Many companies are considering changing their tax withholding practices after FASB modified the accounting rules for share-based awards (ASC 718). For most companies, the modified rules become mandatory for accounting periods starting after December 15, 2016, although companies are able to voluntarily implement the revised rules earlier.
The changes to ASC 718 were mainly intended to facilitate tax withholding for equity awards granted to employees outside the U.S., but have also raised questions for taxes withheld for U.S. executives.
The “Old” Rules and Its Challenges
Under the old rules, companies withholding shares to cover taxes due on share-based awards (i.e., net share issuance) must withhold tax at the minimum statutory rate to avoid liability accounting.
Non-U.S. Employees. This is very problematic for employees outside the U.S., because virtually no country (except the U.S.) has a statutory rate that can be applied to determine the taxes due on income from equity awards. Instead, tax is due at the employee’s marginal tax rate, which makes it very difficult for companies to withhold tax at a single rate per country.
To deal with the minimum statutory rate predicament for employees outside the U.S., in my experience, most companies withhold shares at the employee’s actual marginal rate, which requires companies to go out to payroll prior to each vesting event, determine the applicable rate and then communicate that rate to the broker to calculate the number of shares to be withheld. For companies with large non-U.S. populations and/or frequent vesting events, this obviously is an administrative nightmare. Alternatively, some companies determine a minimum rate per country (usually the lowest marginal tax rate that applies among the employees with equity awards in a particular country). But this approach is not much more efficient because it means that, for most employees, the shares withheld are not sufficient to cover the actual tax liability and any additional taxes due have to be withheld from payroll, which also results in a rather complex withholding process.
If companies find neither approach appealing, they usually are forced to forego the net share withholding method altogether and, instead, sell shares to cover taxes, because this enables them to use a maximum rate per country (and true up any over-withholding through local payroll). However, again, this is often not a desirable solution because selling shares to cover taxes can be challenging if the taxable event occurs during a black-out period.
U.S. Employees. In the U.S., by contrast, companies can withhold tax on income from equity awards at a flat rate of 25% which applies to supplemental wages of up to US$1 million per year. Supplemental wages in excess of US$1 million are subject to tax withholding at a rate of (currently) 39.6%. If shares are withheld at these rates, as applicable, the minimum statutory rate requirement under the old ASC 718 is satisfied with the result that there is no risk of liability accounting.
The challenge relates to executives who are subject to withholding at the flat 25% rate (because their supplemental income has not reached US$1 million), but would like the company to withhold at a higher rate, to avoid having to pay additional taxes when they file their personal tax return at the end of the year (given that their marginal rate is well above 25%), or to avoid being subject to the estimated tax system. Under the old rules, however, withholding at a higher rate is a non-starter because it triggers liability accounting.
What’s New Under Modified ASC 718?
Under the modified rules, it is now possible to withhold shares to cover tax at a rate that cannot exceed the maximum applicable rate in a country.
Non-U.S. Employees. The new rules mean that companies can now withhold tax at a single rate per country, as long as this rate does not exceed the maximum marginal rate in the particular jurisdiction. Companies can easily obtain the maximum rate information from their broker or advisor and are, therefore, no longer dependent on seeking rate information (on an employee-by-employee basis) from local payroll.
While this will be very appealing for many companies, it should be considered that some employees may not react positively to this change, because in many cases, they will receive a smaller number of net shares. This is because the maximum withholding rate in several countries will be higher than the marginal tax rate for most employees (other than a few very highly compensated employees), which results in the company withholding more shares than necessary to cover the tax due. Any over withheld amount will be trued up through local payroll, so the employee will not actually pay more tax than is due, but they will receive less shares and, therefore, lose the potential upside of these shares. Consequently, some companies may continue to withhold shares only at the employee’s actual marginal rate, or withhold at different rates for different employee populations. In either case, companies should consider preparing employee communications to explain the new withholding procedures.
U.S. Employees. The changes raise the possibility that companies can withhold tax at a rate that is higher than the supplemental rate without causing liability accounting. But it is important to keep in mind that the accounting rules do not determine what can or should be withheld from a tax perspective – this is driven purely by the IRS and tax rules.
IRS Information Letter 2012-0063 is very clear that an employer cannot choose to withhold tax at a higher rate on supplemental wages, unless withholding is operated under the aggregate procedure and an employee has provided a Form W-4 asking for increased withholding. Withholding under the aggregate procedure means that the supplemental wages are added to the regular wages for a payroll period to determine how much income tax should be withheld and the employee’s existing Form W-4 is used to determine the withholding rate for the aggregate amount. (Note that the Information Letter is not binding but the regulations also support this conclusion so there is little doubt that the above reflects the IRS’ position.)
In this case, again, the IRS will accept increased withholding if an employee has provided a new Form W-4 prior to the taxable event. But the Form W-4 will not provide for an increased percentage of withholding but only lower the number of exemptions the employee claims or specify a dollar amount to be withheld. The new (increased) rate (after applying the new number of exemptions and/or specified dollar amount) is difficult to figure out and companies likely will need to run the equity award income through their payroll system to determine the tax withholding.
Also, if the employee then wants to go back to his/her “normal” number of exemptions for his/her next salary payment, the employee has to provide a new Form W-4 prior to the next payment date. However, it is possible for the employee to electronically submit a Form W-4, provided certain conditions are met.
That said, generally, there is no penalty for over withholding, provided there is no intent by the company to defraud the IRS and the withholding is at the request of the company. It is difficult to find an intent to defraud, but in certain unique cases, over withholding on the equity award income can be used by the employee to manipulate his/her tax obligations, including through circumvention of the estimated tax system.
Consider the following example that was described by NASPP’s Barb Baksa in her blog:
An executive purposefully sets his W-4 withholding rate for his regular income too low and, as a result, would owe underpayment penalties to the IRS if he could not somehow make up the shortfall in tax withholdings. This executive could exercise options at the end of the year and elect to have the company collect additional tax (above the 25% rate), to eliminate the shortfall. This would certainly go against IRS guidance, as employees are supposed to pay an estimate of their taxes when they are compensated, rather than save their tax payments until the end of the year (allowing them, rather than the IRS, to earn interest on the funds until then).
Still, the information letter (quoted above) does not set forth what the penalties could be if the correct W-4 procedure is not followed and whether the penalties would apply to the company or the employee. As such, it is very difficult to fully assess the company’s risk/exposure.
Taking into account the above, if companies were to allow executives in a one-off situation to elect higher tax withholding for equity award income without a Form W-4, any risk is likely low. However, any system that allows a larger number of employees to elect higher tax withholding for all of their equity income could be concerning because such a system too obviously circumvents the Form W-4 process, could be noticed if the company is audited and, in turn, lead to penalties (although, again, this is not clear from the existing guidance).
The modified accounting rules in ASC 718 which allow withholding in shares at a maximum rate without triggering liability accounting should be welcome news for companies that favor this withholding method and have award holders outside the United States. They can now withhold tax due on equity awards at a single maximum rate per country, but will need to manage employee expectations if this results in an increased number of shares being withheld. In the U.S., employees are now able to elect tax withholding at a rate that is higher than the supplemental rate without triggering liability accounting, but companies will need to carefully review the requirements for such elections to avoid running afoul of IRS rules.