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Pennsylvania residents who exercise stock options issued by their employer may be subject to local earned income tax on the income realized when such stock options are exercised, based on a recent Pennsylvania Supreme Court ruling.

In Marchlen v. Township of Mt. Lebanon, the Pennsylvania Supreme Court on February 22, 2000 reversed the decision of the Commonwealth Court and held that the definition of "earned income" under the Local Tax Enabling Act (53 P.S. 6901 et seq.), which authorizes Pennsylvania municipalities to impose income tax on taxpayers' wages, salaries and other earnings, includes the "spread" between the proceeds realized upon the exercise of non-qualified stock options and the exercise price of such options, and that accordingly a municipality may impose its earned income tax on the amount of such "spread."

In the case before the Court, the taxpayer, an employee of the Aluminum Company of America (Alcoa), realized "spread" income of $58,812.44 upon exercising 1,100 non-qualified stock options which he had been awarded as a participant in Alcoa's stock option plan for employees. Such income, according to the Court, was subject to the Township of Mt. Lebanon 1% earned income tax.

The Court in its opinion states that the value of stock options when they are granted is "purely speculative" and hence not taxable on the date of grant. The Court goes on to state that even when the fair market value of the underlying stock exceeds the exercise price of the options (i.e., the options are "in the money"), the value of the options continues to be speculative and is not "readily ascertainable" until the option is exercised, at which point "spread" income becomes subject to local earned income tax.

The Court's decision leaves unanswered a number of questions regarding the application of municipal earned income taxes to stock option income and raises important issues relating to the application of the Pennsylvania personal income tax to stock option income.

If an option at grant or at any time prior to exercise does have a "readily ascertainable" value because the options are publicly-traded or are subject to valuation based on another accepted valuation methodology, would such value be subject to local earned income tax at such time, even though the options had not been exercised?

Is the "spread" between the fair market value of the underlying stock and the exercise price of an incentive stock option subject to local earned income tax when the incentive stock option is exercised, notwithstanding that such "spread" generally is not subject to federal income tax upon exercise?

To the extent that an employer is obligated to withhold local earned income tax from compensation payable to an employee, does the withholding obligation extend to compensation in the form of the "spread" between the fair market value of the underlying shares of stock on the option exercise date and the exercise price of the option? Does it matter that the "spread" income is not in the form of cash and hence any withholding would have to be made from an employee's cash compensation?

Are taxpayers subject to interest and penalties for failing to pay local earned income tax on their "spread" income for 1999 and other open years? Are employers subject to penalties for failing to withhold with respect to such income?

Are the earned income taxes imposed by the City of Philadelphia and the Pittsburgh School District, which have different enabling statutes, applicable to the "spread" upon a taxpayer's exercise of a stock option?

The Court's decision raises similar concerns with respect to application of the Pennsylvania personal income tax to the "spread" between the fair market value of the underlying stock and the exercise price for incentive stock options, given that the definition of "compensation" for Pennsylvania personal income tax purposes is similar in relevant part to the definition of "earned income" in the Local Tax Enabling Act. It is certainly arguable that the "spread" income associated with the exercise of incentive stock options may result in tax liability for the taxpayer who exercises such options as well as withholding tax obligations for employers.

Pending some judicial or legislative action clarifying these issues, employees who exercise non-qualified stock options should carefully review any relevant municipal earned income tax ordinances to determine whether the "spread" income realized upon the exercise of such options is subject to local earned income tax.

Consideration should be given to filing amended returns for open years (limited to 1997, 1998 and 1999 in most instances) to avoid the accrual of additional interest and penalties. Employers who are subject to withholding obligations with respect to such income should similarly consider filing amended returns and remitting local earned income tax with respect to such earned income, although the fact that the failure to withhold prior to the Supreme Court's decision was consistent with lower court decisions in this matter should mitigate against any attempt by a municipality to impose penalties.

Given that the Marchlen decision involves only non-qualified stock options, it would appear to be reasonable at this time for both employers and employees to continue to treat the "spread" income realized upon the exercise of incentive stock options as not being subject to either Pennsylvania personal income tax or municipal earned income tax, recognizing, however, that local tax collectors and the Department of Revenue may well conclude otherwise in the future.

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