IRS Eyes Payroll Tax On Incentive Stock Options

The IRS is signaling its intent to start imposing payroll taxes on proceeds from incentive stock options.

By Todd L. Treadway

Peter Blank, Editor, The Kiplinger Tax Letter

February 22, 2001

The value of incentive stock options will take a big tax hit if the Internal Revenue Service (IRS) goes ahead with plans to sock them with payroll taxes. Since 1971, the IRS has said employers don't have to withhold income or payroll taxes when an incentive stock option (ISO) is exercised.

But the Service appears to be changing its mind. It is putting everyone on notice that starting in '03 it plans to require employers to withhold Social Security, Medicare and unemployment tax on the options when they are exercised. In short, exercised options will be treated the same as regular wages for payroll tax purposes. That's a hit of 6.2% each for employers and employees for FICA taxes and 1.45% each for Medicare.

Imposition of the FICA tax won't affect high-paids because they already top the wage base on which the tax is imposed-$80,400 this year. But even high-paids will be hit with the Medicare tax because it covers all wages.

Many firms give out these options to workers as inducements to accept riskier positions and to work hard at making the business a success. Options have traditionally gone to company officers and executives, but now many start-up companies offer them to just about all workers as an incentive to stay with a new, untested company.

Tax-qualified incentive stock options will still have a tax advantage because workers who follow the rules pay at capital gains rate-a maximum of 20% as opposed to what is usually a higher rate on their income taxes.

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