Say No to Withholding Taxes for Outside Directors

Sometimes outside directors make a surprising request with respect to their equity awards: they ask you to withhold taxes on them. Unfortunately, withholding taxes on compensation paid to nonemployees is problematic, so this generally isn’t a request you can accommodate.

For this blog entry, I address some questions I am frequently asked on this topic. Check out my video on it as well.

Can companies withhold taxes for outside directors?

Absolutely not! Companies should only withhold taxes for employees. Outside directors and other nonemployees are responsible for paying their own taxes and should make estimated tax payments.

What if they really want us to?

The answer is still no. There's simply no mechanism in the US tax system to enable companies to collect taxes from nonemployees and pay over those taxes to the IRS. The IRS would have to create special rules to allow this and would have to create a system by which the taxes could be collected, deposited, and reported. Interestingly, this was proposed by the Obama administration, but the proposal was never acted on.

What if we just include the directors’ tax payments with our payroll deposit?

This is a bad idea. The IRS is going to treat income reported through your payroll system as employee wages, which are subject to FICA.  Nonemployees aren't subject to FICA; they are subject to SECA (self-employment tax). Trying to deposit the taxes this way is going to make the IRS think the income is subject to FICA, which is going to be a problem to unwind.

But our directors really want us to withhold shares to pay their taxes...

The request to withhold taxes on directors’ equity awards almost always comes up in the context of RSUs. When directors see that shares are withheld to cover the taxes due on RSUs granted to executives and other employees, they sometimes get the idea that it would be nice to be able to use share withholding to cover the tax payments on their own RSUs.

I get it; no one wants to pay their taxes in cash. Oh, the burdens of being a highly-paid director. But even if you could withhold taxes for outside directors (which you can’t—see above), you still probably wouldn’t want to allow the directors to use share withholding. This is because withholding shares to cover taxes when there isn’t a statutory obligation to withhold triggers liability treatment under ASC 718. 

Liability treatment is clearly required on those awards where share withholding is utilized in the absence of a statutory obligation to withhold taxes. But the result can be much worse than this. If the company establishes a pattern of withholding taxes for outside directors when they request it, liability treatment would be triggered not just for the awards for which shares are withheld to cover taxes, but for all awards issued to all outside directors (and all future awards issued to them), even for directors that don't ask the company to withhold shares to cover their taxes. Even allowing only a couple of outside directors to utilize share withholding on their RSUs might be sufficient to establish a pattern.

Liability treatment is usually a deal-breaker for companies. As I note above, in my experience, when directors request tax withholding, it is almost always because they want to use share withholding to cover their taxes. Explaining that this causes liability treatment is usually a good way to shut down that whole conversation.

Is there any way for outside directors to use shares to cover the taxes due on their equity awards?

Outside directors should be making estimated tax payments to the IRS; they should include their RSU income when determining the amount of these payments. If the outside directors want to use shares to cover their taxes, they can sell some of their vested stock on the open market and use the sale proceeds to make their estimated tax payment.

The outside directors could even establish Rule 10b5-1 plans for the sales, so that they don’t need to worry about whether they have material nonpublic information about the company at the time the sales occur. (Of course, the 10b5-1 plans should be established well in advance of the sale dates and at a time when the directors are not in possession of material nonpublic information).

What if the director used to be an employee?

This is an exception. When individuals change employment status during the life of their awards, it is permissible to treat the portion of the award attributable to their service as an employee as wages, which are subject to tax withholding.

Thus, any equity awards that were granted when the now-outside director was an employee could arguably be considered compensation for services performed as an employee. The income attributable to these awards could be reported on a Form W-2 and taxes can be withheld on it and deposited with the rest of your payroll taxes (and this income would be subject to FICA, not SECA).

But this won’t apply to any equity awards granted after the now-outside director ceased to be an employee. The director will likely continue to receive equity grants during their term on the board. The equity grants issued after the director’s last day as an employee are pretty clearly compensation for services as a nonemployee. The income attributable to these awards would not be eligible for tax withholding, would be subject to SECA (not FICA), and would be reported on Form 1099-NEC.

Are there any circumstances where we have to withhold taxes on outside directors?

Here I have some bad news. There are some situations where you are required to withhold taxes for outside directors, but in both cases, the directors are probably going to be unhappy about it.

Non-US Directors: If you have directors who are not US residents or citizens and they travel to the United States in the course of fulfilling their duties as a board member (e.g., to attend a board meeting), the portion of their equity award income that is attributable to the services they performed while in the United States may be subject to US tax withholding. Not surprisingly, the rules here are complicated and can vary depending on the country where the director is resident, but, also not surprisingly, I’ve covered this topic in a blog.

Pennsylvania State Tax: When directors who are not residents of Pennsylvania travel to the state in the course of performing their duties as board members (e.g., for a board meeting), you may be required to withhold PA state tax. I also wrote a blog that covers this topic but the TL:DR version is to just not hold board meetings in Pennsylvania.