Tax withholding for equity compensation

Equity compensation comes in many forms and the federal income tax and payroll withholding rules vary widely depending on the type of equity compensation involved. Equity compensation generally refers to any non-cash incentive pay that represents ownership in the employer entity that is paid to employees or service providers. Equity compensation may be in the form of actual company shares or phantom units; stock appreciation rights; restricted stock; restricted stock units or performance share units (RSUs or PSUs); stock options; or partnership capital or profits interests. For a more in-depth analysis of the forms of equity compensation, read Understanding equity compensation devices.

As a starting point to determine the tax withholding on equity compensation, you must understand the type and amount of equity compensation involved and when the taxable event occurs. This table provides a high-level overview of the general guidelines on taxable events and the timing of federal income tax withholding. There are some exceptions and nuanced tax treatments that are beyond the scope of this article and have not been included.

The next consideration is determining the amount of equity compensation that is to be recognized at the taxable event. Section 83 addresses the tax treatment of property transferred in connection with the performance of services. Section 83(a) provides that the excess of the fair market value of the property over the amount paid, if any, for the property is included in the gross income of the person who performed the services. The amount of income or compensation will depend on the type of equity compensation arrangement. For a more in-depth discussion on valuation of equity compensation in private companies, read General equity compensation valuation rules for private companies.

General rule for tax withholding and timely deposits

As a general rule, when an employee earns wages both the employer and employee are liable for the mandatory employment taxes imposed by the Federal Insurance Contribution Act (“FICA”), which fund Social Security and Medicare, and the employer must submit federal income tax withholding on the compensation. Reg. sec. 31.3121(a)-2(a) provides that wages are generally subject to FICA tax when actually or constructively received. Similarly, Reg. sec. 31.3402(a)-1(b) provides that the employer is required to deduct and withhold income tax from the employee's wages when paid, either actually or constructively. Thus, both employment and income taxes must generally be withheld when wages are actually or constructively received. Equity compensation is supplemental wages for income tax withholding purposes so employers may choose to use flat rates for federal income tax (if the equity compensation is separately identifiable from regular wages that have tax withholding) or the aggregate method of withholding (refer to reg. sec. 31.3402(g)-1. IRS publication 15 is a good resource for additional information on supplemental wage withholding).

Reg. sec. 31.6302-1 provides the deposit rules for FICA taxes and federal income tax withholding. In general, reg. sec. 31.6302-1(a) provides that an employer is either a monthly depositor or a semi-weekly depositor, based on an annual determination. Reg. sec. 31.6302-1(c)(1)-(2) requires deposits by the 15th of the following month (monthly depositor), or the following Wednesday or Friday (for semi-weekly depositor, depending on the payment date). Notwithstanding these general deposit deadlines, reg. sec. 31.6302-1(c)(3) provides that an employer is required to deposit employment taxes on the next banking day after $100,000 or more of employment taxes have been accumulated during the deposit period. This is known as the next-day deposit rule and may often apply to equity compensation awards. Employers are often unaware of the next-day deposit rule and its application to equity compensation until it is too late. The penalty for not making timely deposits ranges from 2% to 15% of the underpayment depending on the number of calendar days a deposit is late (refer to section 6656).

In 2020, the IRS released Generic Legal Advice Memorandum (GLAM) 2020-004 regarding the timing of income inclusion for three specific types of stock-settled equity compensation: nonqualified stock options (NSOs), stock-settled stock appreciation rights (SARs), and stock-settled RSUs. That the GLAM clarifies the taxable event for stock-based equity awards is the exercise date, which means that a recipient may have income before receiving the stock. Under section 83, the fair market value of stock-settled equity compensation award is includible in gross income when the stock is considered transferred, which is the earlier of when the employee exercises the stock award (NSOs or stock-settled SARs), or when the employer initiates payment under the stock award (stock-settled RSUs).

Special timing rule for FICA purposes

There is a special timing rule that applies to FICA for certain deferred compensation arrangements. Under the special timing rule, FICA is withheld when the substantial risk of forfeiture lapses (generally at vesting), rather than at the time of payment (refer to reg. 31.3121(v)(2)-1(a)(2)(ii)). The special timing rule has limited impact on most types of equity compensation, but it may apply to phantom stock or RSUs and PSUs. When the transfer (or payment) of cash or stock is deferred beyond the calendar year in which the substantial risk of forfeiture lapses, then FICA is generally withheld at the vesting date, and income taxes are withheld when the amounts are actually paid to the employee. Other exceptions may apply, such as for short-term deferrals, so it is important for employers to understand whether this special timing rule might apply to certain equity-based payments.

Another timing rule that applies to certain deferred compensation arrangements is the rule of administrative convenience. This rule allows the employer to elect to withhold FICA as late as Dec. 31 of the calendar year in which the substantial risk of forfeiture lapses (reference reg. sec. 31.3121(v)(2)-1(e)(5)). This may result in no Social Security tax withholding on the deferred compensation if the employee already met the required withholding on the Social Security wage base during the calendar year. Medicare tax withholding will still apply as there is no applicable limit. As with the special timing rule, this rule applies only to deferred compensation, though, so employers must carefully understand their equity compensation plans to know whether this rule can apply to the particular payments being made. It would generally not apply to stock options or restricted stock, for example.

Consequences of late withholdings or deposits

Deposits of tax withholdings are due by the close of the next business day for employers with at least $100,000 of employment taxes accumulated to be deposited (one-day rule), or under the general deposit rules for lesser amounts depending on whether the employer is a monthly or semi-weekly depositor (refer to reg. sec. 31.6302-1(c)31.6302-1(c)(3)). Equity compensation payments will often trigger this next-day requirement so it is important to plan ahead. The IRS may waive penalties in certain instances for taxes withheld from NSOs, SARs, and RSUs that are deposited within two days of exercise or payment initiation, but it may still be difficult to comply in that timeframe without advance planning.

The breadth of penalties for failure to make proper withholdings and deposits depends on when it is discovered—whether it is before or after the tax year has closed will be determinative. Penalties and interest could apply to both under-reporting income and under-withholding taxes so reach out to your advisor for assistance.