The NASPP Blog

December 1, 2009

You’ve Been Warned

As I mentioned in my blog on November 17, the IRS and Treasury recently issued final regs for Section 423 plans. In today’s blog, I focus on what I think could be the biggest “gotcha” under the regulations: determining the grant date for shares purchased under an ESPP.

Grant Date under Section 423
The grant date is important under Section 423 for four reasons:

  1. Key to establishing the minimum required purchase price;
  2. Determines the value of the shares for purposes of the $25,000 limitation;
  3. Starts the statutory holding period for qualifying dispositions; and
  4. Compensation income on a qualifying disposition is based on the discount as of this date.

What Do the Regs Say About Grant Date?

Under the final regs, for the beginning of the offering to be considered the grant date, the maximum number of shares that employees can purchase must be specified at the start of the offering. The $25,000 limit and the aggregate number of shares available for grant under the plan are insufficient for this purpose; the plan must include a separate, per-person, per-offering limit. If the plan doesn’t include such a limit, then the purchase date is also considered the grant date.

How Low Can You Go?

Of the above four purposes, #1 is my biggest concern. According to the NASPP’s 2007 Domestic Stock Plan Design and Administration Survey (co-sponsored by Deloitte), 68% of respondents’ §423-qualified ESPPs have a lookback (i.e., base the purchase price on the FMV at the offering beginning, or on the lower of the beginning or ending FMV). If your plan has a lookback, it’s critical that the grant date is the beginning of the offering.

Why? Because under Section 423, the purchase price can’t be less than 85% of the FMV at grant or purchase (whichever is lower). Thus, if your plan includes a lookback, you’d better be sure that the beginning of the offering is the grant date, because it sure isn’t the purchase date.

If you have a lookback and the beginning of the offering isn’t considered the grant date, then the plan can’t qualify for Section 423 treatment. This means the spread at purchase is ordinary income for employees and subject to withholding. But, hey, the good news is that you won’t have to track dispositions.

The Other 29%

According to the NASPP’s 2007 survey, 29% of the respondents don’t have a lookback and instead base their purchase price on the FMV at the end of the offering only. (3% of respondents used some “other” calculation; I don’t know what that would be so I’m ignoring those respondents. 100% – (68% + 3%) = 29%. Hmmm, probably I shouldn’t use section headings that I have to explain.)

If your plan bases the purchase price on the ending FMV only, then you probably don’t care much whether the beginning of the offering is the grant date. It might even be better for the purchase date to be the grant date:

  • Applying the $25,000 limit would be easier. If the FMV declined during the period, the number of shares employees could purchase under this limit would increase. The $25,000 limit could be easily enforced by limiting employee contributions to a percentage of $25,000 that is commensurate with the discount offered under the plan (e.g., if the plan offered a 15% discount, employee contributions would need to be limited to $21,250–85% of $25,000).
  • Assuming employees don’t sell at less than the FMV at purchase, it eliminates any advantages associated with qualifying dispositions. Ordinary income on a disqualifying disposition is the spread at purchase; on a qualifying disposition, it’s the spread at grant. If both dates are one and the same, there’s no advantage to a qualifying disposition. Unless, of course, the price declines. Then the ordinary income on a qualifying disposition is the actual gain, if any, on the sale but on a disqualifying disposition it would still be the spread at purchase.

Consider Yourself Warned; Now Warn All Your Friends

If you have a plan with a lookback, now would be a good time to make sure it includes a per-person, per-offering share limit. Hopefully, your §423 ESPP was drafted to include the necessary share limit (this has actually been an informal IRS position for decades–there are letter rulings on it going back to 1968) or, if it wasn’t, you saw the writing on the wall (or in the NASPP blog) when the proposed regs came out and took care of it.

I’ve seen a number of plans that don’t include a specified limit, but give the board or plan administrator authority to establish a limit. If that’s your plan, and your board, et. al., hasn’t been establishing a limit at the start of each offering, now would be a good time to have them start doing this.

If your plan doesn’t have a limit or even provide discretionary authority to establish one, then you had better get cracking because the final regulations are effective as of January 1, 2010. You’ve been warned, now warn all your friends (you can send them a link to this blog–it’s free even for non-members). I don’t want anyone to come crying to me next year that their ESPP has been disqualified because they didn’t know about this.

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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