The FASB has issued an exposure draft of the proposed accounting standards modification to bring awards granted to nonemployees under the scope of ASC 718. Here are six things to know about it.
It’s Long. At 166 pages, the exposure draft is longer than I expected. Partly it’s so long because there a million places in ASC 718 where the FASB has to replace the word “employee” with “grantee” and the word “employer” with “grantor.”
No More Mark-to-Fair Value Accounting. This is the most significant change: awards granted to nonemployees that are settled in stock will receive equity treatment, the same as awards granted to employees. This means the expense will be determined on the grant date and will be recognized over the service period, with adjustments only for forfeitures and modifications. No more mark-to-fair value accounting until the awards vest.
Contractual Term Is Still Required for Valuation Purposes. The FASB is under the impression that all options granted to nonemployees are fully transferable (seriously, I kid you not—they really think this). So they require that when computing the fair value of options granted to nonemployees, companies have to use the contractual term, not the expected term. The NASPP will be commenting about this, for sure. (If you are a company that grants options to nonemployees, I would like to know if your options are transferable or not—email me at bbaksa@naspp.com).
The Expense Attribution Rules are Confusing. I had expected that expense for awards to nonemployees would be attributed in the same manner as awards to employees, but the exposure draft requires the expense to be attributed as goods or services are received, in the same manner that expense would be recorded for cash compensation. I don’t know beans about accounting for cash compensation (unless its in the form or SARs or RSUs), so I don’t know what that means. Ken Stoler of PwC assures me that it simply provides more flexibility for awards to nonemployees and that companies can probably record expense in the same way they record expense for their employee awards.
Performance Award Accounting is Improved. Currently, ASC 505-50 requires that expense for (non-market) performance awards granted to nonemployees be recorded at the lowest possible payout, which is frequently $0. The exposure draft proposes to align the treatment of nonemployee performance awards with that of employee awards: that is, expense would be recorded based on the expected payout, which makes infinitely more sense.
Comments Are Due By June 5. You can submit comments via the FASB website or email them to director@fasb.org. You can also mail a letter to the FASB but I’m not going bother listing the address here because who actually mails letters anymore?
Last week, I covered the basic rules that apply for tax purposes when options are exercised or awards pay out after an individual has changed status from employee to non-employee or vice versa. Today I discuss a few more questions related to employment status changes.
Is it necessary that the consulting services be substantive?
When employees change to consultant status an important consideration is whether the consulting services are truly substantive. Sometimes the “consulting services” former employees are providing are a little (or a lot) loosey goosey (to use a technical term). For example, sometimes employees are allowed to continue vesting in exchange for simply being available to answer questions or for not working for a competitor. It this case, it’s questionable whether the award is truly payment for consulting services.
A few questions to ask to assess the nature of the consulting services former employees are performing include whether the former employee has any actual deliverables, who is monitoring the former employee’s performance and how will this be tracked, and will the award be forfeited if the services are not performed.
If the services aren’t substantive, it’s likely that all of the compensation paid under the award would be attributable to services performed as an employee (even if vesting continues after the employee’s termination) and subject to withholding/Form W-2 reporting.
Is the treatment different for an executive who becomes a non-employee director?
Nope. The same basic rules that I discussed last week still apply. The only difference is that I think it’s safe to presume that the services performed as an outside director will be substantive (unless the director position is merely ceremonial).
What about an outside director who is hired on as an executive?
The same basic rules still apply, except in reverse. For options and awards that fully vested while the individual was an outside director, you would not need to withhold taxes and you would report the income on Form 1099-MISC, even if the option/award is settled after the individual’s hire date.
For options and awards granted prior to the individual’s hire date but that vest afterwards, you’d use the same income allocation method that I described last week. As I noted, there are several reasonable approaches to this allocation; make sure the approach you use is consistent with what you would do for an employee changing to consultant status.
What about a situation where we hire one of our consultants?
This often doesn’t come up in that situation, because a lot of companies don’t grant options or awards to consultants. But if the consultant had been granted an option or award, this would be handled in the same manner as an outside director that is hired (see the prior question).
What if several years have elapsed since the individual was an employee?
Still the same; the rules don’t change regardless of how much time has elapsed since the individual was an employee. The IRS doesn’t care how long it takes you to pay former employees; if the payment is for services they performed as employees, it is subject to withholding and has to be reported on a Form W-2.
So even if several years have elapsed since the change in status, you still have to assess how much of the option/award payout is attributable to services performed as an employee and withhold/report appropriately.
What if the individual is subject to tax outside the United States?
This is a question for your global stock plan advisors. The tax laws outside the United States that apply to non-employees can be very different than the laws that apply in the United States. Moreover, they can vary from country to country. Hopefully the change in status doesn’t also involve a change in tax jurisdiction; that situation is complexity squared.
Finally, When In Doubt
If you aren’t sure of the correct treatment, the conservative approach (in the United States—I really can’t address the non-US tax considerations) is probably going to be to treat the income as compensation for services performed as an employee (in other words, to withhold taxes and report it on Form W-2).
What is the US tax reg cite for all of this?
My understanding is that none of this is actually specified in the tax regs—not even the basic rules I reviewed last week. This is a practice that has developed over time based on what seems like a reasonable approach.
For today’s blog entry, I discuss how stock plan transactions are taxed when they occur after the award holder has changed employment status (either from employee to non-employee or vice versa). This is a question that I am asked quite frequently; often enough that I’d like to have a handy blog entry that I can point to that explains the answer.
The basic rule here is that the treatment is tied to the services that were performed to earn the compensation paid under the award. If the vesting in the award is attributable to services performed as an employee, the income paid under it is subject to withholding and reportable on Form W-2. Likewise, if vesting is attributable to services performed as a non-employee, the income is not subject to withholding and is reportable on Form 1099-MISC.
Where an award continues vesting after a change in status, the income recognized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is allocated based on the portion of the vesting period that elapsed prior to the change in status.
For example, say that an employee is granted an award of RSUs that vests in one year. After nine months, the employee changes to consultant status. The award is paid out at a value of $10,000 on the vest date. Because the change in status occurred after three-fourths of the vesting period had elapsed, 75% of the income, or $7,500, is subject to tax withholding and is reportable on the employee’s Form W-2. The remaining $2,500 of income is not subject to withholding and is reportable on Form 1099-MISC.
What if the award is fully vested at the time of the change in status?
In this case, the tax treatment doesn’t change; it is based on the award holder’s status when the award vested. For example, say an employee fully vests in a award and then later terminates and becomes a consultant. Because the award fully vested while the individual was an employee, the award was earned entirely for services performed as an employee and all of the income realized upon settlement (exercise of NQSOs or vest/payout of restricted stock/RSUs) is subject to withholding and is reportable on Form W-2.
This is true no matter how long (days, months, years) elapse before the settlement. Under Treas. Reg. §31.3401(a)-1(a)(5), payments for services performed while an employee are considered wages (and are subject to withholding, etc.) regardless of whether or not the employment relationship exists at the time the payments are made.
What is the precise formula used to allocate the income?
There isn’t a precise formula for this. We asked Stephen Tackney, Deputy Associate Chief Counsel of the IRS, about this at the NASPP Conference a couple of years ago. He thought that any reasonable method would be acceptable, provided the company applies it consistently.
The example I used above is straight-forward; awards with incremental vesting are trickier. For example, say an employee is granted an NQSO that vests in three annual installments. 15 months later, the employee changes to consultant status.
The first vesting tranche is easy: that tranche fully vested while the individual was an employee, so when those shares are exercised, the entire gain is subject to withholding and reportable on Form W-2.
There’s some room for interpretation with respect to the second and third tranches, however. One approach is to treat each tranche as a separate award (this is akin to the accelerated attribution method under ASC 718). Under this approach, the second tranche is considered to vest over a 24-month period. The employee changed status 15 months into that 24-month period, so 62.5% (15 months divided by 24 months) of that tranche is attributable to services performed as an employee. If this tranche is exercised at a gain of $10,000, $6,250 is subject to withholding and reported on Form W-2. The remaining $3,750 is reported on Form 1099-MISC and is not subject to withholding. The same process applies to the third tranche, except that this tranche vests over a 36-month period, so only 41.7% of this tranche is attributable to services performed as an employee.
This is probably the most conservative approach; it is used in other areas of the tax regulation (e.g., mobile employees) and is also used in the accounting literature applicable to stock compensation. But it isn’t the only reasonable approach (just as there are other reasonable approaches when recording expense for awards under ASC 718) and it isn’t very practical for awards with monthly or quarterly vesting. It might also be reasonable to view each tranche as starting to vest only after the prior tranche has finished vesting. In this approach, each tranche in my example covers only 12 months of service. Again, the first tranche would be fully attributable to service as an employee. Only 25% of the second tranche would be attributable to services as an employee (three months divided by 12 months). And the third tranche would be fully attributable to services performed as a consultant.
These are just two approaches, there might be other approaches that are reasonable as well. Whatever approach you decide to use, be consistent about it (for both employees going to consultant status as well as consultants changing to employee status).
Read “Employment Status Changes, Part II” to learn about additional considerations and complexities relating to changes in employment status.
Last week, I blogged about the proposed amendments to ASC 718. This week, I have some more information about them.
Is This a Done Deal?
Pretty much. The FASB has already considered—and rejected—a number of different alternatives on most of these issues. My understanding is that there was consensus among Board members as to each of the amendments and most of the changes aren’t really controversial, so we don’t expect there to be much debate about them.
Tax accounting is an exception, of course. This change is very controversial; in fact, the FASB considered this approach back when they originally drafted FAS 123(R) and ultimately rejected it is because of the volatility it introduces to the income statement. So perhaps there will be some opposition to this change.
What’s the Next Step?
The FASB will issue an exposure draft with the text of the changes, then will solicit comments, make changes as necessary, and issue the final amendments. I have hopes that we’ll see an exposure draft by the end of the year, with possibly the final amendments issued in the first half of next year.
ASC 718(R)?
No, the new standard will not be called “ASC 718(R),” nor will the amendments be a separate document. That’s the advantage of Codification. The amendments will be incorporated into existing ASC 718, just as if they had been there all along. In a few years, you may forget that we ever did things differently.
What’s the Next Project?
This isn’t the FASB’s last word on ASC 718. They have a number of additional research projects that could result in further amendments to the standard:
Non-Employees: In my opinion, the most exciting research project relates to the treatment of non-employees. As I’m sure you know, it is a big pain to grant awards to consultants, et. al., because the awards are subject to liability treatment until vested. The FASB is considering whether consultants should be included within the scope of ASC 718, with awards to them accounted for in the same manner as employee awards. If not for all consultants, than at least for those that perform services similar to that of employees.
Private Companies: Another research project covers a number of issues that impact private companies, such as 1) practical expedients related to intrinsic value, expected term, and formula value plans and 2) the impact of certain features, such as repurchase features, on the classification of awards as a liability or equity.
Unresolved Performance Conditions: Another project relates to awards with unresolved performance conditions. I’ll admit that I’m not entirely sure what this is.
That’s All, For Now
That’s all I have on this topic for now. You can expect more updates when we hear more news on this from the FASB.
A big thank-you to Ken Stoler and Nicole Berman of PwC for helping me sort through the FASB’s announcement. If you haven’t already, be sure to check out their Equity Expert Podcast on the amendments.
As is often the case at this time of the year, a lot of tax related questions have been popping up in the NASPP Q&A Discussion Forum lately. For today’s blog entry, I try to quickly answer some of the questions I’ve seen the most frequently.
Former Employees You have to withhold taxes on option exercises by and award payouts to former employees and report the income for these stock plan transactions on a Form W-2, no matter how long it has been since they were employed by the company. The only exceptions are:
ISOs exercised within three months of termination (12 months for termination due to disability).
RSAs paid out on or after retirement (because these awards will have already been taxed for both income tax and FICA purposes when the award holders became eligible to retire). Likewise, RSUs paid out on or after retirement that have already been subject to FICA are subject to income tax only.
If the former employees did not receive regular wages from the company in the current year or the prior calendar year, US tax regs require you to withhold at their W-4 rate, not the supplemental rate. In my experience, however, few companies are aware of this and most withhold at the supplemental rate because the W-4 rate is too hard to figure out.
Changes in Employment Status Where an individual changes status from employee to non-employee (or vice versa) and holds options or awards that continue to vest after the change in status, when the option/award is exercised/paid out, you can apportion the income for the transaction based on years of service under each status. Withhold taxes on the income attributable to service as an employee (and report this income on Form W-2). No withholding is necessary for the income attributable to service as a non-employee (and this income is reported on Form 1099-MISC).
Any reasonable method of allocating the income is acceptable, so long as you are consistent about it.
Excess Withholding I know it’s hard to believe, but if you are withholding at the flat supplemental rate, the IRS doesn’t want you to withhold at a higher rate at the request of the employee. They care about this so much, they issued an information letter on it (see my blog entry “Supplemental Withholding,” January 8, 2013). If employees want you to withhold at a higher rate, you have to withhold at their W-4 rate and they have to submit a new W-4 that specifies the amount of additional withholding they want.
Also, withholding shares to cover excess tax withholding triggers liability treatment for accounting purposes (on the grant in question, at a minimum, and possibly for the entire plan). Selling shares on the open market to cover excess tax withholding does not have any accounting consequence, however.
ISOs and Form 3921 Same-day sales of ISOs have to be reported on Form 3921 even though this is a disqualifying disposition. It’s still an exercise of an ISO and the tax code says that all ISO exercises have to be reported.
On the other hand, if an ISO is exercised more than three months after termination of employment (12 months for termination due to disability), it’s no longer an ISO, it’s an NQSO. The good news is that because it’s an NQSO, you don’t have to report the exercise on Form 3921. The bad news is that you have to withhold taxes on it and report it on a Form W-2 (and, depending on how much time has elapsed, it might have been easier to report the exercise on Form 3921).
FICA, RSUs, and Retirement Eligible Employees This topic could easily be a blog entry in and of itself, but it doesn’t have to be because we published an in-depth article on it in the Jan-Feb 2014 issue of The NASPP Advisor (“Administrators’ Corner: FICA, RSUs, and Retirement“). All your questions about what rules you can rely on to delay collecting FICA for retirement eligible employees, what FMV to use to calculate the FICA income, and strategies for collecting the taxes are covered in this article.
In a flurry of acronyms, the DOL (Department of Labor) and the IRS (I’m sure you all know what this acronym stands for) signed an MOU (Memorandum of Understanding) to improve agency coordination to address worker misclassification. A number of states are also participating in the agreement.
DOL and IRS Sign MOU The agreement provides that the DOL will share information with the IRS and the participating states to address workers classified as contractors that should really be treated as employees. Worker misclassification is a target of the IRS’s current employment tax research study, which I’ve blogged about before (“IRS Auditing Stock Compensation,” June 7, 2011). This MOU will give the IRS additional information to use in its audits.
At the same time, the IRS also announced a voluntary worker classification settlement program, further demonstrating their focus on this issue.
Misclassifying a worker that should be an employee as a consultant can result in a host of legal issues, from benefits that the individual should have been accorded (such as the right to medical benefits and vacation time), tax withholding considerations, overtime pay, and unemployment benefits, to name just a few.
This probably seems like a topic that doesn’t impact stock plan administration that much. Worker classification is determined by HR and/or payroll; the stock plan administration group most likely just assumes their determination is correct and treats each individual’s options and awards accordingly. And, I can’t think of any reason why stock plan administration should question the classification made by HR/payroll; it’s unlikely you have sufficient information to determine an individual’s employment status.
But, while stock plan administration may not be involved in classifying workers as employees or consultants, you should be aware of the impact misclassification can have on stock compensation awarded to the individuals in question.
Tax Withholding on Options and Awards
Of course, the first issue that comes to mind is tax withholding. Individuals classified as consultants aren’t subject to tax withholding. If these individuals should have been treated as employees, however, then taxes should have been withheld on all of their compensation, including their NQSOs and stock awards. Failure to withhold the appropriate taxes can result in penalties to the company up to the amount of the taxes that should have been withheld, as well as interest and administrative penalties.
In addition, the company should have made matching FICA payments on all of the individual’s compensation, also including NQSOs and stock awards. This is even more of a mess because consultants don’t pay FICA, they pay self-employment tax, which is equal to both the individual and company portion of FICA. The misclassified workers will have overpaid their taxes because, as employees, they would only have been responsible for the employee portion of FICA.
ESPP
The company’s Section 423 ESPP is a significant concern. By law, substantially all employees of the company have to be allowed to participate in the ESPP, but, of course, also by law, consultants aren’t permitted to participate. Where consultants should have been treated as a employees, however, it is likely that they should have been permitted to participate in the ESPP. Where an individual that should have been allowed to participate is excluded from the ESPP, the entire offering(s) that the individual should have been allowed to participate in can be disqualified. A mistake here could impact not just the misclassified individual but all other employees participating in the ESPP. When assessing your company’s risk with regards to worker misclassification, this is an important consideration.
Thanks to McGuireWoods for the alert that gave me the idea for this blog entry.
Conference Hotel Almost Sold Out The 19th Annual NASPP Conference is quickly approaching and the Conference hotel is nearly sold out. The Conference will be held from November 1-4 in San Francisco. The last Conference in San Francisco sold out a month in advance–and that was without the reality of Dodd-Frank and mandatory Say-on-Pay hanging over our heads. With Conference registrations going strong–on track to reach nearly 2,000 attendees–this year’s event promises to be just as exciting; register today to ensure you don’t miss out.
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.