TAX NEWS - DECEMber 2009
IRS Tax: IRS issues final employee stock purchase plan regulations
Generally, an ESPP allows employees to purchase stock of their employer or its related corporations through payroll deductions. An ESPP is also permitted to allow employees to purchase employer stock at a discount, based on an exercise price that is no less than the lesser of 85 percent of fair market value on the date of grant or the fair market value on the date of exercise.
Like incentive stock options (ISOs), options granted under an ESPP are eligible for tax-favored treatment under section 421, provided certain requirements are satisfied. Stock transferred to an individual pursuant to the exercise of the ESPP option will receive tax-favored treatment if:
- No disposition of the stock is made within two years from the date of grant of the option or within one year from the date of transfer of the share and
- At all times during the period beginning on the date of grant and ending on the date three months before the exercise of the option, the individual is an employee of either the corporation granting the option or its related corporations.
If an option qualifies for tax-favored treatment, when a share of stock is transferred pursuant to the exercise, there is no income at the time of exercise and no deduction under section 162 is allowed to the employer corporation with respect to the transfer.
The final regulations clarify that the plan document requirements may be satisfied by the terms of the plan document or the terms of the offering under the plan. In order for a plan to be considered an ESPP, the plan must provide that options will be granted only to employees of the employer corporation or of its related corporations.
In addition to requirements set forth in more detail below, the plan or the terms of the offering must satisfy all of the following requirements:
- No options are granted to owners of stock possessing 5 percent or more of the total combined voting power or value of all classes of stock of the employer corporation or its related corporations;
- The option price may not be less than the lesser of an amount equal to 85 percent of the fair market value of the stock at the time of grant or at the time of exercise;
- An option cannot be exercised after the expiration of five years or 27 months from the date of grant, depending on how the option price is determined; and
- An option cannot be transferable other than by will or laws of descent and distribution, and can be exercisable only by the participant during the participant's lifetime.
If the terms of an option are inconsistent with the terms of the plan or an offering under the plan, the option will not be treated as granted under an ESPP, and thus will not be eligible for tax-favored treatment. On the other hand, an option may qualify for tax-favored treatment if the option is granted under an offering with terms that comply with the ESPP requirements, even if the plan terms are inconsistent.
If an option with terms that do not satisfy the ESPP requirements is granted to an employee who is entitled to a grant under the plan, and the employee is not granted an option that qualifies as an ESPP option, the entire offering will fail to satisfy the ESPP requirements. Thus, none of the options granted under that offering will be eligible for favorable tax treatment under section 421. If, however, an option that does not satisfy the requirements is granted to an individual who is not entitled to an ESPP option, the option will not be treated as granted under an ESPP and the grant of the option will not disqualify the options granted under the plan or offering. In addition, if an option that satisfies the requirements at the time of grant subsequently fails to comply with the terms, the option will not disqualify other options granted under the plan or offering.
Notable changes in the final regulations
While the final regulations generally clarify and update the existing regulations, they do provide new guidance in some areas.
Multiple offerings - More than one offering may be made under a plan, and the offerings may be consecutive or overlapping. Although offerings must satisfy the ESPP requirements, offerings are not required to have identical terms.
Employees covered by ESPP - Like the proposed regulations, the final regulations provide that options must be granted to all employees of any corporation whose employees are granted options by reason of their employment by that corporation.
The tax-favored status of options granted under an ESPP will not be jeopardized if the plan excludes:
- Employees employed less than two years;
- Employees who customarily work less than 20 hours per week or less than five months in a calendar year;
- Highly compensated employees who have compensation above a certain level or who are section 16 officers under the Securities Exchange Act of 1934; and
- Employees or citizens of a foreign country (without regard to whether they are also U.S. citizens or green card holders), if the grant of options to such individuals is prohibited by the laws of the foreign country or compliance with the laws of the foreign country would cause the plan to violate the requirements of section 423.
Whether the terms of a plan and offering satisfy this rule is determined on an offering-by-offering basis. As a result, the terms of the offering may provide for different exclusions of employees, but these exclusions must be applied in an identical manner to all employees of every corporation who are granted options under that particular offering.
In addition, the preamble to the final regulations provides that the IRS and Treasury are aware of the complexities associated with participation by nonresident aliens in ESPPs and by employees under a specified age (such as age 18). The Treasury and the IRS have reiterated that they are constrained by statutory authority from creating additional exclusions for those categories of employees.
Rights and privileges - The terms of the ESPP must provide that the employees who are granted options have the same rights and privileges. The proposed regulations provide an exception to this rule, if, in order to comply with the laws of a foreign country, options granted to citizens or residents of a foreign country (without regard to whether they are also U.S. citizens or green card holders) are less favorable than the terms of options granted under the same plan or offering to employees who are U.S. residents. This exception will not be satisfied if foreign citizens or residents are provided more favorable options. The final regulations also include this rule.
The offering-by-offering concept in the final regulations also applies to determining whether the equal rights and privileges requirements have been satisfied.
Maximum number of shares that may be purchased - For purposes of an ESPP, the date of grant is significant in order to determine whether the holding period to obtain tax-favored treatment under section 421 has been satisfied, and to determine the fair market value for purposes of calculating the $25,000 limitation. The final regulations provide rules for determining the date of grant based on whether the terms of the plan or offering designate the maximum number of shares that may be purchased by each employee during the offering or apply a formula on the first day of the offering to determine the maximum number of shares that may be purchased by each employee. In response to comments, the final regulations reflect a change from the proposed regulations, and do not require that there be a specified number of shares to satisfy this requirement or to establish the first day of the offering period as the date of grant for an option.
Annual $25,000 limit - The terms of an ESPP must provide that no employee may be permitted to accrue the right to purchase stock under all ESPPs sponsored by the employer corporation and its related corporations at a rate that exceeds $25,000 in the fair market value of the stock (determined on the date of grant). In a change from the proposed regulations, the final regulations do not impose this limit only in the year the options are first exercisable, but instead provide that the ESPP limit increases by $25,000 for each calendar year during which the option is outstanding.
If the option gives the holder the right to purchase stock in excess of the $25,000 limit, then no portion of the option will be treated as granted under an ESPP, and the option will not be eligible for tax-favorable treatment. This limit applies only to options granted under an ESPP and does not limit the amount of stock an employee may purchase under an ISO plan.
Shareholder approval - An ESPP must be approved by shareholders of the granting corporation within 12 months before or after the date the plan is adopted. Generally, a plan is not required to be re-approved by the shareholders unless there is a change in the shares that are subject to options granted under the plan, or there is a change in the granting corporation.
Such changes are considered the adoption of a new plan. The final regulations adopt the proposed changes to the section 422 regulations, such that only the shareholders of the specific corporation adopting the plan are required to approve the plan.