Application of the Federal Insurance
Contributions Act, Federal Unemployment Tax
Act, and Collection of Income Tax at Source. to
Statutory Stock Options

DEPARTMENT OF THE TREASURY 
Internal Revenue Service 26 CFR Parts 1 and Part 31 [REG-142686-01]
RIN 1545-BA26

TITLE: Application of the Federal Insurance Contributions Act,
Federal Unemployment Tax Act, and Collection of Income Tax at Source
to Statutory Stock Options

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations relating to
incentive stock options and options granted under employee stock
purchase plans. These proposed regulations would provide guidance
concerning the application of the Federal Insurance Contributions
Act (FICA), Federal Unemployment Tax Act (FUTA), and Collection of
Income Tax at Source to these options. These proposed regulations
would affect employers that grant these options and employees who
exercise these options. This document also provides notice of a
public hearing on these proposed regulations.

DATES: Written or electronic comments and outlines of topics to be
discussed at the public hearing scheduled for March 7, 2002, must be
received by February 14, 2002.

ADDRESSES: Send submissions to: CC:ITA:RU (REG-142686-01), Room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday
through Friday between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU
(REG 142686-01), Courier's Desk, Internal Revenue Service, 1111
Constitution Avenue, NW., Washington, DC. Alternatively, taxpayers
may submit comments electronically via the Internet by selecting the
"Tax Regs" option on the IRS Home Page, or by submitting comments
directly to the IRS Internet site at
http://www.irs.gov/tax_regs/reglist.html. The public hearing will be
held in the Auditorium of the Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, Stephen Tackney of the Office of Division
Counsel/Associate Chief Counsel (Tax Exempt and Government
Entities), (202) 622-6040; concerning submissions of comments, the
hearing, and/or to be placed on the building access list to attend
the hearing, Treena Garrett, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Employment Tax
Regulations (26 CFR part 31) under sections 3121(a), 3306(b), and
3401(a) of the Internal Revenue Code of 1986 (Code), and to the
Income Tax Regulations (26 CFR part 1) under section 424 of the
Code.These regulations would clarify current law regarding FICA tax,
FUTA tax, and income tax withholding consequences upon the exercise
of statutory stock options, i.e., incentive stock options described
in section 422(b) and options granted under an employee stock
purchase plan described in section 423(b). FICA tax consequences are
determined by sections 3101 through 3128, FUTA tax consequences by
sections 3301 through 3311, and income tax withholding consequences
by sections 3401 through 3406.

A. Statutory Stock Options

Section 422(b) sets forth the requirements for treatment of options
as incentive stock options. If certain conditions are met, special
tax treatment is provided in section 421(a) for the transfer of
stock to an individual pursuant to the exercise of an incentive
stock option. These conditions include a requirement that the
individual not dispose of the stock within two years from the date
of the grant of the option, and a requirement that the individual
not dispose of the stock within one year after the transfer of the
stock to the individual.

Section 423(b) sets forth the requirements for establishment of an
employee stock purchase plan. If certain conditions are met, special
tax treatment is provided under section 421(a) for the transfer of
stock to an individual pursuant to the exercise of an option granted
under an employee stock purchase plan. These conditions include a
requirement that the individual not dispose of the stock within two
years from the date of the grant of the option, and a requirement
that the individual not dispose of the stock within one year after
the transfer of the stock to the individual.

Section 421(a) provides that at the time stock is transferred to an
individual pursuant to the exercise of an option, if the conditions
of section 422(a) or 423(a) are met, then no income to the
individual results upon the exercise. Section 421(b) provides that
at the time stock is transferred to an individual pursuant to the
exercise of an option, if the stock is sold or disposed of by the
individual and the holding period requirements of section 422(a)(1)
or 423(a)(1) are not met, then any income to the individual which
results for the taxable year, in which the option was exercised,
attributable to the sale or disposition of the stock is income to
the individual in the taxable year, of the individual, in which the
sale or disposition occurred.

Section 423(c) provides guidance when the option price of a share of
stock acquired by an individual pursuant to the exercise of an
option granted under an employee stock purchase plan is less than
100 percent of the fair market value of the share at the time the
option was granted. Section 423(c) provides that in the event of
either the disposition of the share of stock by the individual which
meets the holding period requirements of section 423(a) or in the
event of the individual's death while owning the share of stock,
that any resulting compensation is attributable to the individual in
the taxable year in which the disposition or death occurred. The
compensation attributable to the individual is the amount equal to
the lesser of (1) the excess of the fair market value of the share
at the time of the disposition or death over the amount paid for the
share under the option or (2) the excess of the fair market value of
the share at the time the option was granted over the option price.

B. FICA, FUTA, and Income Tax Withholding

1. FICA

FICA tax is generally imposed on each employer and employee. Under
section 3111, FICA tax is imposed on the employer in an amount equal
to a percentage of the wages paid by that employer. Under section
3101, FICA tax is also imposed on the employee in an amount equal to
a percentage of the wages received by the employee with respect to
employment.

FICA tax is composed of a tax for Old-Age, Survivors, and Disability
Insurance (OASDI) and a tax for Hospital Insurance (HI). The OASDI
portion of FICA tax is imposed separately on the employer and on the
employee in an amount equal to 6.2 percent of wages. Under section
3121(a)(1), the wages subject to the OASDI portion of FICA tax are
limited to the contribution and benefit base for OASDI for that year
($80,400 for calendar year 2001). The HI portion of FICA tax is
separately imposed on the employer and the employee in an amount
equal to 1.45 percent of wages. There is no dollar limit on the
wages subject to the HI portion of FICA tax.

Under section 3102, the employer is required to collect the employee
portion of FICA tax by deducting the amount of the tax from wages,
as and when paid, and is liable for payment of the tax required to
be collected. Under §31.3102-1(a) of the Employment Tax
Regulations, the employer is required to collect the employee
portion of FICA tax, notwithstanding that the wages are paid in
something other than money, and to pay over the tax in money.

2. FUTA

FUTA tax is generally imposed under section 3301 on each employer in
an amount equal to a percentage of wages paid by the employer with
respect to employment. FUTA tax is imposed on the employer in an
amount equal to 6.2 percent of wages. Under section 3306(b), wages
of an employee subject to the FUTA tax are limited to $7,000 per
calendar year.

3. Income Tax Withholding

Income tax withholding is imposed under section 3402(a), which
requires employers paying wages to deduct and withhold income tax on
those wages. The amount deducted and withheld is determined in
accordance with tables or computational procedures prescribed by the
Secretary of the Treasury.

C. Wages

1. FICA

For FICA purposes, section 3121(a) provides that the term wages,
with certain exceptions, means all remuneration for employment,
including the cash value of all remuneration (including benefits)
paid in any medium other than cash. Similarly, under
§31.3121(a)-1(b), the term wages means all remuneration for
employment unless specifically excepted under section 3121(a) or
§31.3121(a)-1(j). Neither the Code nor the regulations contain
an exclusion from wages for the value of stock transferred pursuant
to the exercise of an option.

Under §31.3121(a)-1(e), in general, the medium in which the
remuneration is paid is immaterial. It may be paid in cash or in
kind. The amount of non-cash. remuneration is based on the fair
market value of the non-cash remuneration at the time of payment.

Under §31.3121(a)-2(a), in general, wages are received by an
employee at the time that they are paid by the employer to the
employee. Wages are generally paid by an employer at the time that
they are actually or constructively paid. Under
§31.3121(a)-1(i), remuneration for employment, unless
specifically excepted under section 3121(a) or
§31.3121(a)-1(j), 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.

2. FUTA

For FUTA purposes, section 3306(b) provides that the term wages,
with certain exceptions, means all remuneration for employment,
including the cash value of all remuneration (including benefits)
paid in any medium other than cash. Similarly, under
§31.3306(b)-1(b), the term wages means all remuneration for
employment unless specifically excepted under section 3306(b) or
§31.3306(b)-1(j). Neither the Code nor the regulations contain
an exclusion from wages for the value of stock transferred pursuant
to the exercise of an option.

Under §31.3306(b)-1(e), in general, the medium in which the
remuneration is paid is immaterial. It may be paid in cash or in
kind. The amount of non-cash remuneration is based on the fair
market value of the non-cash remuneration at the time of payment.

Under §31.3301-4, wages are considered paid when actually or
constructively paid.

Under §31.3306(b)-1(i), remuneration for employment paid by an
employer to an individual for employment, unless specifically
excepted under section 3306(b), constitutes wages even though at the
time paid the individual is no longer an employee.

3. Income tax withholding

For income tax withholding purposes, section 3401(a) provides that
the term wages, with certain exceptions, means all remuneration for
services performed by an employee for his employer, including the
cash value of all remuneration (including benefits) paid in any
medium other than cash. Similarly, under §31.3401(a)-1(a), the
term wages in general means all remuneration for employment for
services performed by an employee for his employer unless
specifically excepted under section 3401(a) or 3402(e).

Under §31.3401(a)-1(a)(4), in general, the medium in which the
remuneration is paid is immaterial. It may be paid in cash or in
kind. The amount of non-cash remuneration is based on the fair
market value of the non-cash remuneration at the time of
payment..Sections 3121(a) and 3306(b) were amended by section 327(b)
(1) and (c)(4), 1 respectively, of the Social Security Amendments of
1983, Public Law 98-21, 97 Stat. 65 (1983). 9 Under
§31.3402(a)-1(b), the employer is required to collect the tax
by deducting and withholding the amount from the employee's wages as
and when paid, either actually or constructively.

Under §31.3401(a)-1(a)(5), remuneration for services, unless
specifically excepted by 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. The legislative
history of sections 3401 through 3404 indicates that a purpose of
income tax withholding is to enable individuals to pay income tax in
the year in which the income is earned. H.R. Conf. Rep. No. 78-510
at 1 (1943); H.R. Rep. No. 78-401 at 1 (1943); Rep. No. 78-221 at 1
(1943); and Senate Rep. No. 78-221 at 1 (1943). Therefore, income
tax withholding is generally imposed only upon remuneration paid by
an employer to the extent that an employee recognizes income.
Section 421(a) provides that if a share of stock is transferred to
an individual in a transfer which meets the requirements of section
422(a) or 423(a), no income is recognized at the time of the
transfer.

As part of the Social Security Amendments of 1983, Public Law 98-21,
97 Stat. 65 (1983), Congress amended sections 3121(a) and 3306(b) to
provide specifically 1.Section 603 of the Tax Reform Act of 1976,
Public Law 94-355, 90 Stat. 1520 (1976), 2 amended former section
422 to provide, generally, that qualified stock options could not be
granted after May 20, 1976. Current section 422 (Incentive Stock
Options) was added to the Internal Revenue Code of 1954 (Code), as
section 422A, by section 251(a) of the Economic Recovery Tax Act of
1981, Public Law 97-34, 95 Stat. 172 (1981). Subsequently, section
11801(c)(9)(A)(i) of the Omnibus Budget Reconciliation Act of 1990,
Public Law 101-508, 104 Stat. 1388 (1990), repealed former section
422 that regulations providing an exclusion from wages for income
tax withholding purposes are not to be construed to require a
similar exclusion from wages for FICA and FUTA purposes. The
legislative history to the Social Security Amendments of 1983 at S.
Rep. No. 98-23, 42, 98 Cong., 1 Sess. explains as to FICA and income
tax withholding that th st "[S]ince, [however], the [social]
security system has objectives which are significantly different
from the objective underlying the income tax withholding rules, the
committee believes that amounts exempt from income tax withholding
should not be exempt from FICA unless Congress provides an explicit
FICA tax exclusion." The legislative history further explains that
Congress intended to reverse the holding in Rowan Companies v. U.S.,
452 U.S. 247 (1981), that the definitions of wages for FICA and
income tax withholding purposes were the same. Thus, wages for
income tax withholding purposes are not always the same as wages for
FICA and FUTA purposes.

D. Application of Law to Statutory Stock Options

Revenue Ruling 71-52 (1971-1 C.B. 278) which was published before
the statutory changes to sections 3121(a) and 3306(b) mentioned
immediately above, addressed the FICA, FUTA, and income tax
withholding consequences applicable to the exercise of qualified
stock options under former section 422 . The ruling holds that
2.(Qualified Stock Options) and re-designated former Code section
422A as section 422 of the Internal Revenue Code of 1986, a taxpayer
does not make a payment of wages for purposes of FICA, FUTA, and
income tax withholding at the time of the exercise of a qualified
stock option under former section 422.

Notice 87-49 (1987-2 C.B. 355) addressed potential inconsistencies
among and coordination of the proposed regulations under former
section 422A (current section 422), section 83, and Rev. Rul. 71-52.
Notice 87-49 provided that Rev. Rul. 71-52 was being reconsidered,
but, until the results of such reconsideration were announced, the
principles of Rev. Rul. 71-52 apply to the disposition of stock,
acquired by an individual pursuant to the exercise of an incentive
stock option, which does not meet the requirements of former section
422A(a) (current section 422(a)).

Notice 2001-14 (2001-6 I.R.B. 416) addresses the FICA, FUTA, and
income tax withholding consequences applicable to the exercise of
statutory stock options. Notice 2001-14 provides that in the case of
any statutory stock option exercised before January 1, 2003, the IRS
will not assess FICA or FUTA tax upon the exercise of the option and
will not treat the disposition of stock acquired by an employee
pursuant to the exercise of the option as subject to income tax
withholding. Notice 2001-14 also provides that Revenue Ruling 71-52
is obsolete and that the holding of Revenue Ruling 71-52 does not
apply to the exercise of a statutory stock option or to the
disposition of stock acquired pursuant to the exercise of a
statutory stock option. Consistent with that. conclusion, Notice
2001-14 also provides that the provisions of Notice 87-49 described
above no longer apply.

It has long been recognized that the transfer of stock to an
employee pursuant to the exercise of a nonstatutory stock option
granted in connection with employment constitutes a payment of
compensation to the extent that the fair market value of the stock
received by the employee pursuant to the exercise of the
nonstatutory option exceeds the option exercise price. Commissioner
v. LoBue, 351 U.S. 243 (1956); Commissioner v. Smith, 324 U.S. 177
(1945). The exclusion from gross income for income tax purposes that
is provided by section 421(a)(1) for the transfer of stock upon the
exercise of a statutory stock option, does not alter the
compensatory character of such stock transfers or serve to
distinguish statutory stock options from nonstatutory stock options
for purposes of sections 3121(a) and 3306(b).

Cents Received Pursuant to Notice 2001-14

Notice 2001-14 announced the intent to issue further administrative
guidance clarifying current law with respect to the application of
employment taxes to statutory stock options and solicited public
comments on the anticipated guidance. In response to the request for
comments, the IRS received a number of comments addressing a variety
of topics pertaining to the application of FICA, FUTA, and income
tax withholding to transactions involving statutory stock options.
Because the proposed regulations address only the application of the
FICA, FUTA, and income tax withholding at the time of exercise of a
statutory stock option, only comments relating to these types of
transactions are addressed.

The IRS also received comments regarding an employer's income tax
withholding and reporting obligations upon the sale or disposition
of stock acquired by an individual pursuant to the exercise of a
statutory stock option. The IRS intends to publish two notices,
discussed more fully below, at the time of publication of these
proposed regulations. One notice includes proposed rules addressing
an employer's income tax withholding and reporting obligations upon
the sale or disposition of stock acquired by an individual pursuant
to the exercise of a statutory stock option. That notice discusses
the comments received in response to Notice 2001-14 relating to
those types of transactions.

Most commentators who addressed the application of FICA and FUTA tax
at the time of exercise of a statutory stock option argued that
there was no statutory basis for such application. As discussed more
fully previously, the applicable Code provisions do not provide an
exception from FICA or FUTA tax for wages paid to an employee
arising from the exercise of a statutory stock option.

Several comments were received requesting that the IRS's
acquiescence on decision in Sun Microsystems v. Commissioner, T.C.M.
1995-69, acq. 1997-2 C.B. 1, not be affected by the proposed
regulations. The proposed regulations address only the application
of FICA and FUTA to statutory stock options and do not address the
section 41 issues raised in the Sun Microsystems decision.

Some commentators also expressed concern about the administrative
burden of applying FICA and FUTA tax at the time of exercise,
especially as to former employees, because there is often no payment
of cash compensation to the employee at that time. As a result, some
employees may need to sell some shares of the acquired stock to fund
the employment tax obligations, resulting in a disqualifying
disposition of the shares sold. In addition, some commentators
expressed concern that the administrative burdens stemming from the
application of FICA and FUTA tax upon the exercise of statutory
stock options would make the use of these options less attractive to
employers and employees. However, commentators did not cite
applicable Code provisions that provide a statutory basis for
excluding this type of compensation from the relevant employment
taxes. As discussed below, the proposed regulations would enable the
IRS to issue rules of administrative convenience to lessen the
administrative burdens that commentators cited.

Explanation of Provisions

These proposed regulations would clarify current law regarding FICA
tax, FUTA tax, and income tax withholding on the transfer of stock
pursuant to the exercise of statutory stock options. These proposed
regulations would provide that at the time of the exercise of a
statutory stock option, the individual who was granted the statutory
stock option receives wages for FICA and FUTA purposes. These
proposed regulations would also provide that the amount of wages
received equals the excess of the fair market value of the stock
acquired pursuant to the exercise of the statutory stock option over
the amount paid for the stock.

The position taken in these regulations is based upon the broad
statutory definition of wages for FICA and FUTA purposes and the
absence of any statutory exclusion for this form of remuneration.
These regulations follow the Congressional directive that no
exception from FICA taxes should be created without a specific
exclusion and the section 3121(a) and 3306(b) provisions that no
exception from FICA and FUTA taxes should be inferred from the fact
that income tax withholding does not apply.

These proposed regulations would also provide that income tax
withholding is not required when an individual exercises a statutory
stock option because no income is recognized at the time of the
exercise by reason of section 421(a)(1). In response to the concerns
about administrative burdens, the proposed regulations authorize the
IRS to adopt rules of administrative convenience to assist employers
and employees in meeting the employment tax obligations.
Specifically, the proposed regulations permit the IRS to adopt rules
permitting employers to deem the payment of wages resulting from the
exercise of a statutory stock option as occurring at a specific date
or dates, including over a period of dates, as well as any other
appropriate rules of administrative convenience.

Section 424(h) provides that for purposes of the rules governing
incentive stock option plans and employee stock purchase plans, if
the terms of any option to purchase stock are modified, extended, or
renewed, such modification, extension, or renewal is considered as
the grant of a new option. Section 424(h)(3) generally defines the
term modification as any change in the terms of the option which
gives the employee additional benefits. The proposed regulations
clarify that the adoption of any of the rules of administrative
convenience that may be prescribed by the IRS pursuant to the
proposed regulations, and the application of those rules to
outstanding incentive stock options under section 422 or outstanding
options under an employee stock purchase plan under section 423,
will not constitute a modification for purposes of section 424(h).

These regulations are proposed to apply only upon publication of
final regulations in the Federal Register and cannot be relied upon
prior to publication. These proposed regulations, upon becoming
final, would be effective only for the exercise of a statutory stock
option that occurs on or after January 1, 2003. If these regulations
are finalized as proposed, neither FICA nor FUTA tax will apply to
the exercise of a statutory stock option prior to January 1, 2003.
Consistent with this proposed position, the IRS will not assert FICA
or FUTA tax which is based upon the exercise of a statutory stock
option that occurs prior to January 1, 2003.

While neither FICA nor FUTA tax will apply to the exercise of a
statutory stock option prior to January 1, 2003 if these regulations
are finalized as proposed, an employer will be able to apply the
final regulations to the exercise of a statutory stock option that
occurs prior to January 1, 2003 if the employer elects to do so.

Related administrative guidance.These proposed regulations, along
with the two notices, are intended to clarify the 3 application of
employment taxes to statutory stock options in a manner that
recognizes and addresses the practical burdens that are imposed,
including the imposition of withholding when neither the employer
nor any other person (other than the employee) has control over a
payment of remuneration, while also ensuring that "amounts exempt
from income tax withholding should not be exempt from FICA unless
Congress provides an explicit FICA tax exclusion." Social Security
Amendments of 1983 at S. Rep. No. 98-23, 42, 98 Cong., 1 Sess. th st

As noted above, the IRS is concurrently publishing two notices. One
of the two notices sets forth proposed rules of administrative
convenience under the authority provided to the IRS in the proposed
regulations. These proposed rules would permit employers to deem the
payment of wages resulting from the exercise of a statutory stock
option as occurring at a specific date or dates, including over a
period of dates. The notice also describes certain arrangements
available under the current federal tax law that may assist
employers and employees, including employee pre-funding of the
employee portion of FICA tax and employer advances of funds to
satisfy the employee portion of FICA tax.

The IRS is publishing a second notice that proposes rules regarding
an employer's income tax withholding and reporting obligations upon
the sale or disposition of stock acquired by an individual pursuant
to the exercise of a statutory stock option. As indicated above, the
proposed rule in this notice would state that the employer has no
income tax withholding obligation when an employee sells or disposes
of stock acquired by the employee pursuant to the exercise of a
statutory stock option.3 Special Analyses.

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also
has been determined that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not apply to these
regulations, and because the regulations do not impose a collection
of information on small entities, the Regulatory Flexibility Act (5
U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the
Code, this notice of proposed rulemaking will be submitted to the
Chief Counsel for Advocacy of the Small Business Administration for
comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written (a signed original and
eight (8) copies) or electronic comments that are submitted timely
to the IRS. All comments will be available for public inspection and
copying.

Treasury and the IRS specifically request comments on the clarity of
the proposed regulations, how they can be made easier to understand,
and the administerability of the rules in the proposed regulations.
In addition, the proposed regulations do not include special rules
for transactions in which an individual exercising a statutory stock
option receives stock subject to a restriction, such as a
substantial risk of forfeiture. Treasury and the IRS also
specifically request comments as to whether the proposed regulations
should include such special rules, including. comments as to the
prevalence of incentive stock option plans or employee stock
purchase plans that impose such terms on stock received pursuant to
the exercise of a statutory stock option.

A public hearing has been scheduled for March 7, 2002, beginning at
10 a.m. in the Auditorium of the Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. Due to building security
procedures, visitors must enter at the 10 th Street entrance,
located between Constitution and Pennsylvania Avenues, NW. In
addition, all visitors must present photo identification to enter
the building. Because of access restrictions, visitors will not be
admitted beyond the immediate entrance area more than 15 minutes
before the hearing starts. For information about having your name
placed on the building access list to attend the hearing, see the
"FOR FURTHER INFORMATION CONTACT" section of this preamble.

The rules of 26 CFR 601.601 (a) (3) apply to the hearing. Persons
who wish to present oral comments at the hearing must submit an
outline of the topics to be discussed and the time to be devoted to
each topic (signed original and eight (8) copies) by February 14,
2002. A period of 10 minutes will be allotted to each person for
making comments. An agenda showing the scheduling of the speakers
will be prepared after the deadline for receiving outlines has
passed. Copies of the agenda will be available free of charge at the
hearing.

Drafting Information.

The principal author of these proposed regulations is Stephen
Tackney, Office of the Associate Chief Counsel (Tax Exempt and
Government Entities). However, other personnel from the IRS and
Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 31

Employment taxes, Income taxes, Penalties, Pensions, Railroad
retirement, Reporting and recordkeeping requirements, Social
security, Unemployment compensation. Proposed A endments to the
Regulations Accordingly, 26 CFR parts 1 and 31 are proposed to be
amended as follows:

Part 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.425-1, as proposed at 49 FR 4519 (February 7,
1984), is amended by adding a sentence immediately after the third
sentence of paragraph (e)(5)(i) to read as follows:

§1.425-1 Definitions and special rules applicable to statutory
options.

* * * * 

(e) * * *

(5)(i) * * * In addition, the application to an outstanding option
of any of the methods for the payment or withholding of employment
taxes under sections 3101, 3111, or 3301 that may be prescribed
under §31.3121(a)-1(k)(2) or §31.3306(b)-1(l)(2) of this
chapter is not a modification. 

* * * * *

PART 31 -- EMPLOYMENT TAXES AND COLLECTION OF INCOME TAXES AT THE
SOURCE

Par. 3.The authority citation for part 31 continues to read in part
as follows: Authority: 26 U.S.C. 7805 * * * Par. 4. In
§31.3121(a)-1, paragraph (k) is added to read as follows:
§31.3121(a)-1 Wages.

* * * * *

(k) Statutory stock options -- (1) When an individual receives wages
-- (i) Statutory stock option defined. For purposes of this section,
a statutory stock option is an option that either satisfies the
requirements of section 422(b) or is granted under a plan that
satisfies the requirements of section 423(b).

(ii) Wages at exercise. If an individual is granted a statutory
stock option, the individual receives wages when stock is
transferred to the individual pursuant to the exercise of the
option. The amount of the wages received by the individual is equal
to the excess of the fair market value of the stock, determined at
the time of exercise, over. the amount paid for the stock by the
individual. The provisions of this paragraph (k) are illustrated by
the following example: Example.

(i) Individual X is granted an option under a plan that satisfies
the requirements of section 423(b). The option allows X to acquire
50 shares of stock of X's employer, Y, at an exercise price equal to
85% of the fair market value of the stock at the time the option is
granted. The fair market value of the Y stock at the time the option
is granted is $100 per share. X exercises the option later when the
fair market value of the Y stock is $120 per share. Thus, at the
time of exercise, X acquires 50 shares of Y stock having a fair
market value of $120 per share for $85 per share.

(ii) In this Example, at the time of exercise, X has received wages
equal to the excess of the fair market value of the stock ($120 per
share) over the amount paid for the stock ($85 per share). Thus, for
purposes of section 3121, X has received wages equal to $35 per
share, for a total of $1,750.

(2) Rules of administrative convenience. The Commissioner may
prescribe rules of administrative convenience for employers and
employees to satisfy obligations under sections 3101 and 3111 that
arise with respect to wages received pursuant to the exercise of a
statutory stock option. Such rules may include, but are not limited
to, permitting employers to deem the payment of wages due to the
exercise of the statutory stock option as occurring at a specific
date or dates, including over a period of dates.

(3) Effective date. This paragraph (k) is applicable to the exercise
of a statutory option that occurs on or after January 1, 2003. Par.
5. In §31.3306(b)-1, paragraph (l) is added to read as follows:
§31.3306(b)-1 Wages.

* * * * *

(l) Statutory stock options -- (1) When an individual receives wages
-- (i) Statutory stock option defined. For purposes of this section,
a statutory stock option is an option that either satisfies the
requirements of section 422(b) or is granted under a plan that
satisfies the requirements of section 423(b).

(ii) Wages at exercise. If an individual is granted a statutory
stock option, the individual receives wages when stock is
transferred to the individual pursuant to the exercise of the
option. The amount of the wages received by the individual is equal
to the excess of the fair market value of the stock, determined at
the time of exercise, over the amount paid for the stock by the
individual. The provisions of this paragraph (l) are illustrated by
the following example: Example.

(i) Individual X is granted an option under a plan that satisfies
the requirements of section 423(b). The option allows X to acquire
50 shares of stock of X's employer, Y, at an exercise price equal to
85% of the fair market value of the stock at the time the option is
granted. The fair market value of the Y stock at the time the option
is granted is $100 per share. X exercises the option later when the
fair market value of the Y stock is $120 per share. Thus, at the
time of exercise, X acquires 50 shares of Y stock having a fair
market value of $120 per share for $85 per share.

(ii) In this Example, at the time of exercise, X has received wages
equal to the excess of the fair market value of the stock ($120 per
share) over the amount paid for the stock ($85 per share). Thus, for
purposes of section 3306, X has received wages equal to $35 per
share, for a total of $1,750.

(2) Rules of administrative convenience. The Commissioner may
prescribe rules of administrative convenience for employers to
satisfy obligations under section 3301 that arise with respect to
wages received pursuant to the exercise of a statutory stock option.
Such rules may include, but are not limited to, permitting employers
to deem. the payment of wages due to the exercise of the statutory
stock option as occurring at a specific date or dates, including
over a period of dates.

(3) Effective date. This paragraph (l) is applicable to the exercise
of a statutory option that occurs on or after January 1, 2003. Par.
6. In §31.3401(a)-1, paragraph (b)(15) is added to read as
follows: §31.3401(a)-1 Wages.

* * * * *

(b) * * *

(15) Statutory stock options -- (i) When stock is transferred
pursuant to an exercise -- (A) Statutory stock option defined. For
purposes of this section, a statutory stock option is an option that
either satisfies the requirements of section 422(b) or is granted
under a plan that satisfies the requirements of section 423(b).

(b) Withholding at exercise. If an individual is granted a statutory
stock option, withholding is not required when stock is transferred
to the individual pursuant to the exercise of the option to the
extent that the individual does not recognize income by reason of
section 421(a)(1). The provisions of this paragraph (b)(15) are
illustrated by the following example:

Example.

(i) Individual X is granted an option under a plan that satisfies
the requirements of section 423(b). The option allows X to acquire
50 shares of stock of X's employer, Y, at an exercise price equal to
85% of the fair market value of the stock at the time the option is
granted. The fair market value of the Y stock at the time the option
is granted is $100 per share. X exercises the option later when the
fair market value of the Y stock is $120 per share. Thus, at the
time of exercise, X acquires 50 shares of Y stock having a fair
market value of $120 per share for $85 per share. X. continues to
hold the Y stock after exercise. Under section 421(a), no income is
recognized at the time of exercise.

(ii) In this Example, for purposes of section 3401, X has not
received wages at the time of exercise..(ii) Effective date. This
paragraph (b)(15) is applicable to the exercise of a statutory stock
option that occurs on or after January 1, 2003.

* * * * *

Deputy Commissioner of the Internal Revenue.
Robert E. Wenzel.

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