1. Insights
from People and Organization
www.pwc.com
Tax withholdings for stock
compensation - comparing FASB and
IRS rules
August 24, 2016
In brief
On March 30, 2016, the FASB issued Accounting Standards Update (‘ASU’) 2016-09, Improvements to
Employee Share-Based Payment Accounting, which makes a number of changes meant to simplify and
improve accounting for share-based payments. One important amendment relates to the threshold
permitted on net settlements for tax withholding without triggering liability classification. As many
employers are now considering withholding changes due to the new FASB rules, questions have arisen as
to the permitted methods under IRS guidance. This Insight explores the IRS guidelines in this area.
In detail
Background
The FASB recently issued ASU
2016-09, which makes a
number of amendments to the
accounting for stock
compensation. Refer to our
Insight FASB finalizes changes
to stock compensation
accounting which provides an
overview of the more significant
amendments.
Net settlements to cover
withholding taxes is one of the
amendments in ASU 2016-09.
Companies looking at making
changes to tax withholdings
should consider both the
accounting and IRS withholding
implications.
Accounting Implications
Current guidance requires
liability classification if more
than the minimum statutory
withholding amount is withheld
in a net settlement. Applying
this requirement can be
complex, as minimum rates vary
around the globe and some
jurisdictions apply individual
rates rather than a flat fixed
rate.
The amendment permits equity
classification provided any net
settlement to cover tax
withholding does not exceed the
maximum individual statutory
tax rate in a given jurisdiction.
Observation
This change will likely be a
welcome relief for employers.
Determining the appropriate
minimum statutory
withholding requirement today
can be time-consuming and
complex, particularly for
companies operating in many
jurisdictions in the U.S. or
around the globe. Under the
new regime, it will likely prove
far simpler to determine the
maximum individual statutory
tax rates in these jurisdictions.
What may be more complex is
developing a consistent process
and method to use in net
settlements under the
amendments. Some employers
may not want to withhold the
maximum amount for every
employee (since many likely are
not subject to those maximum
rates), and use of a higher rate
will result in a greater use of
cash by the employer. Yet
developing a consistent and fair
approach to determine the net
settlement on an employee-
basis could be a challenge.
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IRS Withholding Implications
While the FASB has changed the rules
regarding tax withholdings for
financial accounting purposes, there
haven’t been changes in Treasury
regulations. As a result, before making
changes to settlement methods,
companies should understand and
consider how the IRS guidelines work.
Non-qualified stock compensation
awards are considered ‘supplemental
wages,’ which are wages paid in
addition to regular wages1. In general,
there are three methods used to
determine the amount of withholding
on supplemental wages: (1)
mandatory flat rate withholding; (2)
optional flat rate withholding; and (3)
aggregate method withholding.
Mandatory Flat Rate Withholding
An employer is required to withhold
at the highest income tax rate under
the Internal Revenue Code if an
employee receives supplemental wage
payments in the calendar year that
cumulatively exceed $1,000,000. The
mandatory flat rate is 39.6% in 2016
for supplemental wages in excess of
$1,000,000.
Optional Flat Rate Method
If an employee’s supplemental wage
payments in the calendar year do not
cumulatively exceed $1,000,000,
there are two potential withholding
methods: the optional flat rate and
aggregate methods. The optional flat
rate method allows employers to
disregard the amount of regular wages
paid to an employee as well as the
withholding allowances claimed by an
employee on Form W-4, Employee’s
Withholding Allowance Certificate.
Instead, an employer may use a flat
percentage rate of 25% to calculate the
amount of withholding.2
Observation
The 25% flat rate is attractive to
employers because of its simplicity. It
affords the option to apply the same
rate of withholding to all
supplemental wage payments
without analysis or application of the
Form W-4. Employers may also
choose whether or not to apply the
25% rate, to any supplemental wage
payment event, such as a specific
vesting event.
Aggregate (Form W-4) Method
If the conditions for the optional flat
rate method are not met and the
mandatory flat rate method does not
apply, an employer should use the
aggregate method. An employer may
also choose to use this method rather
than the optional flat rate method.
Under the aggregate method, an
employer calculates the amount of
withholding due by aggregating the
amount of supplemental wages with
the regular wages paid for the current
payroll period or for the most recent
payroll period of the year of the
payment, and treating the aggregate
(regular and supplemental) wages as if
it were a single payment. Then, the
rate of withholding is based on the
amount earned by the employee and
the information provided on Form W-
4.3
Observation
Now that ASU 2016-09 permits
share-based withholding up to the
maximum statutory tax rate, many
employers and employees are
interested in raising the withholding
rates on equity compensation
settlements. It is not uncommon for
employees to request that their
employer apply a specific rate of
withholding to a supplemental wage
payment, such as a stock vesting
event.
Under the current Treasury
regulations, however, employees may
not direct an employer to apply a
particular rate of withholding either
generally or to a particular payment.
For supplemental wage payments,
employers may only choose between
the optional flat rate, if the
requirements are met, and the
aggregate method, assuming the
mandatory withholding rate does not
apply.
As a practical matter, an increased
withholding rate may be
accomplished through use of the
aggregate method without making
any change to the employee’s Form
W-4 already in place. This is because,
depending upon the employee’s
individual circumstances, the rate of
withholding under the aggregate
method on a supplemental wage
payment may be higher than the 25%
rate under the optional method.
The following is an example
illustrating the difference in the
optional flat rate method compared to
the aggregate method: Susan is paid
$5,000 per semi-monthly pay period
in regular wages. On Form W-4, she
claimed only one withholding
allowance. The value of one
withholding allowance is $168.80. On
December 15, Susan received $5,000
regular wages and $20,000
supplemental wages from the exercise
of a nonqualified stock option. The
amount of federal income tax
withholding under both the optional
flat rate and aggregate methods are as
follows:
Optional flat rate method:
– Regular wages subject to
income tax withholding:
$4,831.20 ($5,000 - $168.80)
– Income tax withholding on
$4,831.20 from IRS
Publication 15 Percentage
Method: $1,036.28
– Income tax withholding on
$20,000 from optional flat
rate: $5,000
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– Total withholding on
$25,000: $6,036.28
– Combined effective tax rate
on $25,000: 24%
Aggregate method:
– Regular and supplemental
wages subject to income tax
withholding: $24,831.20
($25,000 - $168.80)
– Income tax withholding on
$24,831.20 from IRS
Publication 15 Percentage
Method: $7,969.66
– Combined effective tax rate
on $25,000: 32%
The ‘Special Purpose W-4’
As an alternative to the approaches
described above, employees may
provide a new Form W-4 to their
employer to ‘temporarily’ increase
withholding for a supplemental wage
payment by reducing the number of
claimed exemptions and/or by
requesting additional withholding of a
specific dollar amount. We have
dubbed this the ‘Special Purpose W-4.’
Under the current regulations, once
an employee provides an employer
with a revised Form W-4, the
employer is required to begin
withholding pursuant to the revised
Form W-4 no later than the start of
the first payroll period ending on or
after the 30th day from the date when
the employer received the revised
version.
Observation
If an employee opts to use the Special
Purpose W-4 to increase withholding
on a supplemental wage payment but
not on regular wages, the timing is
critical and employees must be sure
to actively communicate with
employers to ensure that Forms W-4
can be processed timely and be
applicable to the desired payroll
period and/or supplemental wage
payment. Employees must also
submit a second revised Form W-4 to
revert withholding and obsolete the
Special Purpose W-4.
For example, using the same facts as
above, Susan may submit a new Form
W-4 that requests an additional
$2,000 in federal income tax
withholding. If the Form W-4 is timely
submitted and processed prior to the
payroll period in which the
supplemental wages are paid and the
employer chooses to use the aggregate
method, the employer may apply the
revised Form W-4 with the additional
$2,000 withholding requested. Using
this method the employee may
increase the effective withholding rate
to 39.8%. Susan must then submit a
second revised Form W-4 to return
the withholding rate to the original
level.
Observation
We understand some companies are
considering applying other
approaches to net settlement for tax
withholding that don’t strictly comply
with the various approaches outlined
above. We encourage companies to
consider any potential implications
and risks of these alternative methods
prior to implementing these changes.
The takeaway
While FASB has tweaked the
threshold for permitted net
settlements for tax withholdings, the
IRS rules must also be considered.
Companies should begin considering
what changes in settlement approach
may be desired, and how those
changes can be operationalized in
light of existing Treasury regulations.
Footnotes
1. The Treasury regulations define
regular and supplemental wages as
follows: Regular wages are defined
as amounts paid by an employer
for a payroll period either at a
regular hourly, daily, or similar
periodic rate or in a predetermined
fixed amount. Supplemental wages
include wage payments made
without regard to an employee’s
payroll period but also may include
payments made within a payroll
period. They include, but are not
limited to, bonuses, severance pay,
awards, prizes, and taxable fringe
benefits. Supplemental wages also
include income recognized on the
exercise of non-statutory stock
options and income recognized on
the lapse of a restriction on
restricted property transferred
from an employer to an employee.
2. This method is only available if:
(1) the employer has withheld
income tax from regular wages
paid to the employee during the
calendar year of the payment or the
preceding calendar year, and (2)
the supplemental wages are either
paid separately from regular wages
or are combined with regular
wages but are separately stated on
the payroll records of the
employer.
3. Form W-4 will provide the
following information that an
employer will use to determine the
amount to withhold: whether to
withhold at the single or married
rate; how many withholding
allowances the employee claimed
(every allowance reduces the
amount withheld); whether the
employee wants any additional
amount withheld; and whether the
employee claims an exemption
from withholding.
