The IRS has announced an audit initiative focused on Section 409A compliance. Frankly, I’m a little surprised that they haven’t undertaken this sort of audit initiative sooner–I’ve heard from practitioners that, up until now, Section 409A has rarely been a focus of IRS audits. Given the complexity of this area of the tax code and the fact that every time I have a question about it, my sources never seem to be entirely sure of the answer (and I sometimes get conflicting answers), it seems like 409A could be an untapped wealth of compliance errors for the IRS.
Who Are the Lucky Winners?
Some companies are just lucky. The IRS has picked 50 companies to be the subject of the audits, all of which have already been selected for employment tax audits–I guess the IRS is a believer of “when it rains, it pours.” The good news is that if you haven’t already been selected for an employment tax audit, you won’t be part of the initial 409A audit initiative.
What Is the IRS Looking For?
The audits will focus on deferral elections (both initial deferrals and re-deferrals) and payments (including payments to key employees upon separation of service). It’s pretty rare that we see deferral elections for stock compensation; only 29% of respondents to the NASPP’s 2013 Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting) allow deferrals for time-based RSUs and only 24% allow deferrals for performance awards. Based on this, it seems that the audits will concentrate primarily on more traditional NQDC plans, rather than stock compensation.
This seems like a missed opportunity for the IRS–I’ve always found the application of Section 409A to stock compensation to be particularly confounding and full of traps for the unwary. Moreover, I think this is an area of the tax code that often is overlooked when we are thinking about potential concerns related to stock awards. But perhaps the IRS will expand to stock compensation in the next phase of the audit initiative.
The Next Phase?
I say “next phase” because this could be a precursor to a larger, more intensive audit of Section 409A compliance. In a memo on the initiative, Groom Law Group says “The IRS will assess what further steps, if any, to take after the results of these audits are in.” Now is a good time to get out ahead of this and perform your own self-audit of 409A compliance. In his blog on CompensationStandards.com, Mike Melbinger of Winston & Strawn points out that there is a corrections program available for some operational errors under 409A, but that the corrections program is no longer an alternative once you are the subject of an audit.
A few weeks ago I blogged about a potential insider trading loophole relative to 10b5-1 plans. While I don’t have any updates on that front today, I do have word of other insider trading related buzz. This time, it relates to our branches of government. Last week Congress quietly passed a modification to the STOCK Act, effectively eliminating trading disclosure requirements for most high-ranking government staffers that were previously covered under the Act. On Monday, April 15th, President Obama followed suit by signing the modification into law.
I’m Not Sure I’ve Even Heard of the STOCK Act
First things first – what’s the STOCK Act? The STOCK Act (aka the Stop Trading on Congressional Knowledge Act) was passed a year ago in April 2012. It explicitly states that the members of Congress and their staffs are not exempt from the same insider trading prohibitions that apply to everyone else. The law basically mandates that Congress and several thousand high ranking government staffers disclose certain financial information, including stock trades, to an online searchable database. Prior to the Act, such disclosures were not easily accessed by the public – it usually required an in person request to obtain this information.
Sounds Reasonable – What’s the Uproar About?
The changes to the Act preserved the conclusion that insider trading is still prohibited for the same people (Congress, etc.). Some ruffling of feathers comes from what has changed, and that is the disclosure elements of the Act. The original version of the Act requires all affected people to make disclosures to a searchable online database – the idea being more publicly accessible disclosures. The modification to the Act now only requires those online searchable disclosures to be made by the President, Vice-President, Congress and candidates for Congress, and some other other Presidential and Senate-appointed positions. Absent from this disclosure requirement are the thousands of staffers who were previously covered. Activists are calling this an “epic failure” of the original intent of the STOCK Act, which was to make trading by those positions accessible to the public, and allow watchdog agencies policing ability over potential insider trading. Supporters of the modification say that putting financial information for thousands of government employees online, where it can be so easily accessed by the public, is not in our national security best interests.
Why Do I Care?
Regardless of which side of the fence you stand on this issue, sometimes we can find the impact in an overall message or theme. It’s been weeks and weeks of consistency in my Google Alerts – insider trading feels like a topic that’s warming up. The SEC has been in an aggressive mode of cracking down on insider trading, and, as discussed a few weeks ago, there is potential for new types of insider trading investigations – like that into 10b5-1 trading plans. It’s just my opinion, but I somehow think that all of these events keep putting the spotlight onto insider trading, which could mean a new era of scrutiny. While the government keeps refining their own policies around insider trading, we have the opportunity to do the same. If an investigation ever comes your way, you’ll want to be certain that you’ve followed your pre-clearance procedures and disclosure requirements to the “T”.
I’d venture to say the trigger for an insider trading investigation almost never originates in the stock plan group. However, if trades in your company’s stock are ever the subject of an SEC investigation, you can bet there’s going to be a microscope on the company to determine the policies and practices around prevention. I would recommend adding an audit and policy/procedure evaluation of your insider trading prevention practices to your list of 2013 objectives, if you haven’t done so already. It’s always better to be ahead of the curve when it comes to areas of compliance. Our Insider portal offers an overview of the various regulations, as well as sample documents.
As 2012 draws to a close, I can’t help but reflect on the fact that it’s been another relatively quiet year in terms of regulatory developments. This has hopefully meant more time focused on projects and refining administration practices, and less time spent trying to figure out how to implement new legislation. With year-end around the corner and no burning developments (we’ll see what happens with the fiscal cliff issue), now is the perfect time to perform a “health check” on compliance procedures.
A sanity check on compliance procedures is something every company should be doing with regularity. In some cases we have legislation that mandates this type of check (Sarbanes-Oxley 404, for one), but even then the areas of focus are not all-encompassing. Ideally it would be great to identify the key areas of administration for your equity programs and develop a corresponding checklist that can be utilized on a periodic basis as a reminder for areas that need monitoring. Think of it like preventative care for your stock plans. Why not do this now, before the next era of regulatory changes places further demand on our time?
I advocate the idea of a checklist because not all compliance shortcomings are alike. Many failures come not from lax day to day procedures, but from oversights and things long forgotten. For example, there is much fanfare around the adoption of a new equity plan, and the corresponding registration of the shares allocated to the plan on a Form S-8 is something that is usually not forgotten. However, what happens years down the road when the plan is no longer in use? For shares remaining in a defunct plan, the company needs to remember to un-register those shares with the SEC. This is certainly not a day-to-day or even annual occurrence for most companies, but is something that could easily be added to a checklist to ensure no oversight occurs.
Another reason to have a defined checklist? Increased global audit and enforcement. It just seems plainly better for a company to proactively identify and rectify any potential errors or missteps rather than leaving it up to being caught by an external party. Interestingly, when it comes to global tax compliance, the 2012 NASPP/PwC Global Equity Incentives Survey observed a downward trend in the frequency of annual compliance reviews conducted by companies. 57% of companies reported conducting annual compliance reviews in 2011 (and that number was even higher in prior years). In 2012, only 34% of respondents reported performing annual compliance reviews. What’s alarming about a trend like this is that on the flip side, the level of audit activity by regulators is is increasingly strong, and in some cases, continuing to rise. France, for example, is considered one of the most challenging jurisdictions from a tax perspective, and in the 2012 survey it ranked second highest in terms of the percentage of companies audited (17%). Now is not the time to let go of compliance monitoring.
Checklist Tips
The concept of a checklist is likely an all-familiar one in our stock compensation world. I’m not proposing something that’s necessarily novel. However, I notice that most often the “checklists” are oriented towards a specific set of procedures or tasks, like processing an ESPP purchase or RSU release. I don’t often see a full checklist oriented towards across-the-board compliance, and this is an area where I think plan administration could be made much easier. So what would I include in my checklist? Some things you won’t want to miss:
– Plan Management (Plan Reserves, Registration, Fungible Shares and Reconciliation): Ensure reconciliation occurs in all aspects of maintaining shares under the equity plans. This includes registering initial shares, validating plan balances on an ongoing basis, tracking plan reserve increases, and taking action when the plan is no longer in use. This could serve as a stand-alone category on a checklist, with many areas to monitor.
– Handling Exceptions: I could write a whole another blog on tracking exceptions. You know the situation: some anomaly occurs mid-quarter (unexpected acceleration of a grant? unusual termination conditions or modifications?) and then, with no formal process to keep track of the change, it’s forgotten. Adding a few steps around tracking these exceptions to your checklist would save volumes of work down the road trying to recall what occurred and alleviate fears about forgetting something.
There’s only so much I can include in today’s blog. I hope you will consider the notion of adopting a checklist that you can use to broadly monitor compliance on a regular basis. There are a number of focused checklists in our Administrative Tools and Year-End portals that may give you an idea on the types of things to track.
Back in July, I blogged about Barnes & Noble’s grant to their CEO that was in excess of the per-person limit in their plan (“What’s Your Limit?,” July 31, 2012). I thought that was an isolated incident, but now another company has done the same thing, three years in a row! If one more company does it, I think we’ll have to call it a “trend.”
Devry Makes Repeated Grants in Excess of Plan Limit A recent lawsuit against Devry alleges that the company granted options to its CEO in excess of the per-person limit included in its stock plan for Section 162(m) purposes for three years in a row. The total number of excess shares granted to the CEO is almost 160,000 (34,100 shares in excess of the limit in 2010; 20,200 in 2011; and 105,425 in 2012).
Devry has several stock plans and it’s a little hard to tell which plan the options were granted out of. Ultimately, though, it doesn’t matter because, with the exception of their 1994 plan, which, according to their June 30 2012 Form 10-K, is no longer in use, all of the plans limit the number of option shares that can be granted to an individual to 150,000 per year.
Unlike Barnes & Noble’s limit, which was over a three-year period, this is a nice, clean annual limit, so it seems a little surprising that no one at Devry noticed the error. Even more surprising that they managed to make the same error three years in a row.
According to their 10-K, Devry currently has two plans that they grant options out of (a 2003 plan and a 2005 plan). As far as I can tell, based on the Form 4 reporting the grants, the options granted to the CEO were granted out of just one plan (although I can’t ascertain this for certain). I believe that the limit applies only to options granted under the plan in which it is stated. Thus, if a portion (no more than 150,000 shares worth) of each year’s options were granted under one plan with the remaining portion granted under the other plan, it seems to be that neither plan limit would have been exceeded and there’d be no problem under Section 162(m).
Don’t Be My Next Blog Entry!
This is such an easy mistake for shareholders and the IRS to find. The per-person limit is clearly stated in your plan, which is filed with the SEC–there’s list of exhibits in your 10-K telling readers which filing it is included in. And all of your executives’ grants are reported on Form 4 filings. At “The IRS Speaks” panel at this year’s NASPP Conference, Deb Walker of Deloitte pointed out that Section 162(m) is one of the first areas IRS auditors target, because it is an area where there are a lot of compliance failures that are relatively easy to uncover. Make sure your company doesn’t make this mistake; compare all grants to your executives against the per-person limit in your plan. Do this every time an executive is granted an option.
When I worked on the issuer side of stock compensation, I often wondered how other companies were handling the situations I encountered through the course of my day. Did I have the best processes in place? Did my practices mirror industry standards? I wished I had had a way to easily validate my thinking on these topics. Fortunately, you do have a means to measure your level of compliance when it comes to various industry practices: the NASPP Compliance-O-Meter.
The Compliance-O-Meter helps you evaluate your compliance procedures and compare them with other companies’ procedures. You answer four or five short questions about your compliance procedures, receive a score, and then view how other companies have responded to the questions. We also provide a short explanation of the control procedure and how it can help ensure the integrity of your stock compensation program.
I share a few interesting results from our most recent Compliance-O-Meter quizzes:
Domestic Tax Withholding: 42% of companies reported following the cited best practice when it comes to state-to-state mobility tracking, which is to “update their address, note them as a domestic mobile employee, and work with my tax resources to determine the appropriate tax withholding for future transactions.” However, another 47% of quiz participants reported that they automatically withhold based on the employee’s new location, without considering the prior state of residence. Best practice suggests the former jurisdiction should at least be considered in the withholding analysis, so the fact that about half of companies aren’t doing that seems to indicate that a large percentage of organizations still have work to do in this area.
Global Tax Withholding: We asked similar questions in separate Compliance-O-Meter quizzes about domestic and global tax withholding. Interestingly, in answer to the same question I highlighted for domestic tax reporting, nearly 70% of companies do extensive analysis, including involving external advisers, when it comes to country-to-country mobility before assigning a withholding rate.
Insider Trading Policy: We asked companies whether they require those who are subject to their insider trading policy to agree to comply with the policy, in addition to simply acknowledging they have read and understood the policy. Approximately 76% of respondents indicated that they do require the individuals to agree to comply with the policy. However, the remaining 24% of companies said that they do not require agreement to comply. If your company falls into this minority, you may want to discuss with counsel whether an update to the policy may better align your company’s practices with the masses.
From A to Z, or Something Like That…
There are several compliance topics in our quiz archive, ranging from Section 6039 to ESPP design to transfer agents and much more. In addition, we post new topics periodically throughout the year, so be sure to watch our NASPP home page for updates. This week we’ve posted a new Compliance-O-Meter on Life Events: Death and Disability. If you’re not taking advantage of this opportunity to compare your practices to the industry, now would be a great time to start.
In late 2009, the IRS announced a major audit initiative for executive compensation that will ultimately involve at least 6,000 companies (see “IRS Audits: Are You Ready to Rumble?” January 26, 2010). We’re now over a year into that project, so I thought it might be a good time to revisit the subject.
No Need to Be Surprised
If you’ve been wondering what the IRS might audit relating to stock compensation, it turns out that there’s no need to be surprised. The IRS explains what they are looking for relating to stock compensation on their website. Here are a few highlights of what you can expect IRS auditors to investigate:
In the case of restricted stock and units, whether there has been a transfer of property (e.g., does the employee have voting and/or dividend rights) and whether there is a substantial risk of forfeiture for the award. According to Stephen Saxon in the March issue of PLANSPONSOR (“Saxon Angle: Audit Trials“), companies that offer accelerated vesting upon retirement should be especially wary of this issue for their retirement-eligible employees.
Whether ISOs and ESPPs meet the statutory requirements, especially the $100,000 and $25,000 limitations.
Whether income has been properly reported (on Form W-2 or Form 1099-MISC) and taxes withheld (if required) on all types of stock plan transactions.
Whether tax withholding for stock compensation has caused companies to exceed the $100,000 next-day deposit threshold that Rachel blogged about a couple of weeks ago (“Timely Tax Deposits,” May 26), and, if so, if companies complied with the deadline.
Recordkeeping practices relating to grants, exercises, and other stock plan transactions.
Compliance with Section 162(m)–but that’s a topic for another blog.
Things I Sure Hope Won’t Be a Problem
There are a few items highlighted in the IRS’s audit instructions that I sure hope won’t be a problem for any NASPP members–I know you are all too smart to fall for these traps:
Back-dated stock options. No explanation needed on this one.
Transfers of options to a related party. Under this strategy, an executive would “sell” stock options to a family member or trust in exchange for an unsecured, long-term, balloon payment obligation (essentially, the related party just “promises” to pay the executive for the stock option at some point in the future, a long ways in the future). The idea was to get around the gift tax that could apply if the option were simply transferred to the family member/trust. This type of a arrangement has been a no-go with the IRS for some time.
Not issuing stock upon same-day-sale exercises of an ISO or ESPP. Although the tax code itself is not clear, the IRS’s audit instructions specifically state that if, rather than issuing stock on a same-day sale, the underlying shares are simply cancelled in exchange for the spread–in other words, a net exercise–the arrangement is subject to withholding for both income tax and FICA purposes.
Issuing loans to executives for option exercises and then later forgiving or reducing the loans. Public companies shouldn’t be issuing loans to executives at all, much less forgiving those loans.
Last Chance to Qualify for Survey Results This week is your last chance to participate in the NASPP’s 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte). Issuers must complete the survey by this Friday, June 10, to qualify to receive the full survey results. Register to complete the survey today–we’ve already extended the deadline once, we can’t extend it again!
NASPP Conference Program Now Available The full program for the 19th Annual NASPP Conference is now available. Check it out today and register by June 24 for the early-bird discount–this deadline will not be extended.
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.
Register for 19th Annual NASPP Conference (November 1-4 in San Francisco). Don’t wait; the new early-bird rate is only available until June 24.
Participate in the NASPP’s 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte, with survey systems support provided by the CEP Institute). You must complete the survey by June 10 to qualify to receive the survey results.
With the NASPP Conference just barely behind us, today I highlight some tips I picked up on working with your lawyers from one of the sessions at the Conference. While most of us dread having to run projects past legal, the fact is that your lawyers (both in-house and outside counsel) can be an important and helpful member of your team, as demonstrated by the session “Face Your Demons: How You and Your Stock Plan Lawyer Can Work Together More Effectively” (a complete production with skits, props, and even audience participation, the session also demonstrated that even lawyers can have a sense of humor).
Face Your Demons: How You and Your Stock Plan Lawyer Can Work Together More Effectively
Negotiating Vendor Service Agreements / Business Contracts
Your lawyers provide valuable assistance in reviewing vendor service contracts. For one thing, they are probably better at reading fine print than you are (and you don’t really want to read those contracts yourself anyway, do you)?
The salesperson may present the contract as a form agreement, but this is rarely the case. Your lawyers can spot important service limitations that might impact your business–such as limited customer support hours–or gaps in the services that are provided that might later prove critical and can help you modify the contract to better meet your needs.
Lawyers also make excellent partners in negotiations. While many of us are uncomfortable with negotiating, lawyers are typically good at it. Let them play the bad cop to your good cop and take some of the pressure off yourself.
Reduce Exposure of Audits and Litigation / Secure Better Value from Outside Counsel
Of course, one of the tasks lawyers do best is compliance–look to your lawyers for assistance with understanding the potential risk of an audit or litigation–including the likelihood of such an event occurring, possible penalties, and even “softer” impacts, such as public perception and employee morale. This allows you to make informed decisions when evaluating procedures and plan designs. Should you become aware of a compliance failure, your lawyers should be one of your first phone calls (after your manager, of course); they can help you assess the gravity of the situation and strategize an appropriate response.
And, because your lawyers are working with many different clients (and also know other lawyers that have lots of clients), they can be a valuable source of information on industry trends and best practices. Before deciding on a process or design, check with outside counsel to find out if there is a better way.
Solicit More Proactive Legal Advice
When implementing new plans or programs, don’t wait until it’s too late to talk to your lawyers. Get their input early in the process, while you can use their input to shape the program (e.g., making sure there aren’t any unexpected compliance pitfalls or better approaches). And don’t be afraid to push back–working with your lawyers should be a back and forth process.
Navigate Evolving International Issues
I’ve said it before, but it bears repeating–a global stock plan is not a do-it-yourself project. No matter how few employees or countries are involved, never offer stock compensation to non-U.S. employees without consulting outside counsel. (Think about it, you would never implement a plan in the United States, even for just a handful of employees, without legal assistance. The laws aren’t any less complex outside the United States.)
In addition to seeking their advice when new programs are implemented, consider meeting with your outside counsel on a regular basis (e.g., quarterly) to review developments outside the United States that might impact your plans so you can determine if further research is needed.
It’s Renewal Time All NASPP memberships expire on a calendar-year basis. Renew your membership today and avoid the last minute rush on December 31.
Join Now and Get Three Months Free! If you aren’t currently an NASPP member, now is the time to become one! Join the NASPP for 2011 and you’ll get the rest of 2010 for free. Tell all your friends!
Don’t Miss Out–Conference Audio Available If you weren’t able to attend the Conference or did attend but couldn’t get to all the sessions you wanted to (and with over 40 sessions, who could?), you can download the audio from any and all sessions in MP3 format. Purchase just the sessions you want or save by purchasing a package of sessions.
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.