The NASPP Blog

February 9, 2010

More on ESPP Operational Errors

Last week, I blogged about operational errors in Section 423 ESPPs. This week, I follow up that discussion with more on the potential impact of errors and an explanation of how separate offerings can be used to minimize the impact of errors.

Impact of Disqualification

When a purchase fails to meet the requirements of Section 423, it is treated as the exercise of a non-qualified stock option. The spread on the purchase is treated as compensation income, subject to tax withholding (and company matching payments) and reportable on Form W-2. Where an entire offering is disqualified from Section 423, this treatment applies to all purchases made under the offering (by US employees, that is; non-US employees are still subject to whatever tax treatment applies under the laws of their own tax jurisdiction).

The penalties for failing to collect the withholding taxes can be up to 100% of the amounts that should have been withheld, plus interest. The penalties for failing to report the income on Form W-2 can be up to $100 per form–$50 for the return filed with the IRS and another $50 for the statement issued to the employee (subject to annual maximums of $250,000 for the returns filed with the IRS and another $100,000 for the statements issued to employees). 

Designating Separate Offerings to Protect Against Disqualification

The final regs view each offering under the plan as independent of any other offerings. Consequently, operational errors may disqualify a single offering but are unlikely to ever disqualify an entire plan. For example, if a company prohibits an eligible employee from participating in an offering, that would disqualify that offering, but it wouldn’t disqualify prior offerings under the plan (provided the employee either wasn’t eligible to participate in those offerings or was allowed to participate in them), nor would it impact the status of future offerings under the plan (assuming that the error is addressed for those offerings).

I see a fair amount of operational errors with respect to the participation of non-US employees. To protect US participants from the possible ramifications of these errors, separate offerings can be established for non-US participants, where those participants are employed by a separate corporate entity (non-US employees of the US parent have to be allowed to participate in the same offering as US employees). I don’t think it matters much whether you have one separate offering for all non-US employees or separate offerings for each distinct corporate entity, just so long as the employees of non-US entities aren’t participating in the same offerings as US employees.

It may make sense to designate separate offerings for each distinct corporate entity within the United States, as well. One situation where I commonly see eligible employees excluded from participating in the ESPP is when they transfer between corporate entities. HR/payroll processes the transfer as a termination, causing the transferred employee to be withdrawn from the plan. If separate offerings are established for each corporate entity, then this error is a problem only for the offering for the corporate entity that the individual is now employed by; it doesn’t jeopardize the tax treatment for all US employees.

Additional Controls

Given the seriousness of the consequences of this type of error, a control procedure for your ESPP might be to review records of all employees transferred between corporate entities to make sure none have been inappropriately withdrawn from the ESPP.

For more information on the final regs under Section 423, see our alert “Final ESPP Regs Issued.”

NASPP “To Do” List
We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog. 

-Barbara