Tax Withholding Considerations For Those Receiving Equity Compensation

• October 31, 2021
• Chris Wall, CPA, CFP

The United States has a pay as you go taxation system. As you earn income, you are expected to make timely payments to the government for your taxes. For most employees, they manage their tax payments through the tax withholdings in their paycheck. After filling out their W4 when they are hired, most employees let their employer directly remit the appropriate taxes on their behalf. Owners of equity grants may not be able to rely entirely on their paycheck withholdings to avoid IRS penalties.

Quarterly Estimated Payments

In years when equity events take place or there are sales of the company stock, the amount taken out of your paycheck may not be sufficient to avoid penalties. The minimum amount required by law to avoid underpayment charges is 90% of the current year tax liability. If you experience additional income by exercising an option or having an RSU vest, you are responsible for hitting that 90% threshold by making timely payments to the IRS. If you need to make additional payments, the quarterly due dates are:

First Quarter Due Date: April 15^th

Second Quarter Due Date: June 15^th

Third Quarter Due Date: September 15^th

Fourth Quarter Due Date: January 15^th of the next year

Play It Safe

The IRS does offer another alternative to avoid penalties for underpayment. It can be challenging to estimate your current year tax liability if you have a lot of equity activity in the current year. Safe Harbor allows you to withhold 100% of your prior year tax liability if your income is below $150,000 or 110% of your prior year tax liability if your income is above $150,000. If you are unclear of your current year tax obligations, simply take the total amount of tax you paid on last year’s tax return and make sure your withholdings combined with your additional quarterly payments equal that amount. By meeting the 100% or 110% Safe Harbor, you are safe from interest and penalties.

What If You Missed a Payment

Before the due date of your tax return, the amount of tax you owe is evaluated on a quarterly basis. Failure to make a timely quarterly payment will result in interest being charged on the amount you are underpaid. Currently, the interest rate being charged is 3% plus the Federal short-term rate. If you fail to make the appropriate payments by the due date of your return, underpayment penalties are assessed at .5% per month with a maximum penalty of 25%. This is in addition to potential interest charges that can accrue. It is clear that the cost of underpayment can have a compounding effect and that any underpayment should be addressed immediately.

Special Considerations For Incentive Stock Options (ISOs)

Employees who have exercised their ISOs should pay attention to their withholding amounts and quarterly payments. When employees exercise their ISOs and receive the tax advantages of a qualified disposition, their employers are not required to withhold on their behalf for the exercise. In the years when there are a larger number of options exercised, an AMT tax liability may be generated. Failure to account for this AMT adjustment could leave you in the position of being underpaid.

Nonqualified Stock Options (NSOs) and Restricted Stock

Contractors and Outside Directors are often granted NSOs and restricted stock. These parties will typically not have taxes withheld by the company at the time of exercising or vesting. They need to pay particular attention to quarterly payments in order to avoid underpayment penalties.

Restricted Stock Units (RSUs)

Employers are required to withhold at a rate of 22% for RSUS that vest with values under $1 million dollars. Often times, this can leave high income earning employees under-withheld because their federal tax bracket is above the 22% threshold. RSU holders should be aware of their top marginal tax rate and additional quarterly payments should be made by those who are in higher tax brackets.

Don’t Forget About State Taxes

All of the rules mentioned above apply only to Federal Taxes. While many states attempt to mirror the federal system, each state tax system has different rules for estimated payments. Some states offer preferential tax treatment for capital gains while other do not. Some offer Safe Harbor payment for its residents but have income limitations.   Others have estimated tax payment dates that differ from the federal standard. Be aware of the requirements of your state in order to avoid penalties at the local level.

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