The Internal Revenue Service and Treasury Department have proposed new regulations for Internal Revenue Code (“Code”) Section 423 employee stock purchase plans (“ESPPs”). The proposed regulations are the first comprehensive update of existing ESPP tax rules that have been in effect since the 1960s. In addition, the proposed regulations contain important guidance for employers that maintain or that are considering implementing ESPPs. The proposed regulations are scheduled to become effective on January 1, 2010 but may be relied on for periods prior to that date.
An ESPP is a written plan that permits an employer to sell its stock to employees on a tax advantaged basis. Applicable tax rules treat an employee’s participation in an ESPP as the grant of an option to purchase employer stock, and define the period over which the option can remain in effect (referred to under the rules as an “offering”). The principal tax advantages of an ESPP are that eligible employees may purchase stock at up to a 15% discount from its fair market value and not be taxed on that discount or any appreciation in value of the shares after the date of grant until the shares are sold. When the shares are sold, the discount element is taxed at ordinary income rates, and any remaining appreciation is generally taxed at lower rates as capital gain. Such a purchase discount generally cannot be offered under an incentive stock option or a nonqualified stock without triggering adverse tax consequences to the option recipient.
The tax advantages of an ESPP are conditioned on the plan satisfying a number of formal and operational requirements. Such conditions include requirements relating to employee eligibility, shareholder approval, restrictions on option transferability, minimum exercise price, maximum amounts of options that may be issued and exercised under the ESPP, and maximum exercise and post-exercise stock holding periods. The proposed regulations clarify and conform a number of these requirements with the similar requirements that apply to incentive stock options. The more significant clarifications are summarized below.
Inconsistent Stock Option and ESPP Terms
To receive favorable tax treatment, the terms of the options granted under an ESPP must be consistent with the terms of the ESPP document and of the offering. The proposed regulations clarify that if: (i) the terms of an option are inconsistent with the terms of the ESPP or offering (for example, if the exercise price of an option is less than the minimum exercise price allowed under the ESPP or the ESPP offering), (ii) the option is granted to an employee who is entitled to the grant of an option under the ESPP or offering, and (iii) the employee does not also receive an option that qualifies under the ESPP or offering, then none of the options granted under the offering will be eligible for favorable tax treatment. However, if such an option is granted to an employee who is not entitled to the grant of an option under the ESPP or offering (for example, if the nonqualifying option is granted to a consultant or non-employee director), then the grant of the option will not disqualify other options granted in the same offering.
These clarifications are important because the failure of an option to qualify as an ESPP option could result in significant adverse tax consequences to the affected employee (such as immediate taxation of the purchase discount and possibly a 20% penalty for violation of Section 409A of the Code). In addition, if an option qualifies as an option granted under the ESPP, but the terms of the option are not satisfied (for example, where the exercise price of the option is consistent with the terms of the offering, but the participant is allowed to exercise the option at a lower price), the failure to comply with the terms of the option will not disqualify other options granted in that offering.
The proposed regulations retain the requirement that the ESPP be approved by shareholders of the granting corporation within twelve (12) months before or after the date the ESPP is adopted. The plan as approved must state the maximum number of shares that may be granted under the plan as well as the corporations or class of corporations whose employees are eligible to participate. The proposed regulations further clarify the events that trigger when an ESPP must be re-approved by stockholders, generally aligning these requirements with the shareholder approval requirements that apply to incentive stock options. These events are generally:
- Any increase in the aggregate number of shares that may be issued under the plan (other than formula (“evergreen”) increases based on a percentage of shares authorized, issued or outstanding at the time of adoption of the plan, or increases based on a stock split or similar event);
- Any change in the designation of corporations whose employees may be offered options under the plan (other than changes in a pre-established group composed of the grant corporation and its related corporations);
- Any change in the granting corporation or the stock available for purchase under the plan (for example, in a merger situation, where the granting corporation is acquired by a new corporation, and the new corporation’s stock is substituted for the granting corporation’s stock under the plan).
Maximum Aggregate Number of Shares
As noted above, the proposed regulations now clarify that an ESPP may satisfy the requirement to state a maximum number of shares by having an “evergreen” provision. Under an evergreen provision, the maximum aggregate number of shares available for grants increases annually by a specified percentage of the authorized, issued or outstanding shares on the date of the ESPP’s adoption. In addition, an ESPP may now provide that the maximum aggregate number of shares available for grants may change based on other specific sets of circumstances, as long as the stockholders approve an immediately determinable maximum number of shares that may be granted under the ESPP in any event (for example, up to 15% of the total issued and outstanding shares on the date of the offering, but in any event no greater than 200,000 shares).
Employees Covered by an ESPP
At present, an ESPP generally must cover all employees of the granting corporation. Limited exclusions, however, exist for:
- Employees who have been employed less than two years;
- Employees who customarily work twenty hours or less per week;
- Employees who customarily work not more than five months in a calendar year; and
- Officers, supervisors and highly compensated employees.
The proposed regulations clarify that an ESPP may exclude narrower categories of employees as well, such as employees who have been employed for less than one year (instead of two) or employees who customarily work less than 3 months (instead of 5), so long as the exclusion is applied consistently to all employees. The proposed regulations also conform the definition of officers, supervisors and highly compensated employees for this purpose to the definition that applies in the qualified retirement plan context.
Consistent with the principle above, the proposed regulations would permit an employer to exclude certain classes of highly compensated employees, but allow other highly compensated employees to participate. For example, an employer could exclude only those highly compensated employees with compensation above a particular level or officers subject to the disclosure requirements of Section 16(a) of the Securities Exchange Act pf 1934.
Under the proposed regulations, citizens or residents of a foreign jurisdiction may only be excluded if participation in an ESPP would be prohibited under the laws of that jurisdiction or if allowing such participation would cause the ESPP to fail to meet one or more of the applicable U.S. tax law requirements. In addition, the proposed regulations decline to create a categorical exclusion for collectively bargained employees.
Equal Rights and Privileges
An ESPP generally must provide that all plan participants have the same “rights and privileges.” The proposed regulations provide for exceptions to this general rule. For example, an ESPP would now be able to grant options to foreign employees on less favorable terms than those granted to domestic employees, if required to comply with the applicable laws of the foreign jurisdiction. In addition, an ESPP would now be able to provide that an employee could carry over amounts withheld from his or her pay under an earlier ESPP offering or another ESPP to a subsequent offering, provided:
- Each other employee in the subsequent offering is allowed to make direct payments toward the purchase of stock in the subsequent offering equal to the excess of (i) the maximum amount any employee was allowed to carry over from the previous offering over (ii) the amount, if any, carried over by the employee from the previous offering (for example, if A carried over $300 from the previous offering and $300 was the maximum amount carried over by any employee from the previous offering, and B only carried over $100 from the previous offering, B must be allowed to make direct payments toward the purchase of stock in the subsequent offering of $200); or
- The carried over amount is attributable to fractional shares.
Exercise Price and Date of Grant
The exercise price of an option granted under an ESPP generally may not be less than the lesser of 85% of the fair market value of the underlying stock on the date of grant or 85% of the fair market value of the underlying stock on the date of exercise. Under the proposed regulations, the fair market value of the underlying stock may be determined for this purpose in any reasonable manner. In addition, the date of the option’s grant will be the date on which the maximum number of shares that may be purchased by each participant under the offering is determined (regardless of whether the minimum exercise price is fixed or determinable at such time).
Annual $25,000 Limitation
ESPPs currently must provide that no employee may be permitted to purchase stock under all ESPPs of the employer at a rate that exceeds $25,000 in fair market value of the stock for each calendar year in which an option granted to an employee is outstanding and exercisable. The proposed regulations would provide that the $25,000 annual limitation is to be calculated in a manner consistent with the $100,000 limitation for incentive stock options. For example, the fair market value of the stock subject to the limitation would be determined as of the date of grant of the option, and the stock would be taken into account for purposes of applying the limitation in the year in which the option first becomes exercisable.
The proposed regulations emphasize that the rate at which the right to purchase the stock accrues may not exceed $25,000 for each calendar year in which the stock is both outstanding and exercisable. For example, if an option is granted with a two-year term, and the option is immediately exercisable upon grant but no portion of the option is exercised in year 1, up to $50,000 worth of stock (based on the fair market value on the date of grant) may be purchased under the option in year 2. However, if the option was subject to a vesting schedule such that the option did not become exercisable until year 2, then only $25,000 worth of stock (based on the fair market value on the date of grant) may be purchased under the option in year 2 (even though the option has been outstanding for two years).
The proposed regulations clarify how to calculate the amount of ordinary income attributable to the discount element in an option granted under an ESPP when the exercise price is determined based on a percentage of the fair market value of the underlying stock on the date of grant or the date of exercise (whichever is lesser). The ordinary income in this case is equal to the lesser of (i) the discount element that would been recognizes had the option been exercised on the date of grant, and (ii) the excess of the fair market value of the stock at the time of sale over the actual exercise price paid.
It should also be noted that the IRS has asked for comments as to whether a program should be established to allow for the correction of errors that may arise in the form or operation of an ESPP, such as inadvertently excluding eligible employees from participation in the plan. It is unclear whether the IRS and Treasury Department would be willing at this time to implement such a program.
For additional information regarding the new proposed regulations or assistance in reviewing your current stock employee purchase plans in light of the same, please contact any member of the McGuireWoods Employee Benefits or Labor & Employment teams.