FICA taxes on the income. Revenue Ruling 71-52 also concluded that exercise of the statutory option is not an employee wage payment and therefore the employer is not required to withhold FICA taxes at the time of exercise. The IRS extended the holding in Revenue Ruling 71-52 to incentive stock options ("ISOs") under section 422 of the Internal Revenue Code of 1986, as amended (the "Code"), and the general practice has been to treat employee stock purchase plans under section 423 of the Code as also exempt from FICA withholding. In Notice 2001-14, IRS declared Revenue Ruling 71-52 obsolete and, therefore, of no further effect. Notice 2001-14 purports to clarify the FICA tax treatment of ISOs and employee stock purchase plans and holds that, effective for exercises occurring on or after January 1, 2003, FICA tax withholding will apply to the spread in the option at the time of exercise. For the reasons set forth in this letter, we request that the IRS rescind Notice 2001-14 and revive and expand Revenue Ruling 71-52 to clarify that no FICA withholding applies to ISO or employee stock purchase plans at the time of exercise of such options or at the time of any subsequent disqualifying disposition.

     BIO serves as a unifying body for the rapidly growing biotechnology community. BIO's members include more than 1,100 biotechnology companies, academic institutions, biotechnology centers and other related organizations in all 50 states. BIO member companies are involved in the research and development of a wide range of essential products, including health care, agricultural, industrial and environmental technology products. Forty-five percent of FDA-approved biotechnology products have "orphan drug" status, meaning that they are designated by FDA for a rare disease or condition. Among the activities that BIO is engaged in on behalf of its members, BIO monitors and seeks to provide information to both the executive and legislative branches of the United States government regarding issues of concern to the biotechnology community.

     BIO's analysis demonstrates that application of FICA taxes to ISOs and employee stock purchase plans substantially undermines the intent of Congress in enacting sections 422 and 423 of the Code and is not justified by the Code. After the stated legal justifications for Notice 2001-14 are examined, a single, non-legal, justification surfaces: In issuing Notice 2001-14 and renouncing the holding under Revenue Ruling 71-52, IRS made a political decision that few tax dollars were involved at the time Revenue Ruling 71-52 was issued but that more FICA tax dollars are at stake now. This Notice is intended to generate additional payroll tax receivables in an age of concern about the viability of the Social Security system. Despite the pronouncements to the contrary in Notice 2001-14, the legal rationale underpinning Revenue Ruling 71-52 has not been undermined by any statutory change in the 30 years that the ruling has been law. Accordingly, BIO asserts that IRS erred in issuing Notice 2001-14.

     IRS's revenue-raising rationale for Notice 2001-14 is shortsighted. Much of the U.S. economy now consists of start-up technology enterprises and biotechnology is at the forefront of this phenomenon. With cash at a premium (as further described below), emerging biotechnology companies rely on the tax and accounting benefits of incentive stock options to compensate all employees, from those in the boardroom to those in our research laboratories, for sweat equity. The administrative regime that Notice 2001-14 will engender is likely to drastically reduce the number of recipients of incentive stock options at early-stage companies, mainly by limiting the use of options to the management and executive classes. This retrenchment would result in a corresponding shortfall in income taxes when compared to the taxes raised by disqualifying dispositions or application of the alternative minimum tax on a broader base of incentive stock option recipients. The resulting income tax loss is likely to dwarf the FICA employment tax receipts under Notice 2001-14 on a smaller number of incentive stock option recipients.

     The stance embodied in Notice 2001-14 is clearly at odds with the economic needs of the biotechnology industry. Over the past two decades, biotechnology has produced 133 drugs and vaccines, and there are 350 more in late stage development. These advances come at substantial cost. Biotechnology companies by definition rely intensively on research and development ("R&D") activities. The biotechnology industry invested nearly $14 billion in R&D in 2000. That same year, the industry as a whole lost nearly $6 billion. (Compared to what may be viewed as more than 100% reinvestment in R&D by biotechnology companies, across all other industries the average reinvestment in R&D is just 4%.) Biotechnology products face years-long approval processes. As such, the product development timeframe is significantly longer than in most other industries.

     Because the industry is still young, few companies have commercial products. Ninety percent of BIO companies are involved in health care product development and 90% of those companies do not have a single product on the market; many more have only one product approved in the United States. Clearly, with the investments that must be made in R&D, and the lack of sales revenue to absorb R&D and other costs, the vast majority of BIO's members must conserve cash resources.

     FICA taxes are paid in two parts from two sources. The total tax of 7.65% is composed of a 6.2% tax paid on wages up to the Social Security taxable wage base for the year, and a 1.45% Medicare Hospitalization Insurance tax that applies to all wages received during the year. The 7.65% tax is applied to the employee and the employer is required to withhold this tax from wages, but a separate 7.65% tax is assessed against and paid by the employer.

     The issue is whether there should be FICA withholding at the time of exercise of an ISO or at the time of disqualifying disposition of an ISO share. The Code requires that an employer withhold FICA and pay an equal employer FICA tax on all "wages." Section 3121(a) of the Code defines wages, as follows:

[T]he term "wages" means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash; except that such term shall not include -- ... .

The highlighted text shows the only addition to the basic construction of section 3121 since 1970. Section 3121 goes on to list types of compensation and benefits that are not treated as wages.

     In 1971, in Revenue Ruling 71-52, the Internal Revenue Service interpreted section 3121(a) to exclude from the term wages any payment treated as occurring at the time of the exercise of qualified stock options, the predecessor of the ISO, and the income arising at the time of a disqualifying disposition of a qualified stock option.

     Nearly thirty years later, the IRS has issued Notice 2001-14 renouncing the position of Revenue Ruling 71-52. Two reasons are given. The first points to the structure of section 3121(a), makes the observation that all remuneration is wages unless it falls within one of the identified exception under 3121(a), but states that "[n]either the Code nor the relevant regulations contain any provision excluding the value of stock transferred pursuant to the exercise of a statutory option from wages for FICA tax." Notice 2001-14, Section B. The second observation made by the IRS is as follows:

[I]n 1971 the Old-Age, Survivors, and Disability Insurance (OASDI) contribution and benefit base was only $4,800, as compared to the current OASDI wage base of $80,400. Further in 1971, the $4,800 limit applied to the Hospitalization Insurance (HI) portion of the FICA tax as well as the OASDI portion; by contrast, under current law, there is no limit on the amount of wages for purposes of the HI portion. Accordingly, in 1971, since most optionees had other wages that equal or exceeded the FICA wage base, inclusion of option-related income in FICA wages would have had no effect on the FICA tax liability or Social Security benefits of most optionees (and no appreciable affect on FICA receipts). Given the increased wage base for purposes of the OASDI portion of the FICA tax and removal of the limit of the wage base for purposes of the HI portion, that is no longer the case.

     Notice 2001-14 points to the fact that an ISO potentially gives rise to compensation income at the time of a disqualifying disposition, and concludes that it must also give rise to wages for FICA tax purposes at some point. The Notice deems those wages to occur at exercise, instead of at the time of a subsequent disqualifying disposition.

     The threshold inquiry under section 3121(a) of the Code regarding FICA withholding indeed is whether the payment constitutes "wages." In reaching the result under Revenue Ruling 71-52, IRS found ISOs to be a type of payment for services that produces compensation income without being wages for FICA tax purposes. The exercise of an option is the point at which the employer's promise to transfer employer stock in exchange for service is fulfilled. It is therefore reasonable to view the exercise as the event that would give rise to a wage payment, were there a wage payment. However, ISOs exist under a statutory scheme that requires the stock to be held for a period of time in order to obtain the capital gain tax benefits of section 422. This holding period requirement should be viewed as a Congressionally required limitation on the sale of stock since that is necessary to implement the Congressional intent of section 422. If there is a restriction on transfer, the ISO stock does not have a cash value for FICA purposes. Consequently, there are no FICA "wages" at exercise of an ISO. By contrast, at the time the compensatory phase of a nonstatutory stock option ends at exercise, the share is not statutorily subject to covenants that restrict liquidity, and, justifiably, the cash value has been identified as the spread at the time of exercise.

     In 1971, as now, section 3121 of the Code presented a statutory scheme under which all remuneration is wages, unless the remuneration falls into one of the enumerated exemptions. Then, as now, there was no enumerated exemption for stock option exercises or, more generally, for remuneration paid in a form other than cash, if a cash value could be assigned. Then, as now, if a cash value cannot be assigned when payment is made in a non-cash medium, the payment is not wages subject to FICA withholding. Given this statutory scheme, the rationale of Revenue Ruling 71-52 can only be explained by the observation that, at exercise, the payment of ISO shares does not constitute wages because a cash value cannot be assigned to the payment medium without undermining the special tax benefits provided for such options by Congress. Since this basic statutory structure has not changed, there is no justification for the decision to make Revenue Ruling 71-52 obsolete, as stated in Notice 2001-14.

Incentive Stock Options Become a Disincentive

     ISOs are widely used by private technology companies, particularly prior to profitability, when there is no public market for their stock and cash is scarce. Even public companies use ISOs pre-profitability to preserve cash. This is not an accident. Biopharmaceutical companies face an extremely long road to potential profitability given the lengthy timelines and high costs for basic research, pre-clinical and clinical studies, and regulatory review and approval of drugs and biologics. Typically, the time from identification of a candidate molecule until approval of a new drug or biologic is 10-15 years , and the aggregate costs are estimated at $800 million. Thus it is critical for these technology companies to conserve cash as much as possible to fund research and development until obtain their first product approval. Even today, the vast majority of biopharmaceutical companies have no approved products for sale. Funding through the private or public equity markets is not always available to support these lengthy and expensive development programs and the cost of cash is very high.

     Another very important reason that biotechnology companies rely on ISOs has to do with employee recruitment and retention. Such companies need to attract exceptional talent in all areas - business management, research, clinical operations, and marketing, for example - despite limited resources. Many of these companies cannot match the cash compensation and pension plans offered by mature companies in the biopharmaceutical sector. ISOs have been a valuable mechanism for such companies to attract and retain talent. For sweat equity, the employee receives the opportunity to own an interest in the company, and this motivational compensation did not, until now, cost the company a cash outlay. Under the proposed new rules, for rank-and-file employee awards, the cost now will be the same as in the case of an NSO. Assuming the employer can withhold the employee portion of the FICA tax and counting only the employer portion of the FICA tax, the cost is 7.65% of the spread in the option at the time of exercise. If this were the only effect of the FICA surcharge, there would be pressure to work with fewer employees or to reduce incrementally the already low salaries start-up companies pay rank and file. However, when the employee's predicament is taken into consideration, it is more likely that the imposition of FICA withholding requirements upon the exercise of ISOs will provide a final disincentive to employers to use broad-based ISO grants.

     The use of ISOs is already in decline due to the financially harsh imposition of the alternative minimum tax upon many employees who exercise ISOs. Enter the FICA withholding issue. The exercise of ISOs does not result in any cash payment from which an employer may withhold FICA/FUTA taxes. An employee who exercises an ISO does not receive a cash payment until the stock he or she received upon the exercise of the ISO is sold. Until the time such stock is sold, the employer will not have any payment upon which to withhold. As a result, an employer will be forced to withhold by either (i) share withholding, (ii) requiring a payment from the employee to cover the employer's withholding obligation, or (iii) withholding from the employee's other wages.

     Share withholding is a non-starter. It forces a disqualifying disposition of the shares withheld on the one hand, eliminating the tax benefit of the ISO or, on the other hand, the company has to come up with the additional 7.65% employee FICA tax above and beyond its employment tax liability on the exercise. A 15.3% surcharge is not a viable option for a technology start-up company.

     Withholding from an employee's normal wages places a financial burden upon the employee. Many rank and file employees simply will be unable to spare the money, especially after covering the exercise price on the option. If an employee is unwilling or unable to have his or her FICA obligation withheld from his or her normal wages, the employee will have to be required to tender a payment to the employer to fulfill the FICA obligation. While it is possible that an employee may satisfy the FICA obligation from savings, it is much more likely that employees, especially the rank and file, would be compelled immediately to sell a portion of the stock obtained upon the exercise of the ISO to fulfill their FICA obligation if there is a market for the stock. Once again we have a forced disqualifying disposition under Code Section 422. An employee who is forced to perform a disqualifying disposition will fail to receive the financial benefit of an ISO and will be unable to take full advantage of the opportunity to acquire an equity interest in his or her employer.

     In a private company setting, there are only two potential outcomes of imposing FICA withholding on ISOs. When these are summarized, it is easy to see that rank and file will receive few if any option grants at start-ups if the FICA withholding requirement is allowed to become effective:

• Outcome 1: Company provides cash in excess of 15.3% of the spread at exercise of an ISO to cover the employer and employee FICA taxes and the imputed income on paying the employees' FICA taxes. (If the company does share withholding, the results are worse because the regular income tax liability would need to be covered on the disqualifying disposition.)
• Outcome 2: Hire employees at low wages, explain that they will also get an ownership interest through options, but that wages will be disgorged at the time of option exercise to cover FICA withholding.

In fact, in the private company setting, the employer bears the risk of Outcome 1 whenever a former employee chooses to exercise.

Intense Coordination Effort Required

     Whether an employer withholds directly from an employee's wages or receives payment from the employee, the employer will be less likely to offer an ISO plan because of the increased burdens the employer will face under the FICA withholding requirement. First, the mere act of withholding on each ISO exercise will place new burdens on human resources and accounting departments. Corporate secretaries offices (and/or transfer agents for public companies) will have to coordinate with payroll vendors/departments concerning the number of shares exercised, the exercise price, the current value of shares, whether there are sufficient additional wages to withhold from those wages, and whether operating accounts are sufficiently funded to enable share buy-back and withholding. The effort will have to function fairly efficiently in order to enable withholding to occur in time to avoid the assessment of penalties. Further, employers will find that they must invest significant time and resources communicating to employees why they are obligated to withhold upon the exercise of an option. Finally, when an employee is forced to perform a disqualifying disposition, additional reporting requirements will be triggered. The combination of all of these new administrative burdens is likely to discourage employers, especially young biotech companies with small administrative staffs, from using ISOs.

     In the benefits arena, tax laws and the interpretation of them by the IRS tend to encourage business to provide the same types of opportunities to rank and file employees as are provided to the executive class. At start-up technology companies, the existence of ISOs has done more to foster employee ownership than had even been hoped for employee stock ownership plans, or "ESOPs" (the qualified plan vehicle). We urge you to keep along this path of progress by rescinding Notice 2001-14.

     Thank you for your consideration of these comments. If you have any questions or comments, please contact Stephan E. Lawton, Vice President for Regulatory Affairs and General Counsel, at (202) 962-9215.

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