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Subject:   ISO's and leaving the company
Date:   Thu, 30 Dec 2004
From:   Michael

Michael,

I retired in 2002 and was allowed to keep some ISOs expiring in 2008. I exercised them in 2004. The company is taking the position that the gain is ordinary income, subject to social security, Medicare, etc. and requesting payment of 25% of the gain as withholding. They will then send me a W-2 form. Do you agree with this position?

Thank you for your help,
Michael

Answer

Date:   Fri, 07 Jan 2005

Hello Michael,

Yes. When an employee is allowed to keep ISOs after leaving an employer, they are converted to non-qualified stock options.

For income tax withholding, under Treasury regulations section 31.3401(a)-1(a)(5), "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."

A similar rule applies under Treasury Regulations Sections 31.3121(a)-1(i) and 31.3306(b)-1(i) for FICA withholding and FUTA taxes.

There is an exception when an option is exercised after the year of death of a deceased employee. (Revenue Ruling 86-109.)

I do not work extensively in the area of payroll tax reporting. Employers should be seeking their own counsel in this area.

Good luck!

Mike Gray

For more information about incentive stock options, request our free report, Incentive Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.