Late last year, the IRS issued final regulations affecting the form and operation of tax-qualified employee stock purchase plans (ESPPs), as well as final regulations affecting the tax reporting of transfers of shares acquired from ESPPs and exercises of incentive stock options (ISOs). These rules went into effect Jan. 1, 2010.
The new ESPP rules include some important clarifications that may necessitate plan amendments or changes in administrative practices (see our previous newsletter on the 2008 proposed regulations). In addition, employees must receive information reports that meet updated requirements by Jan. 31, 2010, for ESPP and ISO share transactions that occurred in 2009.
Final ESPP Regulations
An ESPP is a written plan that permits an employer to sell its stock to employees at a small discount on a tax-advantaged basis. An employee’s participation in an ESPP is treated for tax purposes as a grant to the employee of an option to purchase employer stock. The period over which the option is in effect is referred to as an “offering.”
The principal tax advantage of an ESPP is that neither the purchase discount (which may be up to 15% from the stock’s fair market value on the date of grant or the date of exercise, whichever is less) nor the option spread over the discount is taxed until the shares are sold. Furthermore, the option spread over the discount is eligible to be taxed at more favorable capital gains rates, provided the employee meets certain holding period requirements. A purchase discount generally cannot be offered under an ISO or a nonqualified stock option without triggering adverse tax consequences for the recipient.
Some of the more important aspects of the regulations are as follows.
Multiple Offerings Allowed
One of the requirements for an ESPP is that all employees who are eligible to participate in a particular offering participate on the same terms and conditions (or, in ESPP parlance, have “equal rights and privileges”) as all other eligible employees. The proposed regulations had implied that there could be only one offering under an ESPP at any given time. However, the final regulations clarify that ESPPs may have multiple offerings. Such offerings can be consecutive or overlapping, and the terms of each separate offering need not be identical, as long as the ESPP and each offering together complies with the ESPP requirements.
This clarification will allow employers to structure their plans more strategically. A plan covering multiple related companies could have one offering for the employees of one subsidiary, and another offering for employees of the parent company and its other subsidiaries. Such an approach may be attractive for situations in which related companies operate in disparate industries or have differing pay practices.
Example – A parent corporation has Subsidiaries A, B and C. It structures one offering for its employees and the employees of Subsidiary A, and a separate offering for the employees of Subsidiary B and Subsidiary C. Under the separate offering for the employees of Subsidiary B and Subsidiary C, options are granted to all employees with an exercise price equal to 90 percent of the fair market value at the time the option is exercised. Under the separate offering for the employees of Subsidiary A, options are granted to all employees with an exercise price equal to 95 percent of the fair market value at the time the option is exercised. The fact that the different offerings have different purchase price discounts won’t cause the ESPP to violate the equal rights and privileges rule.
Employee Exclusions
As a general matter, all employees of a corporation that is a participating employer in an ESPP must be allowed to participate in the plan. However, ESPPs are permitted to exclude employees who have been employed less than two years, employees who customarily work 20 hours or less per week, employees who customarily work not more than five months in a calendar year, and certain highly compensated employees. The final regulations clarify that employee exclusions may differ from offering to offering, so long as the exclusions are otherwise permissible.
Example – An employer establishes two offerings. The first offering excludes from participation clerical employees who have been employed less than two years, but permits all other employees to participate. The second offering excludes from participation all employees who have been employed less than two years. The first offering does not comply with the ESPP requirements because it applies an impermissible exclusion. In contrast, the second offering applies a permissible exclusion because all employees who have been employed less than two years are excluded under the offering.
A number of commentators had requested that the final regulations specifically permit employers to exclude nonresident aliens who have no U.S.-source income and employees below a specified minimum age. The Treasury Department and the IRS rejected these requests on the basis that the Internal Revenue Code does not allow for such exclusions.
However, the regulations do permit individual ESPP offerings to provide more restrictive terms for citizens or residents of foreign jurisdictions to the extent necessary to comply with the laws of that foreign jurisdiction. In addition, the ability to have different terms for different multiple, overlapping offerings may as a practical matter allow employers to structure offerings to address differing legal requirements for employees in non-U.S. jurisdictions.
Maximum Shares Available for Purchase
A key requirement under an ESPP is identifying the “date of grant” of an option awarded under the ESPP. The date of grant is important for many purposes, including applying the $25,000 limitation (discussed below), applying the purchase price discount (for plans with lookback periods), and measuring the start of the holding periods that must be met in order for acquired shares to have favorable tax treatment upon sale.
Under the new rules, the date of grant will be the first day of an offering period, if the terms of the ESPP or the offering specifically designate a maximum number of shares that may be purchased by each employee during the offering. However, the rules do not require that an ESPP or offering designate a maximum number of shares purchasable during an offering (or incorporate a formula to establish such a maximum).
If no limit is designated, the date of exercise (i.e., purchase) will be the date of grant. Importantly, the regulations clarify that merely specifying the $25,000 annual limit (or the total number of shares reserved for issuance under the plan) is not sufficient to establish a maximum share limit. As a result, employers may wish to amend the terms of their plan or modify the terms of their offering periods to designate a specific maximum number of shares that can be acquired during an offering period. This is particularly important for employers with ESPPs that offer a lookback period.
Example – An ESPP provides that the option price will be the lesser of 85 percent of the fair market value of the stock on the first day of an offering, or 85 percent of the fair market value of the stock on the last day of the offering (a lookback period). Options are exercised on the last day of the offering. Notwithstanding the fixed number of shares reserved for issuance under the plan and the fact that the plan document includes reference to the $25,000 limitation, there is no maximum share limit for the offering. Therefore, the date of grant for the option is the last day of the offering when the option is exercised, and the applicable holding periods must be measured from that date.
Annual $25,000 Limitation
An ESPP must provide that all of an employee’s ESPP options (under all ESPP plans sponsored by the employer and its related companies) may not vest and become exercisable with respect to more than $25,000 worth of employer stock (measured of the option date of grant) per year. In the proposed regulations, the limit did not begin to apply with respect to a particular option until the year in which the option was both outstanding and exercisable.
The final regulations adopt a more generous approach that permits the limit to begin to apply in the year in which the option is granted, even if it does not vest and become exercisable until a later year. To the extent the limit is not “used” during the year of grant (because the option does not vest until a later year), it may be added to the limit for the subsequent year.
Example – On Sept. 1, 2010, an employer grants employees an option under an ESPP that automatically will be exercised on Aug. 31, 2011, and Aug. 31, 2012. As a result, on Aug. 31, 2011, the employee may purchase under the option employer stock equal to up to $50,000 (determined at the time of grant of the option), and on Aug. 31, 2012, the employee may purchase under the option an amount of employer stock equal to up to the difference between $75,000 and the fair market value of employer stock purchased during year 2011.
Updated Information Reporting Requirements
Employers are generally required to provide a statement to an employee after the employee exercises an ISO or transfers shares purchased under an ESPP. Such statements must be provided by Jan. 31 of the year following the year in which occurs the exercise or transfer, as applicable.
A 2006 change in the tax laws required employers to also file an information return with the IRS for such stock transfers. This requirement was originally scheduled to go into effect in 2007, but the Treasury Department and IRS waived it for exercises and transfers occurring in 2007 and 2008. Regulations finalized late last year now make this requirement effective for exercises and transfers that occur in 2010 (thereby waiving the information return requirement for 2009). The IRS will make forms available later this year for 2010 (Form 3921 for ISO exercises and Form 3922 for stock transfers under an ESPP).
Employers must continue to provide employees with information statements for exercises and transfers that occurred in 2009. Information statements for 2009 exercises and transfers must be sent to employees no later than Jan. 31, 2010. The required information is intended to allow the employees to calculate any taxes they might owe with respect to the transfer of ESPP shares or exercise of ISOs.
In addition, the final regulations clarify certain aspects of reporting share transfers under ESPPs. First, if the shares acquired under the ESPP are issued directly to the employee or registered in the employer’s records in book-entry form, no transfer of legal title is considered to have occurred and thus no information return is required. However, if the employer instead transfers ESPP-acquired shares to a brokerage account on behalf of the employee, or if the employee sells the shares issued to him or her, or transfers those shares at his or her own initiative to a brokerage account, a transfer of legal title is considered to have occurred and an information report and a return (beginning for transfers in 2010) must be filed.
Transfers to Nonresident Aliens
In response to comments, the final regulations include an exception to the reporting and return requirements for certain nonresident aliens. Neither an information report nor a return is required for employees for whom the employer is not required to file a Form W-2 for certain specified periods.