Tax Type
Withholding Taxes
Description
Income tax for compensation generated through stock options
Topic
Withholding of Tax
Date Issued
03-15-2005
March 15, 2005
Re: Request for a Ruling: Withholding Tax
Dear *****:
This will reply to a letter submitted by ***** (the "Taxpayer"), requesting a ruling on the proper method of withholding Virginia individual income tax for compensation generated through stock options. More specifically, you ask whether the Taxpayer may rely on employee representations made on withholding exemption forms. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer is a corporation that grants both statutory stock options, also known as incentive stock options ("ISOs"), and nonstatutory stock options ("NSOs"), as part of its employee compensation packages. When stock purchased pursuant to exercised options is sold, the Taxpayer withholds Virginia income tax based on Virginia Forms VA-4 (Virginia Income Tax Withholding Certificate) and Form VA-4b (Virginia Employee's Withholding Income Tax Credit for Income Taxes Paid to Another State) as completed by the employees.
The Taxpayer does not maintain any record of its employees' domiciles other than the VA-4 and VA-4b forms. The Taxpayer requests a ruling on how Public Document ("P.D.") 99-79 (4/20/99) would affect its withholding requirements.
RULING
Statutory stock options
ISOs are not subject to federal income tax at the time they are granted or exercised unless the statutory requirements are not met. The gains are recognized when the shares are sold and they are treated as capital gains provided that a two-year holding period is met. If the shares are sold before the holding period ends, the gains are treated as ordinary income. For Virginia income tax purposes, capital gains are taxed at the same rate as all other income.
ISO - Virginia source income for nonresidents
In P.D. 99-79, the Commissioner ruled that the appreciation in the value of stock from the date of grant to the date of exercise is compensation from Virginia sources for services performed in Virginia by an employee who is granted ISOs. If a taxpayer moves from Virginia after the date the ISOs were granted, the nonresident taxpayer is subject to Virginia income tax on the appreciation of the value of the stock. Further, the amount of a nonresident's Virginia source income with respect to ISOs granted in connection with Virginia employment is determined at the time the stock is sold and income or gain is recognized for federal purposes.
The Department acknowledges that there could be a significant administrative burden for both a nonresident taxpayer and the Department in determining whether ISOs held by nonresidents are subject to Virginia income taxation. As such, in the interest of fairness, the compensation earned from the appreciation of stock acquired through ISOs will not be considered Virginia source income for nonresidents provided that the individuals were not residents of Virginia for at least two years prior to the sale of the stock..
Nonresident taxpayers who do not meet the two-year holding requirement are subject to Virginia income tax on the appreciation of stock granted pursuant to ISOs. Their Virginia source income would be an amount equal to (1) the lesser of the income or gain recognized for federal income tax purposes or the amount by which the fair market value of the stock exceeded the option price at the date the ISO was exercised, (2) multiplied by the number of days of the taxable year(s), or portions) thereof, that the individual resided in Virginia from the period of the ISO grant date to the date of exercise, and (3) divided by the number of days from the ISO grant date to the date of exercise. See P.D. 85-134 (6/18/85).
ISO - withholding requirements
Federal income tax withholding is imposed under § 3402(a) of the Internal Revenue Code ("IRC"). Under IRC § 3401(a), "wages" are defined as remuneration for services performed by an employee for an employer, including the cash value of all remuneration paid in any medium other than cash. Income tax withholding operates on the premise that the income tax is to be collected and remitted in the year in which the income is earned. According to IRC § 421, no income is earned from the grant or exercise of ISO's. Rather, compensation is recognized upon the disposition of the stock acquired from the exercise of the options. Currently, the Internal Revenue Service ("IRS") does not treat the proceeds from the disposition of stock acquired from the exercise of ISO's as income subject to withholding.
Virginia Code § 58.1-461 requires that every employer who pays wages, to employees must withhold Virginia income tax from such employees' wages. Virginia Code § 58.1-460 defines "wages" for Virginia purposes as wages are defined in §§ 3401(a), 3402 and 3405 of the IRC. Because the IRS does not require income tax to be withheld with regard to ISOs, no income tax withholding is required for Virginia purposes from the grant, the exercise or the disposition of stock acquired from the exercise of ISOs.
Nonstatutory stock options
NSOs generate income at the earliest point at which a fair market value can be readily ascertainable. As such, income from NSOs can be recognized when they are granted, exercised, or sold. The income recognized is considered to be compensation and taxed as ordinary income for federal income tax purposes.
NSO - Virginia source income for nonresidents
For Virginia income tax purposes, a nonresident individual will recognize: income from an NSO at the same time compensation is recognized for federal income tax purposes. The amount of income that is subject to Virginia tax will depend on when the fair market value of an NSO is readily ascertainable.
If an NSO has a readily ascertainable fair market value at the time of grant, compensation for federal purposes is equal to the fair market value of the option at the time of grant less any amount paid for the option. For Virginia purposes, salaries arid wages of nonresident employees are sourced to their state of employment unless they reside in a state that has entered into a reciprocal agreement with Virginia.
If the fair market value of NSOs are not readily ascertainable until the time they are exercised or sold, compensation from Virginia sources would be equal to the appreciation of the value of the stock between the date of grant to the date of exercise or sale. In a case where an individual moves out of Virginia after the date the NSOs are granted, Virginia source income would be an amount equal to (1) the amount that the fair market value of the stock exceeded the option price at the date the NSO was exercised, (2) multiplied by the number of days of the taxable year(s) or portions) thereof that the individual resided in Virginia from the period of the NSO grant date to the date of exercise or sale, and (3) divided by the number of days from the NSO grant date to the date of exercise or sale.
NSO - withholding requirements
Virginia Code § 58.1-461 requires employers to withhold taxes from employee wages for each payroll period. Virginia Code § 58.1-460 defines "employer" as, "the person, whether a resident or nonresident of the Commonwealth, for whom an individual performs or performed any service as an employee . . . ." [Emphasis added]. Further, this section defines "employee" as, "an individual, whether a resident or a nonresident of the Commonwealth, who performs or performed any service in the Commonwealth for wages." [Emphasis added]. Consequently, an employer may be required to withhold Virginia income taxes for an employee who is not a resident of Virginia when that employee earns income from Virginia sources.
When the fair market value of the option is readily ascertainable at the time of grant, employers would withhold Virginia income tax if the employee resided in Virginia or was employed in Virginia at the time of the grant. If the options did not have a readily ascertainable fair market value at the time of the grant, or if the options were sold prior to exercise, employers would be required to withhold income tax on Virginia source income of nonresidents as described under the preceding heading.
The Taxpayer asserts that the administrative requirements of determining a nonresident employee's Virginia source income tax withholding would be unduly burdensome to maintain. P.D. 84-90 (7/3/84) provides that employers may rely on withholding information provided by employees. Thus, the Taxpayer may rely upon the Form VA-4 and Form VA-4b as provided by its employees when filing Virginia withholding returns and withholding income tax. Employees would be responsible for providing updated information to the Taxpayer for withholding tax purposes. If employees fail to update withholding information with their employer, they would be liable for any underpayment of Virginia income tax and the corresponding interest and penalty, if applicable. If would certainly be beneficial to employees for employers to request updated withholding information at the time compensation resulting from the grant of the NSOs is recognized.
The Code of Virginia sections and public documents cited, as well as other reference documents, are available on-line in the Tax Policy Library section of the Department's web site, located www.tax-virginia.gov. If you have any questions about this response, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings at *****.
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- Sincerely,
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Kenneth W. Thorson
Tax Commissioner
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AR/30645B
Rulings of the Tax Commissioner