The Rules on Tax Withholding for Outside Directors

Sometimes outside directors make a surprising request with respect to their equity awards: they ask you to withhold taxes on them. Unfortunately, withholding taxes on compensation paid to nonemployees is problematic, so this generally isn’t a request you can accommodate.

For this blog entry, I address some questions I am frequently asked on this topic. Check out my video on it as well.

Can companies withhold taxes for outside directors?

Absolutely not! Companies should only withhold taxes for employees. Outside directors and other nonemployees are responsible for paying their own taxes and should make estimated tax payments.

What if they really want us to?

The answer is still no. There's simply no mechanism in the US tax system to enable companies to collect taxes from nonemployees and pay over those taxes to the IRS. The IRS would have to create special rules to allow this and would have to create a system by which the taxes could be collected, deposited, and reported. Interestingly, this was proposed by the Obama administration, but the proposal was never acted on.

What if we just include the directors’ tax payments with our payroll deposit?

This is a bad idea. The IRS is going to treat income reported through your payroll system as employee wages, which are subject to FICA.  Nonemployees aren't subject to FICA; they are subject to SECA (self-employment tax). Trying to deposit the taxes this way is going to make the IRS think the income is subject to FICA, which is going to be a problem to unwind.

But our directors really want us to withhold shares to pay their taxes...

The request to withhold taxes on directors’ equity awards almost always comes up in the context of RSUs. When directors see that shares are withheld to cover the taxes due on RSUs granted to executives and other employees, they sometimes get the idea that it would be nice to be able to use share withholding to cover the tax payments on their own RSUs.

I get it; no one wants to pay their taxes in cash. Oh, the burdens of being a highly-paid director. But even if you could withhold taxes for outside directors (which you can’t—see above), you still probably wouldn’t want to allow the directors to use share withholding. This is because withholding shares to cover taxes when there isn’t a statutory obligation to withhold triggers liability treatment under ASC 718. 

Liability treatment is clearly required on those awards where share withholding is utilized in the absence of a statutory obligation to withhold taxes. But the result can be much worse than this. If the company establishes a pattern of withholding taxes for outside directors when they request it, liability treatment would be triggered not just for the awards for which shares are withheld to cover taxes, but for all awards issued to all outside directors (and all future awards issued to them), even for directors that don't ask the company to withhold shares to cover their taxes. Even allowing only a couple of outside directors to utilize share withholding on their RSUs might be sufficient to establish a pattern.

Liability treatment is usually a deal-breaker for companies. As I note above, in my experience, when directors request tax withholding, it is almost always because they want to use share withholding to cover their taxes. Explaining that this causes liability treatment is usually a good way to shut down that whole conversation.

Is there any way for outside directors to use shares to cover the taxes due on their equity awards?

Outside directors should be making estimated tax payments to the IRS and should include their RSU income when determining the amount of these payments. If the outside directors want to use shares to cover their taxes, they can sell some of their vested stock on the open market and use the sale proceeds to make their estimated tax payment.

The outside directors could even establish Rule 10b5-1 plans for the sales, so that they don’t need to worry about whether they have material nonpublic information about the company at the time the sales occur. (Of course, the 10b5-1 plans should be established well in advance of the sale dates and comply with the other requirements of the rule).

What if the director used to be an employee?

This is an exception. When individuals change employment status during the life of their awards, it is permissible to treat the portion of the award attributable to their service as an employee as wages, which are subject to tax withholding.

Thus, any equity awards that were granted when the now-outside director was an employee could arguably be considered compensation for services performed as an employee. The income attributable to these awards could be reported on a Form W-2 and taxes can be withheld on it and deposited with the rest of your payroll taxes (and this income would be subject to FICA, not SECA).

But this won’t apply to any equity awards granted after the now-outside director ceased to be an employee. The director will likely continue to receive equity grants during their term on the board. The equity grants issued after the director’s last day as an employee are pretty clearly compensation for services as a nonemployee. The income attributable to these awards would not be eligible for tax withholding, would be subject to SECA (not FICA), and would be reported on Form 1099-NEC.

Are there any circumstances where we have to withhold taxes on outside directors?

Here I have some bad news. There are some situations where you are required to withhold taxes for outside directors, but in both cases, the directors are probably going to be unhappy about it.

Non-US Directors

If you have directors who are not US residents or citizens and they travel to the United States in the course of fulfilling their duties as a board member (e.g., to attend board meetings), the portion of their equity award income that is attributable to the services they performed while in the United States may be subject to US tax withholding. See the article "Keys to Tax Compliance Readiness When a US Nonresident Director Joins a US Board" for more information.

There Are Some Exceptions

Companies do not have to withhold taxes for non-US directors if any of the following conditions apply:

• The director is a US citizen.
• The director is a permanent resident of the United States (i.e., a green card holder) or otherwise qualifies as a resident under the substantial presence test.
• There is a tax treaty between the United States and the country that the director resides in that provides an exemption.

Withholding and Reporting Procedures

If none of the above exceptions apply, the company should withhold federal income tax on compensation paid to the director. Unfortunately, this isn’t as simple as adding the director into payroll and including the deposit with your payroll taxes. That won’t work because directors aren’t employees.  Here are the procedures:

• The tax withheld must be deposited via the Electronic Federal Tax Payment System (EFTPS).
• The income and withholding are reported on Form 1042, which must be filed with the IRS by March 15 of the following year.
• The income and withholding are also reported on Form 1042-S, which also must be filed with the IRS by March 15. A copy of Form 1042-S is also issued to the director.

Withholding is only required on income earned for services performed in the United States. If directors are performing services outside the United States, withholding could be limited to the income attributable to services performed in the United States. But the rules on how to allocate the income are complicated (especially when it comes to equity awards) and the company has to keep detailed records of where and when the director performed services. As a result, some companies choose to withhold on all compensation paid to non-US resident directors and let the directors sort it out on their tax returns.

The Director’s Obligations

At a minimum, the director will have to file a US tax return (on Form 1040-NR). He/she might also have to make quarterly estimated tax payments (on Form 1040-ES (NR), if the amounts you withhold won’t be sufficient to cover the director’s tax liability.

All of which the director may be none to thrilled about. There is some irony here: US directors want you to withhold taxes but you can't; non-US directors don't want you to withhold taxes but you are required to. The upshot is that no one is happy (least of all, you).

What About Non-US Taxes?

Yep, you could also have an obligation to withhold taxes in the director’s country of residence. The requirements here vary by country. Consult your global equity plan advisors. 

Pennsylvania State Tax

When directors who are not residents of Pennsylvania travel to the state in the course of performing their duties as board members (e.g., for a board meeting), you may be required to withhold PA state tax if the payments exceed $5,000 per year.

There are two key things to know about this requirement:

1. Withholding on compensation paid to nonemployees is only required on PA-source income. In the context of compensation, this is payment services performed in Pennsylvania.
2. Withholding for nonemployees is only required for those who aren’t residents of PA. You don’t have to withhold PA PIT for nonemployees who reside in PA.

The upshot here is that this new requirement is most likely to be a concern for Pennsylvania-based companies, and companies that hold board meetings in Pennsylvania, that have directors who live outside of Pennsylvania. (Pro tip: Regardless of where your company is based, avoid this rule by not holding board meetings in Pennsylvania.)

Withholding and Reporting

When withholding of PA PIT is required for outside directors, the withholding rate is 3.07%.  The taxes withheld are reported in box 16 of Form 1099-MISC; the company will then have to file the Form 1099-MISC with the state, in addition to filing it with the IRS and providing a copy to the nonemployee.