On August 16, 2022, President Biden signed the Inflation Reduction Act (“IRA”) into law. One of the new provisions the IRA introduced is the stock buyback excise tax under Code section 4501, which applies as of January 1, 2023 and was designed to target large corporations that implement stock buybacks.
Code section 4501 imposes a 1% excise tax on the value of covered corporation stock that is repurchased by the covered corporation or a 50% affiliate. A covered corporation generally means a publicly traded US corporation. However, certain repurchases (or fundings of a repurchase) by a US affiliate of a foreign corporation are also subject to excise tax. $1,000,000 in stock repurchases per year is treated as de minimis so that the excise tax does not apply unless that threshold of stock purchases is exceeded.
What amount is liable to the excise tax?
While the value of the repurchased stock is subject to the excise tax, two compensation-related items can reduce the excise tax.
First, Code section 4501(c)(3) provides that the amount taken into account for purposes of the stock repurchase excise tax “shall be reduced by the fair market value of any stock issued by the covered corporation during the taxable year, including the fair market value of any stock issued or provided to employees of such covered corporation or . . . of a specified affiliate.” (Emphasis supplied.) IRS guidance in Notice 2023-2, section 3.08, follows section 83 rules to determine when the stock was issued or provided to an employee for purposes of this netting rule. In other words, restricted stock is treated as provided to the employee when it vests, or if the employee makes a section 83(b) election, at transfer. Stock issued on settlement of an RSU is treated as provided to the employee when the corporation initiates the transfer of the stock. Similarly, stock issued on exercise of an option is treated as provided to the employee when the employee exercises the option.
For excise tax netting purposes, the stock is required to be valued as it would be under section 83 on the date the stock is issued or provided to the employee. Note that this may be different as a practical matter than the amount reported to the employee as compensation and withheld upon due to the administrative difficulty of running payroll on the basis of a contemporaneous value, rather than a value on a preceding day. It should also be noted that the valuation for excise tax netting purposes may also differ from the valuation approaches prescribed in the Notice for determining the value of the repurchased shares (e.g. daily volume-weighted average price, closing price, average of high-low, and trading price at the time of repurchase).
The treatment of stock held back for withholding (i.e. net share withholding) is addressed in Section 3.08(3)(a)(iv) of the Notice, which provides that stock withheld by a covered corporation or an affiliate to satisfy an employer’s income tax withholding obligation described in section 3402, an employer’s Federal Insurance Contributions Act (“FICA”) withholding obligations described in section 3102, or the exercise price of an option is not treated as stock issued or provided to an employee by a covered corporation or specified affiliate. By contrast, if the stock is issued and then immediately sold by the broker to cover these obligations (i.e. sell to cover method of withholding), the stock is treated as issued or provided to the employee and does count for purposes of netting against repurchases. The notice does not indicate whether shares held back or sold to cover state income taxes or taxes required to be withheld as backup withholding under section 3406 or cross-border withholding under section 1441/1442 are treated similarly, but presumably that would be the case. The notice does not indicate the treatment of shares held back or sold to cover tax withholding obligations imposed by foreign law, such as the pay as you earn and social tax regimes common in other countries.
The examples in Notice 2023-2 illustrate the principle. Example 24 illustrates application of the netting rule to an RSU that vests after a set period of services are performed and shortly after vesting, the shares underlying the RSUs are transferred. The RSU grant is for 100 shares and, after the vesting condition is met, the employer initiates the transfer of 60 shares, with 40 shares held back to cover the employer’s withholding tax obligations. The example concludes that the fair market value of the 60 shares can be net against the repurchased shares for purposes of the base of the excise tax liability (but the 40 shares held back for withholding taxes cannot). Similarly, Example 25 illustrates that shares held back to satisfy an option’s exercise price are not net against the repurchased shares for purposes of the excise tax.
By contrast, Example 26 addresses a broker assisted net exercise where 100 shares are issued on option exercise, the broker pays the exercise price, and the broker immediately sells 80 shares of the stock to cover the exercise price. In such a case, the full 100 shares transferred to the broker account are treated as issued or provided to the employee for purposes of netting against repurchased shares.
Does the Notice address the treatment of stock contributed to retirement plans?
In addition to the above treatment of stock compensation, there is also a specific exemption to the extent repurchased stock (or an amount equal to such repurchased stock) is contributed to an employer-sponsored retirement plan. That stock is excepted from the excise tax. The Notice indicates that this would include a section 401(a) tax qualified retirement plan (including an employee stock ownership plan), or a “similar plan” (the reference to Section 401(a) should cover 401(k) defined contribution plans, defined benefit pension plans and ESOPs, but the reference to “similar plan” is not clearly defined). The Notice seems to contemplate that the contribution must take the form of actual employer stock rather than cash equal to the value of the repurchased stock. That would present some practical limitations and issues for employers.
For example, no more than 10% of a tax-qualified defined benefit pension plan’s assets (based on fair market value) can consist of employer stock. Defined contribution plans like a 401(k) plan are not subject to the 10% limit. However, holding employer stock in a self-directed 401(k) plan has substantial fiduciary considerations under ERISA and a number of employers no longer offer employer stock funds in their 401(k) plans given those concerns.
The Notice addresses the issue of timing of such contributions for purposes of the excise tax by applying principles similar to those under section 404(a)(6). The Notice permits an employer to treat contributions as having been contributed in the prior taxable year if contributed by the filing deadline for the IRS Form 720, Quarterly Federal Excise Tax Return that is due for the first full quarter after the close of the taxpayer’s taxable year if made on account of that year under section 404(a)(6) principles. However, not all plans may have a clear allocation method for allocating the contributed stock among plan participant accounts and if the method used to allocate the stock is not one of the safe harbor methods used under the Code, additional plan testing may be required. Similarly, it is not clear from the Notice whether the contributed stock could be used to satisfy existing employer contribution obligations under the plan (e.g., match or profit share).
When are issuers subject to the excise tax?
The 1% excise tax is effective for repurchases of stock occurring after December 31, 2022, and is reduced under the netting rules by any stock issued during the taxable year. The IRS expects to require a Form 720 excise tax filing to be made only once per year, in the first quarter after the close of the year of the repurchases. Presumably, this means the tax is not due until that return is filed and that deposit and late payment penalties are not applicable before then.
Stock and retirement plan professionals whose companies have repurchased shares likely will need to coordinate with their tax department colleagues who are charged with preparing the excise tax return regarding the amount of stock issued to employees, amounts held back for withholding taxes and option exercise amounts, and contributions of stock to retirement plans. This coordination may also need to address some of the valuation issues. (such as how to value stock issued to employees and whether a consistently used Form W-2 reporting valuation convention is adequate) and whether to consider requesting clarification from the IRS on those issues.
The Treasury announced that it intends to issue proposed regulations and it has solicited comments from the public over the 60 days following the December 27, 2022, publication of Notice 2023-2 on issues that taxpayers feel are unclear or that should be further addressed in those regulations. The IRS has specifically requested comments on whether for netting purposes stock issued should be valued using a price other than the market price at issuance and whether the employer sponsored retirement plan definition should be expanded. While the formal 60-day comment period has ended, we find the IRS is generally open to receiving constructive comments on its proposals even after the stated deadline. Until proposed regulations are issued, taxpayers may rely on the rules provided in Notice 2023-2.
 This description of the timing of section 83 income (and wages) is consistent with the IRS position in prior guidance, such as in GLAM 2020-004 (May 22, 2020).