How to Withhold and Deposit Taxes on Equity Awards

Tax withholding for equity awards is complicated and mistakes can be costly. In this blog entry, I answer some common questions on withholding for US federal tax purposes.

Withholding Rates

What federal income tax withholding rate applies to stock plan transactions?

For federal income tax (FIT) purposes, the compensation income recognized by an employee in connection with stock plan transactions is treated as a supplemental wage payment.  Under Regulation §31.3402(g)-1(a)(5), where an employee has received less than $1 million in supplemental payments during the year, federal income tax may be withheld using either for the following methods:

• W-4 Rate: The compensation income resulting from the supplemental payment may be aggregated with the employee’s regular wages for the period, with withholding computed on the total amount (the “W-4 rate”). 

• Flat Rate: Alternatively, the compensation income recognized in connection with the supplemental payment is eligible for withholding at the flat rate for supplemental wage payments.

If an employee has received more than $1 million in aggregate supplemental payments within a year, any supplemental payments (or portions thereof) to the employee in excess of this amount are subject to withholding at the maximum individual tax rate for federal tax purposes.  See the NASPP article “US Tax Withholding Rates for Stock Plan Transactions ” for more information.

What other federal taxes must be withheld on stock plan transactions?

Employment taxes under the Federal Insurance Contributions Act (FICA) should also be withheld on stock plan transactions.  FICA is made up of two separate taxes: old age, survivor, and disability insurance (Social Security) and hospital insurance (Medicare). 

The Social Security component of FICA is collected up to an annual maximum.  The Medicare component is collected against the employee’s total earnings; a higher rate applies to earnings in excess of a specified threshold. 

In addition to withholding FICA taxes, the company must make matching payments that equal the amounts withheld from employees’ income (except that the additional Medicare tax that applies to earnings above a specified threshold is not matched by the company).  The FICA rates and their applicable ceilings, if any, are subject to change annually.

Depositing Tax Withholding with the IRS

What is the deadline to deposit taxes withheld on stock plan transactions with the IRS?

Taxes withheld on stock plan transactions should be deposited with the IRS according to the company’s regular deposit schedule (either monthly or semi-weekly) and method.  If you normally use the IRS’s electronic payment system for tax deposits, you should also use this system to deposit taxes withheld on stock plan transactions.

If the cumulative tax withholding for all employees exceeds $100,000, the amounts withheld must be deposited with the IRS by the next business day regardless of whether your company normally deposits on a monthly or semi-weekly schedule. 

For most stock plan transactions, the deposit liability accrues on the transaction date: exercise date for cash and other non-same-day sale option exercises, vest date for restricted stock, release date for restricted stock units.  For same-day sale exercises and releases of RSU awards, the IRS has instructed its auditors to treat the deposit as timely if made within one day of the settlement date, provided settlement occurs no more than two days after the transaction date.   

What amounts are included for purposes of assessing whether the one-day deposit requirement is triggered?

The one-day deposit requirement applies cumulatively on an entity-wide basis. You include all federal tax withholding (FIT and FICA) on all compensation paid to all employees during the deposit period.

What happens if the next day is a holiday?

If the next-day deposit requirement is triggered, the tax withholding must be deposited with the IRS by the next business day. If the next calendar day is a weekend or holiday, the deposit is not due until the next business day.

Any legal holiday observed in the District of Columbia counts a holiday for purposes of the next-day deposit liability. Refer to the IRS calendar for a list of legal holidays.

When is Tax Withholding Not Required?

The company is not required to withhold taxes in the following circumstances:

• Compensation income recognized upon disposition of shares acquired under an incentive stock option or qualified employee stock purchase plan
• Transactions conducted by outside directors, consultants, and other nonemployees
• Transactions by employees whose regular wages are not subject to tax withholding (i.e., because they have claimed exempt status on their Form W-4)

Former Employees

Transactions by former employees are generally subject to the same withholding and reporting requirements that apply to current employees. Under Regulation §31.3401(a)-1(a)(5) any payment for services constitutes wages regardless of whether or not the employment relationship exists at the time the payment is made: 

“Remuneration for services, unless such remuneration is specifically excepted by the statute, constitutes wages even though at the time paid the relationship of employer and employee no longer exists between the person in whose employ the services were performed and the individual who performed them.

Example. A is employed by R during the month of January 1955 and is entitled to receive remuneration of $100 for the services performed for R, the employer, during the month. A leaves the employ of R at the close of business on January 31, 1955. On February 15, 1955 (when A is no longer an employee of R), R pays A the remuneration of $100 which was earned for the services performed in January. The $100 is wages within the meaning of the statute.”

One possible exception to the above requirement is a situation where former employees continue to provide services to the company as nonemployees AND vesting of their equity awards is contingent upon fulfillment of the service requirement. In this situation, it may be possible to attribute a portion of the income recognized in connection with stock plan transactions to services performed as a nonemployee, which is not subject to withholding. See the NASPP Blog “Taxation When Employment Status Has Changed” for more information.

Penalties

Penalties for late deposits can vary from 2% to 15% of the amount of the deposit; the penalties increase based on the number of days the deposit is late.

Under Section 6672 of the Internal Revenue Code, a 100% penalty, plus interest, may be imposed for failing to withhold and pay over taxes to the IRS. 

More Information

The NASPP Course “Taxation of Equity Compensation Essentials” will help you build the know-how and confidence you need to successfully manage the taxation of your company’s equity awards.

The NASPP article “ US Tax Withholding for Stock Compensation” includes an in-depth examination of how equity award transactions are reported on forms W-2 and 1099, as well as how taxes should be withheld on equity awards in a variety of circumstances.