IRS Audits Of Equity Comp: New IRS Guide Shows What To Expect

An IRS audit: a prospect that provokes stress and anxiety. Even if you are not personally targeted for an audit, an IRS audit of your company's equity compensation can still put you on the hook. Depending on what IRS examiners find, a company audit can lead to individual audits and amended personal tax returns for executives and employees.

The IRS recently surprised tax experts by issuing a new version of its stock compensation auditing guide, which had not been updated since 2015. Developed as an internal manual for IRS employees, it also offers businesses a helpful window into what IRS agents examine in audits related to all types of equity compensation. It’s a heads-up on stock options, restricted stock, restricted stock units (RSUs), stock appreciation rights (SARs), phantom stock, and employee stock purchase plans (ESPPs) for anyone who has these benefits or advises clients with them.

Professionals and taxpayers alike should review the guide to avoid pitfalls and tax situations that could trigger a dreaded IRS audit—the worst of which has been vividly described by tax attorneys as “an autopsy without the benefit of death.”

What IRS Agents Inspect With Stock Options And ESPPs

The IRS manual is called the Equity (Stock) - Based Compensation Audit Technique Guide. It gives IRS examiners a roadmap for audit scrutiny into when income should have been recognized, reported, and subjected to withholding, along with the related records, documents, and terms to review. In some ways, it also provides a brief general review and summary of equity comp taxation and IRS interpretations of the Internal Revenue Code (IRC).

As publishers who takes pride in the clear plain-English explanations of tax rules offered on myStockOptions.com, we could quibble with the IRS-speak and some inaccurate interpretations of the IRC in the audit guide. However, for now, let us simply highlight some issues the guide instructs IRS examiners to focus on in their search for tax errors:

• Loans to exercise options to ensure that they are recourse loans (i.e. you personally pay should you default) and whether they were forgiven/canceled or reduced.
• Qualifying and disqualifying dispositions for incentive stock options (ISOs) and tax-qualified ESPPs. These are shares from ISO exercises or ESPP purchases that were sold either before or after the statutory holding periods of two years from grant and one year from exercise/purchase that provide the best tax treatment.
• Annual limits on the size of ISO grants (only $100,000 can be vesting/first exercisable in one year) and ESPP purchases ($25,000 annual limit). While your company probably has a stock plan administration program to help it adhere to these limits (which are not adjusted for inflation), company mistakes can change your tax treatment by turning your ISO grant and ESPP into nonqualified stock options.
• Restrictions on transferred stock that create a substantial risk of forfeiture (SRF) which needs to lapse before taxes apply. The SRF concept is standard, for example, with most grants of restricted stock or RSUs, which must vest before you recognize taxable income and could be forfeited if you were to leave the company before the vesting date. A stock buyback right for your company at job termination is not seen by the audit guide as an SRF that postpones income recognition, as it defines those as “non-lapse restrictions.”
• Transfer of stock options to related persons, which makes them a “listed transaction” and could be an abusive tax shelter.
• Company reporting requirements for your ISO exercises (on Form 3921) and ESPP purchases (on Form 3922).
• Form W-2 reporting, including special reporting and codes for nonqualified stock options and other grants.
• Appropriate amounts and timely deposits of withholding for federal income tax, FICA (Social Security and Medicare), and FUTA.
• Timely IRC Section 83(b) elections for the early-exercise stock options used by private companies. Also for startups, whether any elections were made under IRC Section 83(i) to defer income.

IRS Collection Efforts Have Intensified, Including Audits

The updated audit guide also reflects the ways in which the IRS directs more audit attention toward higher-income taxpayers. The IRS has intensified its efforts in that area during recent years.

In 2023, the IRS announced a special focus on ensuring that large corporations and rich individual taxpayers pay taxes owed. In particular, the IRS said it is “ramping up efforts” to pursue high-income, high-wealth individuals who have not paid their taxes. The agency is concentrating in particular on roughly 1,600 US taxpayers with more than $1 million in annual income and over $250,000 in federal tax debt. Simultaneously, the IRS reassured middle-class taxpayers that audit rates would not increase for yearly incomes of under $400,000.

The initiative to collect past-due taxes from delinquent millionaires has paid off significantly. In early 2024, the IRS revealed that it had recovered more than $482 million in previously unpaid taxes. Just this month, the IRS reported that it had collected over $1 billion in past-due taxes from the target group. The agency stated that the revenue to that point represented payments from over 1,200 of the 1,600 targeted millionaires.

These efforts are funded by the $80 billion in additional multi-year funding that the IRS received under the 2022 Inflation Reduction Act. The agency wants to reduce the embarrassingly wide $688 billion gap between estimates of the amount of tax owed each year and the amount that is voluntarily paid.

Likelihood Of Getting Audited: Data On IRS Audit Activity

In general, the more you make, the more likely you are to be audited by the IRS. Sudden income spikes, such as income from a stock option exercise or the vesting of RSUs, are a red flag that can trigger an audit.

The IRS periodically publishes information about its general audit activity. The latest update, the 2023 IRS Data Book, covers the IRS fiscal year from October 1, 2022, through September 30, 2023. It reveals the following facts:

• Over the decade preceding 2023, the IRS examined tax returns filed by 8.7% of taxpayers with income of more than $10 million; 3.1% of taxpayers with income of $5–10 million; and 1.6% of those with income of $1–5 million.
• In 2023, the IRS completed 582,944 tax-return audits, resulting in nearly $32 billion of extra tax revenue.
• Most audits in 2023 (77.3%) were conducted via correspondence; 22.7% were conducted “in the field.”

Increasingly, IRS computers automatically check tax-return accuracy. The Automated Underreporter Program compares income in tax returns with IRS data. When the computers find a discrepancy, they automatically issue a notice (CP-2000) requesting an explanation.

CP-2000 Notice For Not Reporting Company Stock Sales Accurately

For example, when you immediately sell all shares acquired from a vesting of restricted stock or exercise of stock options, you may think you do not have taxable income beyond the ordinary income reported on your W-2, as there was no capital gain upon the stock sale. However, even in this situation, you must report the stock sale on IRS Form 8949 and Schedule D of your Form 1040 tax return, as the IRS still receives Form 1099-B from your brokerage firm to report the sale. If the sale is not also reported on your IRS forms, the IRS will send you a CP-2000 notice looking for you to pay taxes on the full amount of the sale proceeds!

Additional Tax Resources

For additional tax resources on all types of equity compensation and ESPPs, including tax-return reporting, see the Tax Center on myStockOptions.com.

myStockOptions Webinars

See the myStockOptions Webinar Channel for upcoming webinars and past webinars on demand. Each webinar offers CE credits for CFP, CPWA/CIMA, CEP, EA (live webinars only), and CPE (live webinars only), plus CFA self-determined credits. Featured experts present real-world case studies. On-demand webinars are listed below. Click on the links to register now!

FUNDAMENTALS

• Equity Comp Masterclass (Part 1): Stock Options

• Equity Comp Masterclass (Part 2): Restricted Stock/RSUs & ESPPs

• Stock Compensation Bootcamp For Financial Advisors

• Stock Comp Tax Essentials: Crash Course

ADVANCED

• Equity Comp Masterclass (Part 3): Best Ideas From Top Advisors

• Restricted Stock & RSU Financial Planning: Insights From Leading Advisors

• Stock Option Exercise Strategies: Managing Risk & Building Wealth

• Year-End Financial & Tax Planning For Equity Comp

• Preventing Tax-Return Mistakes With Stock Comp & Stock Sales

SPECIALIZED

• Stock Comp Financial Planning For Private Company Employees: From Startup To IPO Or Acquisition

• 10b5-1 Trading Plans And Other SEC Rules Advisors Must Know

• Strategies For Concentrated Positions In Company Stock

• Negotiating Equity Comp At Hire & Protecting It In Job Termination

Wealth Tax Debate: The Movie

As the 2020 presidential election year approaches, Democratic candidates, most notably Senator Elizabeth Warren, have proposed a 2%–3% wealth tax on the assets of the super-rich to help ensure that they pay their fair share along with other taxpayers.

Upon first hearing about a wealth tax, we at myStockOptions.com thought it could apply to any company founder that built a successful company, executives with substantial grants of stock options or restricted stock units, or employees who joined an early-stage startup and now have significant wealth after an IPO or acquisition. However, the proposed tax is really for the super-wealthy: billionaires and mega-millionaires. Under Senator Warren’s proposal, for example, the wealth tax would be triggered only if your household net worth, including stock holdings, is over $50 million. It would apply to individuals such as Jeff Bezos, Michael Bloomberg, Bill Gates, Larry Ellison, Larry Page, Mark Zuckerberg, and others whose enormous wealth comes from stock in the companies they founded.

To find out more, we watched the live internet-streamed seminar The Wealth Tax Debate, recently held by the Penn Wharton Budget Model (PWBM). It’s a nonpartisan research-based initiative at the Wharton School, the business school at the University of Pennsylvania. Three scholars discussed the feasibility and tradeoffs of the wealth tax proposed by Senator Warren and other Democratic presidential candidates. Below I present a few highlights from each speaker’s talk.

While this streaming video is perhaps not as exciting as Amazon Prime or Netflix, for anyone interested in tax and public policy issues it’s an absorbing drama and short enough to watch in one sitting. It runs about 90 minutes (presentations 50 minutes and Q&A for remainder), shot with a single camera and no editing, with the speakers’ slide decks on screen during their talks.

After watching the full 90-minute running time of the seminar, you’ll come away with a better understanding of the complex issues involved with the wealth tax. Those who oppose the wealth tax will give this movie a thumbs up, while supporters of the wealth tax may find parts of it tough viewing.

Wealth Tax In Brief

Many of the wealthiest US citizens have vast assets but little income, so traditional income taxes struggle to reach them. In the view of some of the Democratic presidential candidates, a wealth tax would ensure that these very richest Americans pay their fair share.

Another underlying purpose for the wealth tax concerns democracy. By reducing income inequality, the wealth-tax proposals seek to protect democracy itself by limiting political oligarchy: the amount of wealth and related political influence that the rich can accumulate. The aim is to control the potential for one tiny plutocracy to dominate election campaigns.

The Wealth Tax Debate

In the Penn Wharton seminar, Senator Warren’s proposed wealth tax is the primary focus of the three speakers. Her proposal’s research, rationale, and estimates of revenue potential were developed by Emmanuel Saez and Gabriel Zucman, two economists at the University of California, Berkeley.

Part One: Economic Growth

Richard Prisinzano, Director of Policy Analysis at Penn Wharton Budget Model (PWBM), presented his research team’s initial projection of the impact Senator Warren’s proposed wealth tax would have on revenue and the US economy. The researchers found that if the tax raises as much new revenue as intended and the revenue is used to cut the federal debt, annual economic growth in the United States would slow from the current average of 1.5% to an average of just over 1.3% over a decade.

Broadly, the PWBM finds that wealthy Americans would simply consume more, save less, and invest less to reduce taxable wealth. The resulting drop in investment would, in its modeling, reduce economic growth. “The wealth tax shrinks the economy because saving is more expensive,” Mr. Prisinzano summarized. “The results also suggest that the negative effect of the tax increases as the tax rate increases.”

For commentaries that critically review at least parts of this PWBN analysis for not fully considering the potential economic growth generated from government programs that spend the new tax revenue, see articles in Business Insider, The Week, and New York Magazine’s Intelligencer.

Part Two: Questions Of Revenue, Constitutionality, And Alternatives

Natasha Sarin, Assistant Professor of Law at the University of Pennsylvania Carey Law School, dissected the revenue estimates of Senator Warren’s wealth tax that were calculated by Emmanuel Saez and Gabriel Zucman at UC Berkeley. In short, she finds their assessment flawed and unrealistic. When she dynamically corrects what she considers “sloppy math” and unfounded assumptions about actual wealth holdings and tax compliance among the rich, she projects that the proposed wealth tax would generate $1.1 trillion, far lower than the Warren team’s estimate of $2.75 trillion.

Additionally, the task of annually assessing the net worth of the wealthy for a wealth raises difficult practical issues. Given that over 50% of wealthy assets are illiquid, how would they be valued?

Furthermore, shifting from economics to law, Professor Sarin noted that a wealth tax would almost certainly be challenged as unconstitutional and probably nixed from the start. Under the US Constitution, direct taxes must be evenly apportioned across the states. However, the roughly 75,000 super-wealthy households impacted by a wealth tax are not evenly distributed across states. Given two centuries of legal precedent against a wealth tax, she believes that the current US Supreme Court, for better or worse, would inevitably rule that a wealth tax is unconstitutional.

Professor Sarin shows in her slide deck that, instead of attempting a wealth tax that may be problematic, there are more efficient ways to raise federal revenue:

• crack down on IRS tax compliance among the wealthy (she recently wrote a paper on this with economist Lawrence Summers)
• close corporate and individual tax shelters
• eliminate the stepped-up basis of assets at death
• cap taxable deductions for the wealthy
• end pass-through deductions
• broaden the estate-tax base
• increase the corporate tax rate

She estimates that these measures would increase revenue by $2.83 trillion, slightly beating the revenue estimate of $2.75 trillion put forward by Senator Warren’s team—and hugely exceeding Professor Sarin’s $1.1 trillion estimate of the wealth tax’s actual revenue potential.

Part Three: Tax Tradeoffs

Greg Leiserson, Director of Tax Policy and Chief Economist at the Washington Center for Equitable Growth, discussed the approaches and tradeoffs of taxing wealth. He explained the issues in the different approaches of taxing wealth itself compared to taxing the income generated from wealth, and the difference between taxation based on valuation compared to when the gains are realized.

He summarized the advantage of the income approach:

• More seamless integration with existing income tax
• Greater risk sharing between taxpayer and government
• Reduced constitutional risk

He summarized the advantages of the wealth approach:

• Taxes assets that generate consumption flows
• Less volatile revenues
• Easier to explain

He concludes that any approach needs to look at who the tax is burdening, which we assume impacts compliance, and how much revenue is going to be realistically raised. (For the challenges involved in raising more tax revenue from the super-wealthy, see what financial advisors have to say in an article from The New York Times.)

Wealth Planning: Not Just For The Super-Rich

Whatever the size of your wealth from stock compensation and company stock holdings, you and your advisors will find useful planning ideas and insights in the section Financial Planning at myStockOptions.com.

SCOTUS Decision On Stock Options At Railroad Companies: Do The Justices Understand Stock Compensation?

Some interesting summer reading came our way in a recent Supreme Court decision that features stock options: Wisconsin Central Ltd. v. United States. The decision is an easy read that provides some insights into what the justices in our highest court know about equity compensation. While initially it appears that the application of the decision is narrow and applies only to employee stock options (also perhaps RSUs and other types of stock compensation) at railroad companies, the implications are broader.

In short, by a 5–4 margin, the Supreme Court ruled that options are not taxable compensation under the Railroad Retirement Tax Act (RRTA) because they are not "money remuneration" as meant by the term in the statute, which was written in 1937. Significantly, when Congress adopted the RRTA it also enacted the Federal Insurance Contributions Act (FICA), which taxes "all remuneration," including benefits "paid in any medium other than cash." Therefore, according to Justice Neil Gorsuch, who wrote the majority opinion, "the Congress that enacted both of these pension schemes knew well the difference between 'money' and 'all' forms of remuneration and its choice to use the narrower term in the context of railroad pensions alone requires respect, not disregard."

The RRTA, which few stock comp professionals are familiar with, provides funding for pension-like benefits to railroad employees instead of Social Security retirement benefits. The spread at exercise would still be subject to the standard income tax rules, as the NASPP recently confirmed in its blog. For railroad companies, a commentary from PwC provides some guidance on the decision. Of course, for those not working on the railroads, the spread at the exercise of nonqualified stock options (NQSOs) remains subject to Social Security and Medicare taxes.

Does The Supreme Court Understand Stock Options?

The vote on the court followed the conservative-versus-liberal pattern of many 5–4 decisions. Therefore, in our view, the majority opinion and the dissenting opinion (by Justice Breyer, joined by Ginsberg, Sotomayor, and Kagan), represent an argument over two points:

• the approach the Supreme Court should take in interpreting statutory language
• the ability of government agencies, such as the Treasury Department and the IRS, to issue regulations when terms of a statute are ambiguous

Like any well-written Supreme Court decision, this case can be analyzed on many different levels. At myStockOptions.com we were interested to see how well the Supreme Court justices understand and explain stock options and equity compensation. They seem to know how stock options work, they recognize the differences in the taxation of ISOs and NQSOs, and they comprehend the underlying purpose of equity compensation for employers. Justice Gorsuch succinctly states that the goal of options is "to encourage employee performance and align employee and corporate goals" and describes in his own way the various exercise methods. In his dissent, Justice Breyer discusses how companies use stock options to compensate employees—in part, "hoping that by doing so they will provide an incentive for their employees to work harder to increase the value of the company."

For Justice Gorsuch, the author of the majority opinion, it didn't seem to matter as much that stock options can be easily exercised and the shares sold for money. Yet in the minority opinion, Justice Breyer elucidates in detail the procedure for cashless exercises and provides data on how a large percentage of employees at railroad companies use this exercise method. He also notes that many of the country's "top executives are compensated in both cash and stock or stock options," with stock-based compensation often exceeding cash salary. The strongest argument in his dissenting opinion is that cashless exercise makes options almost identical to money remuneration. After reading a summary of the justices' questions during the oral argument and the lawyers' replies, we do wonder if the decision hinged on whether the justices who supported the majority opinion fully understood how cashless exercises really work. For stock plan professionals who lived through the intense debates as to whether stock options should be expensed on the income statement (they have been since 2006), it is odd that the decision does not mention the accounting rules, even in its discussion of whether options have a "readily discernible value."

Updated Stock Compensation Audit Guide From The IRS Provides Compliance Checklist

To help its examiners, the IRS develops Audit Techniques Guides (ATGs) to provide insights into the issues and accounting methods that are unique to certain industries and types of compensation. While ATGs are designed to provide guidance for IRS employees, they can also reveal tax issues that need special attention from taxpayers, companies, and tax professionals.

In late August, the IRS released an updated version of its ATG for audits involving stock compensation: Equity (Stock) - Based Compensation Audit Techniques Guide, which seems to be a set of marching orders for IRS examiners. Companies, tax professionals, and compensation consultants will want to review it. (The update to the equity comp ATG follows a recent update to the IRS audit guide on nonqualified deferred compensation, issued in June.)

In this blog commentary, we provide an outline of the updated ATG on stock compensation. Parts of the guide summarize and confirm the tax treatment for different types of equity compensation. Other parts raise issues about how the IRS applies and interprets certain IRC sections and IRS regulations. Although we are still absorbing some of the guide, we are eager to publish this outline of it now to present its important points to the many people who follow myStockOptions.com and stock compensation developments.

How The IRS Prepares For Audits

During the initial examination process, a review of the company's SEC filings and the taxpayer's internal documents is a good place to start, recommends the ATG. The review of these documents may help to identify people who have received equity-based compensation, suggests the guide, which gives some tips for examiners (and anyone, really) on how to find the key provisions in SEC filings and company documents.

What IRS Looks For In Stock Transfers And Awards

The ATG lists, with brief explanations, the hot IRS topics that are leading to tax errors in recognizing income, withholding, reporting, and underpayments. Given all the other subjects related to stock compensation that the IRS could have selected, we assume that these are high priorities. In the guide, the IRS tells its auditors to determine whether:

• stock was actually transferred
• stock options were transferred to a related person
• the purchase price was reduced for a note used to acquire employer stock
• elections were punctually made under IRC §83(b) and records verify these timely elections
• a substantial risk of forfeiture exists to delay vesting according to the facts and circumstances
• dividends were paid on restricted stock

For each of these, the IRS explains the issues and then covers ways in which examiners can root out potential tax errors.

What IRS Looks For With Stock Options

In addition to the items listed above, the ATG delves into even greater detail with stock options. The guide tells IRS auditors to determine the type of stock options granted and to then closely examine whether:

• statutory stock options, which in IRS terminology includes ISOs and tax-qualified ESPPs, are following the specific IRC provisions for them, both in their grant terms and in the taxes incurred when shares are sold
• reporting and filing rules were complied with, including those for Form W-2 and those required for ISOs and ESPPs under IRC Section 6039
• appropriate amounts were promptly deposited for the withholding of FICA, FUTA, and federal income tax

The ATG also covers other types of equity-based compensation, instructing its examiners to look at the payout structure of phantom stock plans and of stock appreciation rights (SARs) at exercise. While the guide has information on restricted stock units (RSUs) near the end, this is merely a summary of the tax rules for them and a reminder that RSUs must follow IRC Sections 451 and 409A to avoid taxation at grant.

Here We Grow Again: myStockOptions.com Expertise Expands With New Articles On Diversification, IPOs, And Foreign-Asset Reporting For Employees With Equity Compensation

At myStockOptions.com, our array of award-winning articles on all aspects of equity compensation has grown. In recent weeks, we have welcomed new contributions from expert authors on three crucial topics.

Importance Of Diversification For Employees With Equity Awards And Company Stock

Through its author's personal example, a new article at myStockOptions.com presents the dangers of a concentrated stock position, discusses why diversification may be hard for employees with shares from equity compensation, and explores strategies for preserving your net worth. In Your Company Stock: The Importance Of Diversification, CFP Laura Tanner recounts her experience with stock compensation at a company where she used to work as a research scientist, and she explains the lessons she learned.

To read the article and find more insights into investment diversification for employees with stock options, restricted stock/RSUs, or ESPPs, see our section Financial Planning: Diversification.

Careful Planning For Pre-IPO Equity Comp When The Company Goes Public

Initial public offerings (IPOs) are on the rise. The high-profile IPOs of Facebook and Twitter are just two of many IPOs that have been launched over the past couple of years, including several in Silicon Valley. In the newest installment of our Stockbrokers' Secrets series, our pseudonymous financial advisor W.E.B. Bantling provides a pep talk about smart planning for pre-IPO stock options, restricted stock, or RSUs when the company goes public. At the time of the IPO, when the company finally pours long-awaited liquidity into those grants, planning considerations must be carefully weighed.

In the author's experience, clients at companies preparing for an IPO are often giddy with thoughts of the wealth and opportunities it will provide. Many of them have worked at these companies since the startup stage, and the IPO represents a long-awaited event that may be life-altering for both their company and them. However, the author always emphasizes five planning points that may help to manage employee expectations in an IPO situation. He shares some of this wisdom in the new article, Stockbrokers' Secrets: Financial Planning For Equity Compensation At IPO Companies, available in our section Pre-IPO: Going Public.

International Equity Awards And Company Stock: Tricky Rules Of IRS Reporting For Assets And Income In Foreign Financial Accounts

United States citizens and resident aliens are taxable on their worldwide income. The related IRS reporting rules are complicated, and mistakes can lead to costly penalties. In fact, the IRS has launched an aggressive initiative to identify taxpayers with unreported foreign income and/or assets in foreign financial institutions. Charges of tax evasion stemming from unreported foreign income have been brought against dozens of individual taxpayers, including bankers, lawyers, and advisors.

In a new article at myStockOptions.com, compensation and tax expert Richard Friedman presents the rules and related issues of IRS reporting for assets and income that an international US taxpayer may hold in a foreign financial account—including those acquired through stock options, restricted stock, RSUs, or other equity awards. The article, International Equity Awards And Company Stock: The Confusing World Of IRS Reporting For Overseas Assets And Income, is available in our section Financial Planning: High Net Worth.

License Our Expertise For Your Employees

For companies, education is vital for ensuring that stock compensation motivates and retains highly valued employees and executives. All of our expert yet reader-friendly articles, FAQs, and other content are available for licensing by companies that want to improve their stock plan education and communications for participants. Content licensing is just part of the suite of corporate services that we offer.

Recent Tax Developments That Affect Stock Compensation

Tax returns have been our focus (and probably yours too) over much of the past two months. However, now that tax-return season is over, it's time to catch up with some major recent tax-related developments that have an impact on stock compensation. The tax content at myStockOptions.com has been fully updated for the developments presented below. (Relevant updates have also been made at our separate website myNQDC.com, which covers all topics in nonqualified deferred compensation.)

"Substantial Risk Of Forfeiture" And Restricted Stock

The concept of "substantial risk of forfeiture" (SRF) under Internal Revenue Code Section 83 directly affects the timing of:

• the taxation of restricted stock grants
• the FICA taxation of RSUs
• the taxation of nonqualified stock options (in limited situations)

In short, for as long as any type of compensation is subject to the possibility of forfeiture, it is not taxed. With restricted stock, income is therefore not recognized while the stock is subject to this risk during the vesting period. Once this risk lapses upon vesting, and thus you could quit the company without forfeiting the shares, the value of the stock is taxed.

The IRS issued final regulations, somewhat similar to the proposed regulations, that confirm and clarify previous IRS revenue rulings, court decisions, and the widely accepted understanding of what constitutes a substantial risk of forfeiture. For example, the proposed and final regulations confirm that transfer restrictions such as a lockup agreement, a noncompete, or a potential insider-trading liability are not SRFs, even though they present the possible forfeiture or disgorgement of some or all of the stock, or another penalty. For more details, see a related FAQ at myStockOptions.com, along with memos from Towers Watson and a blog analysis from the law firm Winston & Strawn.

Tax Reform?

Dave Camp, the Chairman of the House Ways and Means Committee, has distributed a draft of a broad tax-reform law that carries a few proposals aimed at executive and equity compensation. For example, the bill known as the Tax Reform Act of 2014 would eliminate the exception for performance-based compensation (e.g. stock options) from the $1 million deduction limit under Section 162(m) and would include the CFO among the covered employees whom it applies to. The proposed legislation would repeal Section 409A, and a new Section 409B would tax compensation when it is no longer subject to a risk of forfeiture (i.e. at vesting) under Section 83 of the tax code—a shift that would cause a major change in the taxation of nonqualified deferred compensation. Other proposed tax changes would indirectly affect stock compensation. These proposals include the elimination of the alternative minimum tax and a provision to tax capital gains at 60% of a person's marginal tax rate.

Numerous law, consulting, and accounting firms published memos about the proposed legislation and its potential impact on equity compensation and other employee benefit plans. These include commentaries from Proskauer Rose and Groom Law Group. An analysis from Buck Consultants reassuringly echoes many other commentaries by saying that the draft has "little chance of becoming law." However, the firm notes, many of the revenue-raising provisions in the draft that include modifications to employee benefits could be "picked up in the future to offset federal spending and reduce deficits."

Tax Treatment For Disgorgements And Clawbacks

Uncertainty surrounds the tax treatment that applies when an executive must return compensation through a clawback provision. In a blog commentary about this topic at his firm's website, attorney Michael Melbinger of Winston & Strawn discusses a recent case decided by the US Court of Claims, Nacchio v. United States. This case concerned a disgorgement (as a penalty for insider trading) of stock-sale gains on which taxes had been paid. The court allowed a claim-of-right tax credit under IRC Section 1341. By analogy, notes Mr. Melbinger, this precedent can apply to most (if not all) Dodd-Frank clawback situations. For more on this topic, see a related FAQ at myStockOptions.com.

Discounted Stock Options Hit With Section 409A Surtaxes

A recent summary judgment decision, in Sutardja v. United States (Federal Claims No. 11-724T 227-13), makes it clear that discounted stock options face the draconian penalties of IRC Section 409A. The ruling upheld the IRS assessment of a 20% surtax plus interest on income the plaintiff received at option exercise under deferred compensation arrangements found to be noncompliant with 409A. The amounts in dispute total $3,172,832, plus another $304,456 in interest. While in this challenge to the IRS assessment the court still must decide whether discounted stock options were actually granted, it brushed off all the plaintiff's legal arguments claiming that Section 409A does not apply to discounted options.

This case drew attention in a few different law firm blogs. These included Benefits Notes by Leonard Street & Deinard, where attorney bloggers discussed the case on March 7 and again on March 12. As the attorneys warn, the IRS is strictly enforcing the Section 409A rules in examinations of employers. Unless discounted options are structured to be exercised only on a fixed date or upon an allowable 409A event, the law firm urges companies to use one of the safe harbors in the regulations on setting exercise prices. It also warns executives that "they can be the ones who suffer even if they are not the ones who set the discounted price for the options."

In an alert on March 21, the law firm Morgan Lewis examines some implications of the decision. In their view, the case symbolizes the need for careful attention in determining and documenting how the fair market values of options are determined—at the risk of dire tax consequences. The firm also notes that the plaintiff, a co-founder of a now public and successful semiconductor company, "may still prevail" in the trial to determine whether the options were discounted when the company was private, so additional developments in this case "merit watching."

In his Executive Compensation Blog (Mar. 26), comp and benefits attorney Michael Melbinger of Winston & Strawn criticizes the IRS decision to bring the case, given the common stock option grant practices at the time of the disputed activities. He feels "it is extremely disappointing that the IRS would demand penalties under the facts and timeline in this case."

For additional information on discounted stock options, see the related FAQ on myStockOptions.com. See also myNQDC.com, our sister website on nonqualified deferred compensation, for details on IRC Section 409A.

Back-To-School Reading: Preventing SEC And IRS Problems For Executives Selling Or Buying Company Stock

As tangy autumn breezes usher in that back-to-school feeling, we at myStockOptions.com have published a pair of exclusive new articles for executive education about stock compensation and related issues.

In a two-part series, Compliance Concerns That Executives Must Understand To Prevent SEC, IRS, And Corporate Problems, financial planner Richard Friedman of The Ayco Company explains his top 10 most important points executives must know to stay out of trouble with their equity awards. This article nicely complements the other articles and FAQs in the SEC Law section at myStockOptions.com. Part 1 focuses on compliance issues involving company stock holdings and transactions, including the topics of insider trading, Section 16, share-ownership requirements, and Rule 144. Part 2 presents several more issues, including those involving foreign financial interests, nonresident state tax returns, retirement plan funding, and company rules.

"Ways to measure and address risk have become important for Corporate America," asserts Mr. Friedman. "One of the often underappreciated moral hazards facing companies of all sizes is the risk that an executive or employee may violate corporate, tax, or securities law. As companies are subject to enhanced and often mandated disclosure, violations can lead to unwanted public attention, embarrassment, and reputational risk."

Meanwhile, compensation and benefits attorney Michael Melbinger, of Winston & Strawn in Chicago, has written an article specifically on the unique equity-award tax issues faced by non-US executives preparing to work in the United States. Foreign Executives Transferring To The United States: Tax-Planning Strategies For Equity Compensation outlines the significant tax and estate-planning opportunities—and traps—that exist for foreign executives coming to America. "If you are a foreign national who will become a resident alien in the US," writes the author, "timing is crucial in the recognition of income and the payment of deductible expenses."

At myStockOptions.com, our publication schedule runs all year. Check back often for new articles, and remember that any or all of our content is available for licensing by companies as part of their stock plan education for employees and executives.

With Options And Restricted Stock, Attempts To Delay Taxes Usually Fail

In the standard tax treatment of stock options, the exercise of the options triggers taxes. For NQSOs, ordinary income tax is paid on the value of the spread at exercise. With incentive stock options, the spread at exercise is part of the calculation for the alternative minimum tax. With restricted stock/RSUs, the date of vesting and share delivery is used to calculate taxes on the income represented by the shares you receive.

But what happens if you cannot sell shares to pay the taxes on this stock-based income? Your company may impose a blackout on trading its stock. There may be a lockup, or perhaps the shares temporarily cannot be resold because of other securities law restrictions, such as insider trading prevention or the Section 16 short-swing profit rule. Maybe the shares are not registered with the SEC, or perhaps they are subject to a noncompete clause or a clawback. It would appear unfair to have to pay taxes on stock income received through exercise or vesting if you could not sell the underlying shares at all, even just to pay the taxes.

As unfair as it seems, this is the reality presented by the US tax code, the IRS, and numerous court decisions. Taxation on the stock-based income can be delayed only by a true risk of forfeiture in the grant. In Strom v. United States (2011), the 9th Circuit Court of Appeals recently reinforced the difficulty faced by challenges to this rule. Earlier, the federal district court had supported the plaintiff's arguments that the date for the tax calculation should be delayed if a sale at exercise would trigger penalties under Section 16, but the circuit court rejected this position. By remanding the case back to the district court, the appeals court did show at least some curiosity about the taxpayer's other contention: that the merger rules on pooling accounting which applied at that time, though not now under FASB 141, are another reason for delaying the tax treatment date.

If you challenge existing tax rules, beware of getting too creative. In Notice 2004-28, the IRS indicates the danger of assuming a delay in taxation when completing a tax return. Claims that a tax treatment date is delayed or deferred could be considered "frivolous" and provoke an IRS challenge, along with civil (or even criminal) penalties. The IRS has been aggressively pursuing these cases in various courts—and continues to win them.

Stock Comp More Likely Than Ever To Trigger IRS Audits

Fluctuations of income, including sudden increases from stock compensation, can be a red flag triggering a dreaded audit by the IRS—especially now. The IRS Data Book has disclosed a large increase in audits among people whose adjusted gross income is over $500,000 per year, with a particularly big jump for those with income over $5 million. For taxpayers earning between $500,000 and $1 million yearly, the audit rate rose from 2.77% in 2009 to 3.37% in 2010. Annual incomes between $5 million and $10 million saw a 11.55% audit rate in 2010, up from 7.52% in 2009.

IRS audits are performed at three different levels, depending on the zeal of the investigation.

• Correspondence audits are conducted by mail and seek to verify deductions and credits that you have claimed on your tax return. The number of correspondence audits has risen by over 100% in recent years.
• Office examinations, held on IRS property, entail a meeting between you and IRS compliance officers to scrutinize your tax return.
• Field examinations, the most demanding (and uncomfortable) type of audit, involve a visit by IRS revenue agents to your office or home for a thorough analysis of information pertaining to individual and/or corporate tax returns.

Normally the IRS can perform audits only within a three-year statute of limitations that starts on the filing date of a tax return. However, in some circumstances the IRS can obtain a six-year statute of limitations for what it believes to be "substantial underreporting of income."

For more on IRS audits of both individuals and corporations, see the related FAQ on myStockOptions.com. For help in avoiding the types of tax mistakes that can draw the attention of the IRS, see the articles and FAQs in the Tax Center on myStockOptions.com and in the Taxes section of myNQDC.com.