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In a previous post, we summarized a new Financial Accounting Standards Board (FASB) rule that allows increased share withholding for taxes under United States Generally Accepted Accounting Principles (GAAP). This new rule permits cash settlement of a share-based award for tax withholding up to the maximum statutory tax rate in the applicable jurisdiction without causing adverse accounting treatment of the equity award.

The rule generally became effective for calendar year companies on January 1, 2017. Many companies are now considering implementing increased share withholding for taxes and must consider their existing equity plan provisions and securities law, IRS, and payroll issues.

The following equity plan provisions should be considered:

  • Companies should review their equity plans and confirm whether such plans permit share withholding in excess of the minimum applicable tax rate.
  • Shareholder approval is not generally required to amend an equity plan to permit share withholding in excess of the minimum applicable tax rate. However, because of certain stock exchange rules and in light of recent Institutional Shareholder Services (ISS) guidance, a company with a plan that permits withheld shares to be added back to the plan’s share reserve should consider whether to limit the number of shares that can be added back for withheld taxes.

There are several securities law issues that can affect share withholding for taxes by Section 16 of the Securities and Exchange Act of 1934 (Section 16) officers, including the following:

  • In order to exempt the disposition of shares through share withholding from being a “sale” of shares under Section 16 (the short swing profit rules), a company’s compensation committee or board of directors must approve the share withholding before any shares are withheld for Section 16 officers. The resolutions authorizing share withholding should be as specific as possible.
  • The company should not retain discretion to determine whether shares will be withheld, or the amount of share withholding, for Section 16 officers. 
  • Share withholding for Section 16 officers should not exceed the participant’s estimated tax obligations attributable to the award, in order to avoid creating a separate derivative security.
  • Unresolved Section 16–related litigation has been instituted with respect to open market purchases occurring within six months of share withholding transactions (even though the transactions were reported as exempt). Until this issue is resolved, Section 16 officers should carefully consider whether to engage in nonexempt purchases of company stock in the six months before or after a tax withholding share transaction.

From a tax perspective, a company does not have to treat all employees the same with respect to tax withholding on shares. Federal tax withholding on equity awards can be determined in one of two ways:

  1. By treating the payment as a supplemental wage payment subject to the 25% withholding rate on supplemental wages up to $1 million (39.6% on supplemental wages of greater than $1 million).
  2. By applying the withholding amount generated by an employee’s Form W-4. On Form W-4, an employee may adjust the withholding amount by changing the number of exemptions or entering a specific dollar amount of withholding. The IRS process does not allow an employee to specify a specific percentage for federal income tax withholding on Form W-4. The Form W-4 must apply to all wages paid to the employee while the Form W-4 remains in effect.

Companies using Forms W-4 for share withholding should implement procedures to ensure that an employee who increases tax withholding through Form W-4 does not direct withholding of amounts in excess of the maximum applicable tax rate and, in the case of Section 16 officers, the employee’s estimated tax obligation on the equity award distribution. 

Companies should discuss increased share withholding with their payroll departments and stock plan administrators in order to understand any administrative limitations on implementation.