On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the “Act”), a major piece of corporate tax legislation. The Act contains significant new rules for nonqualified deferred compensation plans which were analyzed in the October 2004 Trucker Huss Special Alert (“Deferred Compensation Update”). The Act also contains a number of other provisions which will affect employee benefits.
Taxation of Incentive Stock Options and Employee Stock Purchase Plan (“ESPP”) Options
The Act affects the taxation of statutory stock options (incentive stock options and employee stock purchase plan stock options) in two very significant ways:
- Exclusion from Employment TaxesSection 251 of the Act amends the Internal Revenue Code (the “Code”) to exclude income realized from either the acquisition or disposition of statutory stock options from the definition of remuneration for the purposes of the Federal Insurance Contributions Act (“FICA”) and from the definition of wages for purposes of the Federal Unemployment Tax Act (“FUTA”). Accordingly, neither the transfer of stock pursuant to the exercise of statutory stock options to an employee nor the disposition of such stock is subject to withholding of social security (FICA) and unemployment (FUTA) taxes.
This amendment resolves a long standing issue regarding the proper FICA and FUTA withholding treatment for statutory stock options. Proposed regulations by the Internal Revenue Service (the “IRS”) would treat the exercise of statutory stock options as resulting in remuneration or wages subject to FICA and FUTA withholding; however, in 2002 the IRS announced that it would not require either FICA or FUTA withholding upon either the exercise of a statutory stock option or upon the disposition of the shares of stock acquired by the exercise until it issued further guidance on the matter. Accordingly, Section 251 reverses the proposed regulations and establishes as law the position of the IRS announcement. (For a brief discussion of the 2002 IRS announcement, and the previous IRS positions on this issue, see the August 2002 edition of Benefits Report.)
- No Income Tax Withholding on Disqualifying Dispositions or Certain ESPP Discount Options Section 251 of the Act provides that, under Section 421(b) of the Code, wage withholding is not required on disqualifying dispositions of incentive stock options or ESPP stock options, with respect to any increase in income attributable to such a disposition. Furthermore, the Act amends Section 423(c) of the Code so that when the price of an ESPP stock option is between 85 percent and 100 percent of the value of the stock no withholding is required on any compensation attributed to the stock option discount.
In contrast to the ambiguity concerning the proper FICA and FUTA withholding treatment for statutory stock options, the IRS issued regulations that provided that the exercise of a statutory stock option and the disposition of stock acquired by an exercise does not give rise to income tax withholding. The IRS has announced that it would follow this rule until further guidance is issued. Accordingly, the amendments made by the Act to Code sections 421(b) and 423(c) appear merely to affirm and codify the position elaborated in the proposed regulations and in the IRS announcement.
All of the amendments under Section 251 of the Act will simplify withholding requirements; however, reporting requirements remain unaffected.
The amendments are effective for stock acquired through the exercise of statutory stock options on or after October 23, 2004, the day after the enactment of the Act.
Supplemental Wage Payments—Increase in Flat Rate Withholding for Large Payments
When an employer pays supplemental wages which are not paid for a specific payroll period (such as a bonus or a commission) the employer may elect one of two possible withholding methods: a flat percentage under Section 3402(b) of the Code or wage bracket withholding under Section 3402(c) of the Code. Section 904 of the Act provides that when an employer elects under Treasury Regulation 31.3402(g)–1 to use a flat percentage rate to determine the amount of money to be withheld from a supplemental wage payment:
- The rate of withholding must not be less than the lower of 28% or the corresponding rate in effect under Section 1(i)(2) of the Code. For 2005 and subsequent years, the “corresponding rate” is 25%. Accordingly, under the Act, an employer who elects the flat rate must withhold at least 25%.
- Whenever the aggregate total of all supplemental wage payments made by an employer to an employee during a single calendar year exceeds $1 million, the rate used for the amount in excess of $1 million must be the maximum rate in effect under Section 1 of the Code for the applicable year. For 2005, the maximum rate is 35%.
For employers electing the flat percentage method, Section 904 of the Act thus establishes both a minimum withholding rate which applies to all supplemental payments up to and including $1 million and a special increased withholding rate for all amounts in excess of the yearly one million dollars aggregate. As an illustration of how these rules will work, if an employee receives supplemental wages totaling $2 million in 2005, the employer must withhold at least $600,000 ($250,000 = 25% on the first $1 million plus $350,000 = 35% on the second million).
This amendment applies to all payments made after December 31, 2004.
Minimum Cost Requirement for Transfer of Excess Pension Assets
Section 420 of the Code establishes rules for qualified transfers of excess pension assets of a defined benefit plan (other than a multiemployer plan) to a health benefits account which is part of the plan. Among the criteria that a qualified transfer must satisfy are the minimum cost requirements of Code section 420(c)(3). Regulations under Code section 420(c)(3)(E) prevent an employer who significantly reduces retiree health benefits during a specified cost maintenance period from satisfying the minimum cost requirement of a qualified transfer of excess assets.
Section 709 of the Act modifies Code section 420(c)(3)(E), as well as relevant provisions in the Employee Retirement Income Security Act (“ERISA”), to allow certain employers who make insignificant cost reductions in retiree health benefits to satisfy the minimum cost requirement for a qualified transfer. Specifically, an eligible employer does not violate the minimum cost requirements if the employer reduces applicable employer costs by an amount that does not exceed the maximum permissible reduction in retiree health coverage under the regulations. For purposes of this amendment, an employer is an eligible employer if for the taxable year preceding the year in question, the qualified current health liabilities of the employer were at least 5% of the gross receipts of the employer as determined under Code sections 448(c)(2), (3)(B) and 3(C).
This amendment creates a safe harbor for determining certain minimum or insignificant reductions which are outside the purview of the current regulations.
This amendment applies to taxable years ending on or after October 23, 2004, the day after the enactment of the Act.
S Corporation ESOPs
Section 240 of the Act amends Section 4975 of the Code by adding a new subsection (f) that permits an ESOP maintained by an S corporation to use S corporation earnings distributions attributable to shares of qualifying employer securities allocated to ESOP participants’ accounts to make principal and interest payments on the loan used to acquire such shares. Prior to the Act, the IRS had taken the position that only S corporation earnings distributions on unallocated shares could be used to make ESOP acquisition loan payments. Section 4975(f) of the Code also provides that an S corporation ESOP will not be able to use the earnings distributions on shares of employer securities allocated to a participant to make ESOP acquisition loan payments unless the ESOP provides the participant with employer securities with a fair market value of not less than the amount of the earnings distribution that would have been allocated to that participant had the cash dividend not been used to make payments on the loan. This amendment applies to S corporation earnings distributions made after December 31, 1997.
The Act also made a number of other changes to the rules related to S corporations, including increasing the number of maximum S corporation shareholders from 75 to 100, and allowing an election to treat all family members within six generations to be counted as one shareholder for the 100 shareholder limit.
Extension of Certain IRS User Fees
Section 891 of the Act amends Section 7528(c) of the Code to extend the imposition of IRS user fees for ruling letters, opinion letters, determination letters and other similar requests from December 31, 2004, to September 30, 2014.
The Act contains a number of other provisions that may either directly or indirectly affect employers or employees. These include: Section 802 of the Act which imposes an excise tax on stock compensation of insiders in expatriated corporations; Section 892 which makes certain changes to COBRA fees; Section 905 of the Act which extends capital gains treatment to the sale of stock acquired pursuant to the exercise of stock options by insiders in order to comply with conflict of interest requirements upon taking certain jobs with the federal government; and Section 907 which limits the employer deduction for certain entertainment expenses. These provisions are mainly technical in nature and affect only a limited number of individuals or employers. If you need further information about any of these provisions, please contact us.