IRS Rule Amending Stock Exemptions Under Fire

May 6, 2002 ( - A newly proposed rule by the Internal Revenue Service to impose payroll taxes on employee stock purchase plans has industry insiders up in arms.

In particular, lobbyists for the tech industry are chagrined because the rule would include ESPPs and other plans currently exempt. ESPPs are widely used by employers in the embattled sector.

The Problem

ESPPs allow companies to take a portion of a participant’s after-tax wages to purchase company stock at a discounted rate – usually 10% to 15% below market price. Participants can then choose whether to sell their stock immediately or hold on to it.

The new rule would tax the discount, thus creating a new problem for participants. Unless participants were to sell the stock they receive through their company’s ESPP the same day they receive it, they would owe money on the earnings they have yet to receive. In turn, employers would be required to pay the IRS a matching amount. 

To add insult to injury, the new rule would create a conundrum for employers and participants at the same time. Employers would have to withhold payroll taxes without knowing an actual amount to calculate withholdings on. Participants, on the other hand, would have to sell their stock to cover the cost of the tax. And, those participants who sold quickly would be subject to higher taxes at the end of the year because they would be disqualified from the lower capital-gains tax.

On The Hill

The IRS put the new rule into effect last year when it overturned the exemptions from payroll taxes on certain kinds of stock. Soon after, the IRS decided to delay the change so that it could clarify the effect the rule would have. Last November the IRS came back, clarified the changes and declared that the new rule would go into effect on January 1, 2003.

Several members of Congress have proposed legislation to block the regulation from taking effect, including Senator Pat Roberts (R-Kan) and Senator Hillary Clinton (D-N.Y.). Another bill sponsored by Representative Amo Houghton (R-N.Y.) opposing the rule passed a House vote last month.

Critics of the rule are skeptical that any final legislation on the issue will come out of Congress this year. They say the Republican House and Democratic Senate are not likely to agree right away and other issues such as the war on terrorism and the accounting industry’s problems will most likely overshadow the debate on the new rule. The IRS is planning a hearing on May 14.

Weighing In

Opponents of the new rule say it would add another level of complexity to an already complicated process. 

“Many people oppose this rule because it would discourage employers from offering the programs due to the new administrative and economic burdens it would impose,” said Scott Roderick, director of publishing and information technology at the National Center for Employee Ownership.

Caroline Graves Hurley, tax counsel and director of tax policy at the American Electronics Association, said the new rule is troubling because it flies in the face of why ESPPs were set up in the first place.

“Congress created these benefits to afford beneficiaries better tax benefits,” she said. “By changing the rules the IRS will create a significant tax increase on employers and employees by imposing wage withholdings on income that is not wages.”

Hurley continued that the Joint Committee on Taxation released findings that found that the passage of the new rule would turn into a $23 billion tax increase over the next 10 years. However, she added that while over each year, the increase might seem small; employers would feel the changes the most.

John Scott, director of retirement policy at the American Benefits Council agreed.
“Employees would have to sell their stock to pay for owning the stock,” he said. “And employers would have to get into a lot of modification issues to impose this proposal.”

To raise awareness about the issue, the AEA is teaming up with ABC to sponsor an informational teleconference on May 13th. Members of both groups will be on hand to answer questions about the IRS’ regulatory aims and the history of the plans.