Effective May 28, 2024, following recent changes to US Securities and Exchange Commission and NASDAQ Stock Market rules, most standard broker-dealer securities transactions will have to be settled within one business day after the Deposit Withdrawal at Custodian date (DWAC or trade date). This will likely have significant federal employment tax implications for employers that compensate employees through nonqualified stock option or stock award programs since employers will have one less day to calculate the withholdings owed with respect to employees’ equity compensation and deposit those withholdings with the IRS and state tax authorities.
This shortened settlement cycle is commonly referred to as a “T+1” settlement. Prior to this rule change, investors generally had two business days after the trade date to settle securities transactions, known as a “T+2” settlement cycle.
Under the new T+1 rule, an investor who buys securities generally must make payment to the facilitating broker-dealer no later than one business day after execution of the trade. On the other side of the transaction, a selling investor generally must deliver the securities to the facilitating broker-dealer no later than one business day after execution of the trade.
In the case of stock option exercises or vesting/settlement of other stock awards, the stock will need to be delivered to employees’ brokerage accounts no later than one day after the DWAC date. Accordingly, employers will need to make payroll deposits by the second business day after the DWAC date instead of the third business day.
Under the federal employment tax deposit rules (see Code Section 6302 and the Treasury Regulations promulgated thereunder), employers generally must deposit payroll taxes on a monthly or semi-weekly basis depending on the amount of taxes reported during a specified “look-back” period. Notwithstanding the general monthly and semi-weekly rules, employers that accumulate $100,000 or more in employment taxes must deposit those taxes with the IRS by the close of the next banking day (the Next Day Deposit Requirement).
Employers that fail to meet the Next Day Deposit Requirement may be liable for failure-to-timely-deposit penalties under Code Section 6656, which range from 2% for deposits 1-5 days late, 5% for deposits 6-15 days late, 10% for all undeposited taxes after the 15th day, and 15% if the employer does not respond promptly to an IRS penalty notice.
With respect to employee stock award transactions, the IRS has largely recognized that the deposit liability date (i.e., when employment taxes have reached $100,000 or more) is the next business day after the settlement date. Notably, in General Legal Advice Memorandum (GLAM) 2020-004, the IRS had incorrectly assumed that the DWAC date was the option exercise date (or the RSU/SAR vesting date).
However, shortly after issuance of the GLAM, the IRS issued updated Internal Revenue Manual instructions in Section 20.1.4.26.2(5), concluding that if payroll tax deposits are made by the “third day” after the DWAC date then penalties are not appropriate. This reference to the “third day” will automatically change to the “second day” after the DWAC date as a result of the imminent change from a T+2 settlement to a T+1 settlement cycle. As such, the IRS will begin its counting of “days of lateness” for Code Section 6656 penalty purposes one business day sooner.
Moreover, since the IRS arbitrarily counts “days of lateness” based on calendar days (even though bank deposits cannot be made on weekends and holidays), this one-day shortening of the deposit deadline makes it even more likely that the IRS-imposed penalties might reach 5% instead of only 2%.
For example, assume that an RSU vests on a Monday, July 1, and the DWAC is that day. The new settlement date is July 2 and the payroll tax deposits are due July 3. But assume that the employer is unaware of the settlement date change and does not make its deposits until July 9 (after the long holiday weekend).
These deposits are now six days late, and the deposit penalty would be 5% of all the late deposits. If these deposits were made on July 8 the penalty would be only 2%, but under either scenario it is clear that the reduction of the settlement date (and therefore the liability date) by one day can significantly impact an employer’s penalty exposure.
To avoid potential deposit penalties, whether employers make their own payroll tax deposits or hire a third-party payroll service provider to make deposits, employers should check to be sure that their scheduled dates of deposit for equity compensation are accelerated to accommodate the new T+1 rule.
In the alternative, funds can be deposited before the accelerated settlement date takes effect (and left on deposit with the IRS in each succeeding quarter by filing proper credit carryover instructions with each quarterly Form 941) in order to be able to use the “deposit allocation” rules of Code Section 6656(e) and Rev. Proc. 2001-58, 2001-2 C.B. 579.