Stop the Tax Increase on ISOs and ESPPs –

Reversing 30 years of tax policy, the Internal Revenue Service has proposed rules that will impose employment withholding taxes on the exercise of statutory stock options – both incentive stock options (ISOs) and employee stock purchase plans (ESPPs) starting in January 2003. Policy makers need to be alerted to this threat and this tax increase must be stopped in its tracks.

The proposed IRS rule will hurt rank-and-file workers as well as businesses and it will be an administrative nightmare for companies to enforce. Ultimately, it may well discourage employers from even offering ISOs and ESPPs in the fist place.

ISOs and ESPPs have always been subject to favorable tax treatment. Neither one is taxed as income when it is exercised. Rather, the holder of the stock pays a capital gains tax at the disposition of the stock if certain requirements are met. These programs have proven to be extremely valuable tools for companies (especially startups) to recruit, retain and incentivize employees. Congress recognized this fact when it conferred favorable tax treatment on them some time ago.

Now, however, the IRS proposes that the spread at the exercise of a statutory option be treated as “wages” for purposes of the Federal Insurance Contributions Act (FICA), which pays for Social Security, and the Federal Unemployment Tax Act (FUTA). As such, employers and employees would collectively pay up to 15.3% of the value of the spread in new taxes. Since Social Security taxes apply only to the first $84,900 of income, the IRS proposal would disproportionately hurt rank-and-file workers who are below senior management and upper income levels.

An added twist is that in order to pay this tax, many of these workers may be forced to ignore the holding requirement and dispose of their stock immediately after exercise, thereby negating the stock’s favorable tax treatment. This, of course, is precisely the opposite effect that Congress intended when it provided these options favorable tax treatment.

In addition to the problems presented to rank-and-file employees, administering these taxes will be a challenge, to say the least. Since employers are responsible for making certain that payroll taxes are paid, companies will be in a tough position considering that employees often leave before they exercise their options. Employers and employees will likely have to enter into arrangements whereby the employer advances to the employee (or deducts from his or her paycheck) the funds necessary to pay the employee’s portion of the tax. Compliance costs may well cause employers to terminate such programs or not set them up for their employees.

Stock options have proven to be a remarkable tool for motivating employees, thereby contributing to worker productivity, stronger performance by the company and growth in our overall economy. The utilization of stock option programs has been a hallmark of American competitiveness in the global economy. Indeed, more and more companies throughout the world have begun to emulate the American model by offering stock-based incentives. At the same time, foreign governments have sought to change tax laws in order to accommodate and encourage their use.

The proposed change in tax regulations moves the nation in the opposite direction, discouraging the use of incentive stock options, and it may well put U.S. businesses at a competitive disadvantage on the global playing field.

NVCA, other trade associations and individual companies are taking action against the IRS proposal. The primary focus is building support for legislation – H.R. 2695 and S.1383 that would block the proposed rule from taking effect. The House bill was introduced by Rep. Amo Houghton, R-NY, and the Senate bill by Sen. Hillary Rodham Clinton (D-NY).

NVCA and its allies will also be working with the Treasury Department to further delay the implementation date for the IRS rule in order to secure adequate time for Congress to act. All of us can support these efforts by alerting our senators and congressional representatives to this threat and asking them to support the legislative fix.

The American entrepreneurial model is one that has made the world green with envy. At the foundation of this model are tools used to align the interests of workers with shareholders. This arrangement has worked remarkably well in the past and will continue to do so if policy makers will let it.

Robert E. Keith is a General Partner at TL Ventures (http://www.tlventures.com) in Wayne, Pennsylvania. He sits on the NVCA Board of Directors and is chairman of its Capital Formation Committee.