The House Financial Services Committee has recently been engaged in efforts to help start-up companies raise capital, including a bill (H.R. 4571) that directs the SEC to increase the threshold (from $5 million to $20 million) at which companies are required to provide additional disclosures to employees under Rule 701.
Background
Privately held companies typically rely on Rule 701 to issue stock through compensatory awards granted to employees. Where a company has relied on Rule 701 for the issuance of more than $5 million worth of stock in a 12-month period, the company is required to provide additional disclosures to employees, including the financial statements of the company prepared in accordance with US GAAP, risks associated with purchasing the company’s stock, and a summary of the material terms of the plan.
Proposed Change
The legislation passed by the House Financial Services Committee directs the SEC to increase the $5 million threshold to $20 million and further requires that this amount be indexed to inflation on a five-year basis. The bill makes no other changes to Rule 701.
The $5 million threshold has been in place since Rule 701 was adopted in 1988. Originally, Rule 701 actually capped issuances at $5 million; in 1999 the Rule was amended to merely require additional disclosures when this threshold is exceeded.
This threshold is frequently a concern for private companies, especially technology start-ups and others that grant equity broadly throughout their employee population. Anyone who has tried to buy real estate recently in California knows that $5 million in today’s economy isn’t what it was in 1988. According to the inflation calculator on the Bureau of Labor Statistics website, $5 million in 1988 had the buying power of a little over $10 million today; half the amount of the increase proposed by the House Finance Committee. We guess if the House Finance Committee is going to go for something, they might as well go for broke (or perhaps the bill sponsors felt they needed a little room for negotiation).
Next Steps
This legislation still needs to be voted on by the full House, then by the Senate, and then signed into law by the President. GovTrack.us (where you can sign up to receive email, Twitter, or Facebook updates on the bill) gives the bill only a 31% chance of passing. And after the bill is signed into law, the SEC has to draft a proposed rule, solicit comments, review the comments and issue a final rule before the change will take effect.
But, what is particularly interesting here is that—unlike some other limits I’d like to see adjusted for inflation (the ESPP $25,000 limit and the ISO $100,000 limit come to mind)—Congressional action isn’t necessary for Rule 701 to change. This is a rule promulgated by the SEC; as such, it could be modified by the SEC with or without direction from Congress. The SEC revamped Rule 144 in 2007; it’s been a lot longer than that since Rule 701 was updated. Perhaps this legislation will put this issue on the SEC’s radar.
It seems like just yesterday I was blogging about the SEC exempting stock options from the 500-holder limit for private companies, but it turns out that I never blogged about that because it happened back in 2007, before we had The NASPP Blog. Time flies and here we are almost five years later and the SEC has provided broad no-action relief from the same limit for RSUs.
What the Heck?
For those of you that aren’t sure what I’m talking about, let’s take a step back. Under U.S. securities laws, private companies that have more than $10 million in assets and more than 500 holders in any company security are required to register with the SEC under the 1934 Act. Most private companies are loath to exceed this threshold because registration causes them to be subject to pretty much all the same public reporting requirements as public companies–Forms 10-Q and 10-K., Form 8-K, Section 16, the whole shebang. It’s all the onerous parts of being a public company but without the upside of raising a bunch of money in an IPO and having publicly traded securities.
Stock options are a type of security, as are RSUs. Now the rule is that the company can’t have more than 500 holders in a single class of securities, so a company could have 499 shareholders and 499 option holders and 499 RSU holders without triggering the registration requirement (so long as none of the optionees exercised their options and none of the RSUs were paid out). But if a company had, say, 501 option holders, the company could be required to register with the SEC. This is a problem for private companies with, say, more than 500 employees that want to grant stock options to all their employees.
So, in 2007, after issuing numerous no-action letters on the matter, the SEC carved out an exception providing that compensatory employee stock options don’t count for purposes of the 500-holder limit, provided the options meet certain requirements. (See the NASPP alert, “SEC Exempts Stock Options from Registration for Private Companies,” December 15, 2007).
Now RSUs, Too
The 2007 exemption, however, didn’t extend to RSUs. So, where a private company wanted to grant RSUs to more than 500 employees, the company had to either register with the SEC or request relief from the registration requirement via a no-action letter–even if the RSUs, by their terms, could not possibly ever be paid out before the IPO.
Earlier this month, however, the SEC granted no-action relief for RSUs to the law firm Fenwick & West. By granting relief to a law firm, rather than a specific company, this no-action letter serves as broad relief for all private companies that wish to offer RSUs to their employees.
The RSUs must meet certain conditions to be eligible for relief–the awards must be granted by a private company, granted to individuals providing service to the company as defined under Rule 701, and transferable under only limited circumstances. In addition, the company must disclose information relating to its financials and risk factors to employees.
But Not Stock Acquired Under RSUs and Options
The relief described above extends only to options and RSUs themselves; it doesn’t cover stock employees acquire under options or RSUs. That stock still counts towards the 500-holder limit.
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 we keep an ongoing “to do” list for you here in our blog.
Ah, 1969–the summer of love…and the birth of AMT. The Tax Reform Act of 1969 created a minimum tax designed to ensure that individuals with high incomes could not avoid paying federal income tax (thus, the concept of a minimum amount of tax that must be paid by high income filers). This was in response to a scandalous statement that 150 tax payers making over $100,000 paid no income tax. This minimum tax evolved into what is now the Alternative Minimum Tax. Although AMT receives regular bombardment on all sides, the revenue stream that AMT provides the federal government has made it prohibitive for anyone with the power to change the system to speak up and push for a solution (However, many politicians are perfectly happy to talk about the problem).
The Confusion
The fundamental differences between regular income tax and AMT are that AMT has only two tax brackets and that many exemptions and itemized deductions are not available under AMT. Because AMT is a parallel tax system, it’s difficult for many individuals to even determine if they are subject to AMT or not. In any given year, all tax payers theoretically need to consider whether they are subject to ordinary income tax or AMT. There is no one test to determine if you need to pay AMT; essentially, you must compute your taxes due under both systems and determine which is higher. A lot of middle income tax payers assume that their tax filing is so simple that surely they don’t need to worry about AMT. However, even if you have only personal exemptions and take the standard deduction, it is possible (extremely unlikely, but possible) to end up being subject to AMT. Fortunately, virtually all tax programs incorporate questions to help you determine whether or not you are subject to AMT and the IRS provides a handy little AMT Assistant that will help you determine if you should even bother.
ISOs and AMT
Incentive stock options create a special set of confusions and misunderstandings when it comes to AMT. Here are a few reasons why:
If an employee exercises an ISO and doesn’t sell shares in the same tax year, she or he needs to file Forms 6251 and 8801 for the year of exercise – regardless of whether or not AMT is due. Now that the IRS is being notified of ISO cash exercises courtesy of Form 3921, it’s especially important that your employees are aware of this.
If an employee exercises and sells ISOs in the same year, resulting in a disqualifying disposition, there is no AMT income from the ISO exercise (provided all the shares are sold) because you the preferential tax treatment on the exercise is eliminated. It’s important that your employees are aware that Form 3921 does not take any disposition into account.
ISOs fall into a special category of AMT income that is eligible for a tax credit in subsequent year. However, in order to calculate–or even qualify–for the credit, a tax payer must file Forms 6251 and 8801 every year until the credit can be claimed. Claiming an AMT credit is particularly tricky and a fabulous reason to rely on a tax professional, which brings up the topic of tax and financial planning resources for your employees. Calculating the credit is difficult, too, because it is limited to AMT income that is in excess of regular income. Consider partnering with your broker(s) or other service provider to help put employees in contact with tax professionals.
Disqualifying dispositions that occur in a year subsequent to exercise are a mess because the employee could end up with AMT in the year of the exercise and ordinary income in the year of the sale. However, that ordinary income could result in a favorable AMT adjustment when calculating AMT in the subsequent year.
Find out more about ISOs on the NASPP’s Incentive Stock Options portal. Also, the NASPP’s fabulous and freshly updated Stock Plan Fundamentals course starts in April. The entire second session (of six) is dedicated to the taxation of equity compensation, including ISOs.