For today’s blog, I feature five trends in tax withholding practices for restricted stock and units, from the 2016 Domestic Stock Plan Design Survey (co-sponsored by the NASPP and Deloitte Consulting):
Share Withholding Dominates; Sell-to-Cover Is a Distant Second. The majority (79% of respondents for executive transactions, 77% for non-executive transactions) report that share withholding is used to fund the tax payments the majority (greater than 75%) of award transactions. Most of the remaining respondents (17% of respondents for executive transactions, 18% for non-executive transactions) report that sell-to-cover is used to pay the taxes due on the majority of award transactions.
Rounding Up Is the Way to Go. Where shares are withheld to cover taxes, 75% of respondents report that the shares withheld are rounded up to the nearest whole share. Most respondents (62% overall) include the excess with employees’ tax payments; only 13% refund the excess to employees.
FMV Is Usually the Close or Average. The overwhelming majority (87%) of respondents use the close or average stock price on the vesting date to determine taxable income. Only 12% look to the prior day’s value to determine taxable income, despite the fact that this approach provides an additional 24 hours to determine, collect, and deposit the tax withholding due as a result of the vesting event (see “Need More Time? Consider Using Prior Day Close“).
Form 1099-B Is Rare for Share Withholding. Although share withholding can be considered the equivalent of a sale of stock to the company, only 21% of respondents issue a Form 1099-B to employees for the shares withheld.
Companies Are Split on Collecting FICA from Retirement Eligible Employees. Where awards provide for accelerated or continued vesting upon retirement, practices with respect to the collection of FICA taxes are largely split between share withholding and collecting the tax from employees’ other compensation (41% of respondents in each case).
For today’s blog, we have a special guest entry from Emily Cervino of Fidelity Stock Plan Services on a subject near and dear to my heart: defining FMV as the prior day close for purposes of determining taxable gain on award vesting events and the price of shares purchased under your ESPP.
What a Difference a Day Makes! Considering Prior Day Close
By Emily Cervino of Fidelity Stock Plan Services
At the recent NASPP Annual Conference in Houston, I had the opportunity to present “This Ain’t My First Rodeo: Lessons Learned about Equity Compensation.” I took advantage of the new format introduced at the conference: laser-focused, 20-minute sessions during breaks—as an alternative to the traditional, more in-depth breakout panels. I love this format. Short sessions appeal to conference-goers who are looking to cram in as much learning as possible, as well as those whose shorter attention spans make an hour-long, detailed session a hard sell.
I broke this micro-session into even smaller bits and used it as an opportunity to talk about four concepts that can make equity professionals’ lives easier. One concept, which I’d like to review here, is reconsidering the fair market value (FMV) definitions used for equity awards. FMV is an important concept used to set the price on stock options, calculate the taxable income on cash exercise and restricted releases, and determine the purchase price for ESPP.
Back when I started out, things were simpler. FMV was used for grant pricing, and, when it came to calculating taxable income on stock option exercises, where the vast majority of transactions were same-day sales, the actual sale price was utilized. Today, the equity landscape has changed dramatically. The majority of grants now come in the form of restricted stock, which doesn’t include an exercise. Rather, as a time-based vehicle, restricted stock releases (creating a taxable event) are based on a preset schedule.
According to the NASPP Stock Plan Design Survey, 87% of companies use close or average as the FMV to calculate taxable income on restricted stock.(1) Among clients of Fidelity Stock Plan Services, we see very similar results, with 85% of companies using close or average.(2) Which means, for most companies, taxable income can’t be calculated until the market closes on vest date. The exceptions (12% of NASPP responses, 13% of Fidelity clients) are using prior day close (or average), a better option that provides them with a full additional day for calculations! That means on the day before vest date, the FMV is determined as of market close, and the restricted release process can begin, allowing shares to be delivered to participants sooner.
And the benefits don’t end there. This is also a great strategy for ESPP. NASPP doesn’t specifically ask about FMV for ESPP, but in the Fidelity client base, while close and average still rule, we see 5% using prior day close, and a full 20% using current day open price as FMV, providing the benefit of extra hours to one-in-four companies processing their ESPP.
So why do most companies stick with close or average? This may be one of those things that falls into the “we’ve always done it this way” category. While many companies have changed the award types they grant, their FMV definition hasn’t yet evolved.
Plan Sponsors should check out their plan documents. It may be that FMV is only defined for grant pricing, where close or average is a great strategy. The plan document may provide flexibility with respect to the FMV used for tax purposes and/or ESPP. Even if the plan prescribes close or average FMV for tax and/or ESPP, a switch to prior day close (or current day open price) could be effected at the board or committee level and would not require shareholder approval.
Check it out! The gift of time is priceless.
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[1] 2016 NASPP Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting LLP)
2 Fidelity client base, as of 9/30/2016
Emily Cervino is a Vice President at Fidelity Stock Plan Services. She has been an active participant in the equity compensation industry since 1998, and now focuses on strategic marketing initiatives, thought leadership, and building Fidelity’s strong industry presence.
Emily is a frequent speaker at equity compensation events, past president of the Silicon Valley Chapter of the NASPP, a member of NASPP, GEO, and NCEO, and a 2015 recipient of the NASPP’s Individual Achievement Award. Emily is a Certified Equity Professional (CEP) and she holds Series 7 and 63 securities registrations.
Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author, and not necessarily those of Fidelity Investments.
Links to third-party websites may be shared on this page. Those sites are unaffiliated with Fidelity. Fidelity has not been involved in the preparation of the content supplied at the unaffiliated site and does not guarantee or assume any responsibility for its content.
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PricewaterhouseCoopers has published a summary of SEC comments on stock compensation (“2013 SEC Comment Letter Trends: Employee Stock Compensation,” available in the NASPP’s Surveys & Studies Portal). The comments were made in the course of the SEC’s review of various types of public filings (mostly Forms S-1, but also some Forms 10-K and other filings). I thought it would be interesting to take a look at what PwC found for today’s blog.
Companies Targeted
The majority (79%) of the companies to receive comments were technology, pharmaceutical, and life science companies. But don’t read anything into this–as noted above, the majority of the SEC’s comments were on S-1 filings, and these industries represented the majority of IPOs last year (particularly IPOs where employees held substantial amounts of stock compensation).
Areas Commented On
81% of the SEC’s comments related to information on stock compensation included in the MD&A. Of the comments related to the MD&A, 90% related to the discussion of critical accounting policies, et. al., for stock compensation. Based on the sample comments excerpted by PwC, it seems that many of these comments requested more information on the valuation of the company’s stock on grant dates.
Types of Comments
PwC found that, overall, 50% of the comments related to disclosure, 41% related to valuation, and 9% related to other accounting issues. Of the 41% of comments related to valuation, many of these seem to relate to the valuation of the company’s underlying stock on grant dates, rather than the valuation of stock options. Also, a little over one-third of the comments that PwC classified as disclosure-related were on the disclosures related specifically to valuation. Another 29% were on disclosures related to IPOs; many of these comments focused on valuation of the company’s stock (specifically on the differences between the most recent valuation and the IPO price).
Accounting Recognition Comments
Not much here. PwC notes that:
“Interestingly, we did not come across many comments related to some of the more complex areas of stock compensation accounting. For example, we saw only one comment on classification of awards as equity verses liability, no comments on expense attribution methodology, one comment on award modifications, and no comments on determination of the grant date.”
Key Takeaways
Overall, it seems that the SEC either (1) focused primarily on stock valuation-related issues in their review of stock compensation info in public filings, or (2) focused on everything but simply didn’t find much to comment on beyond the stock valuation issues.
If you are a public company, this is probably good news. Because your stock is publicly traded, so long as your grant dates are accurate, there’s not a lot for the SEC to question with regards to your stock value. But if you are a private company, you’ll want to make sure your house is in order when it comes to grant date stock valuations.
I’m a big fan of learning from my own mistakes, but if given the opportunity, I’m an even bigger fan of learning from the mistakes of others. And frankly, when it comes to our jobs, it can cost everyone involved a lot less to learn from the mistakes others have made than repeating the mistakes ourselves. Thanks to the National Center for Employee Ownership, this is now possible!
Earlier this year, the NCEO asked some of the industry’s leading equity compensation lawyers, plan administrators (including yours truly), tax and accounting consultants and software vendors to share some of the mistakes they’ve made in equity compensation and what they did about them. The stories that came in were riveting and provided enough content for an entire book!
The book was recently published and is appropriately titled, “If I’d Only Known That.” It is information packed with a focus on better understanding the complex relationships between accounting, tax, securities law, plan design, administration, and humanity, using stories of how bad things happen to good people in equity compensation, and is written by industry professionals for people who work in the industry. It is arranged into three categories–communication and education; plan design and modifications; and administration, policy and process. So, for instance, you could expect to find stories about ESPP contribution carryover and fair market value nightmares (see below for a summary of a related story I contributed to the book) in the “administration, policy and process” chapter.
******************** Throughout my career I have been a big proponent of validating fair market values. This obsession derives from a story I share in the book titled, “Check and Double Check.” Here is an overview of the story and the lesson learned:
Summary of Story: A mid-size semiconductor company offers a tax qualified ESPP to its employees. Immediately following the close of the stock market on the day of purchase, the plan administrator entered the company’s stock price (obtained from Yahoo! Finance) in its stock plan system, which was the resulting purchase price for the offering. The purchase was processed, and shares were distributed to participants’ accounts. Several months later, an employee contacted the company because they had identified a difference between the company-referenced purchase price and various online resources, including Yahoo! Finance. The employee’s information was accurate. As a result, the company had to reverse and reprocess the purchase, which meant that all interim activity had to be reprocessed, e.g., reversing terminations/withdrawals that occurred following the purchase and communicating the mistake to employees.
Lesson: Companies should incorporate a FMV validation into their SOX controls, e.g., obtain a sign-off from a second person that FMV’s entered into the stock plan database agree to two primary credible sources.
Fair market values touch so many areas of stock compensation. Be sure you have processes in place to ensure the fair market values you use to do your jobs are accurate.
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“If I’d Only Known That” is a great resource for both service providers and plan administrators. For service providers, it’s a great marketing tool for conveying the necessity of professional assistance to clients and prospects. For plan administrators, it’s an invaluable tool to help skirt mistakes before they happen. Invest in your career–purchase a copy of this book now!
Special pricing on all book orders! The NCEO is offering special member pricing to all NASPP members who purchase a copy of the book. To get the NCEO member price ($25), add the book to your cart and then enter the appropriate code (“Known” for the print version and “KnownPDF” for the digital version) in the “Payment code” field on the shopping cart page and click the “Enter” button to the right. Codes are not case-sensitive.
There isn’t a U.S. rule or regulation that gives a specific definition for the fair market value, either for creating an option exercise price or for calculating income on transactions, even though fair market value (FMV) is a fundamental measure for all awards. Section 409A regulations require that a consistent and reasonable valuation method be applied to stock grants. For private companies, coming up with a reasonable method for valuing company stock is complex, but for public companies it is generally accepted that the FMV for stock plans is based off the open market trading value of the stock.
Not so Definite
All stock plans should define the fair market value, but should also give the Plan Administrator the authority to determine FMV as needed. This is particularly crucial for companies whose stock becomes very thinly traded, but can also be an important piece of flexibility for other stock transactions.
The grant date fair value should, if at all possible, follow the plan definition. For transactions, however, there may be a need to have more than one definition for FMV. Most of applicable tax code (e.g., Section 409A, 422, or 83) focuses on the method used for determining grant date fair value. Section 409A is the most specific, permitting the use of an average sale price provided that the period used does not exceed (and is both set and irrevocable) 30 days prior to the grant date. However, 409A does permit the company to use more than one FMV, provided each application of FMV is consistent.
There may be situations where ESPP purchase or restricted stock vesting event dates fall on a non-market day and the plan defines FMV based on current day trading values. Alternatively, many companies prefer to define the FMV for transactions with a sale (e.g., broker assisted cashless exercise or immediate sale on vesting of restricted stock) as the sale price. There are also situations where the company has a unique need that justifies defining the transaction date fair value as something other than the plan definition. All of these are reasons why a company may choose to use more than one definition for fair market value.
Make it Official
Even if your company doesn’t plan on ever diverging from the plan definition of fair market value, you should still consider the possibility of a non-market day transaction and create an official definition of FMV for that circumstance. If you are currently using or considering using an different FMV definition than the one in the plan, assuming you have confirmed that the plan gives the plan administrator that authority, best practice would be to have that policy made official. In addition, even if you have created an official policy or procedure, the best way to show that the company is being reasonable and consistent with its definition of FMV is to have the Board or the Board’s designated compensation committee ratify the policy in a resolution.
What Other Companies Are Doing
Curious about how other companies define FMV? In the NASPP’s 2010 Domestic Stock Plan Design Survey, 78% of respondents use grant date closing price for option grants, but only 60% use closing price as the FMV for exercises. In addition, 80% use the actual sale price for broker-assisted cashless exercises.
A policy is only as solid as its exceptions. You may have a well-defined plan or policy for your company’s current situation that has bare spots that may not stand the test of time–and unusual circumstances. It’s difficult to cover all your bases when you are creating a new policy or plan, but it’s even more difficult when you jump into managing an existing plan under inherited policies.
The problem is that it is rare that a stock plan manager has time to pick through every piece of every plan document and policy and play out every scenario to determine if there are cracks that need to be exposed. This is where experience really counts; whether it is your own personal experience or experience you picked up second hand by listening to the holes other stock plan administrators have encountered. Whenever you are networking, attending a presentation, or perusing a discussion forum and you hear a new predicament, run–don’t walk–back to your desk and check to see if your company could potentially run into the same issue.
Just to give you a taste, here are three problems to think about:
Insider Trading Policy
Generally speaking, insider trading policies restrict the transactions of individuals deemed to be in possession of insider information. They help to protect both the company and the individuals by preventing transactions that would either be or appear to be insider trading. However, there are a couple places where ambiguity could trip you up. For example, if your insider policy doesn’t detail what constitutes a transaction, you could find yourself up against (or in the middle of) a blackout period scrambling to determine the correct course of action. Cash exercises and trading shares to cover tax liability on restricted stock vests are the most common sources of contention. Even if you’ve covered yourself by getting all your insiders into Rule 10b5-1 trading plans, there could still be an issue when someone not normally considered to be an insider is marked for a particular blackout period because she or he is either recently promoted or currently in the middle of a project that provides access to nonpublic information. If that same person has, for example, a restricted stock vest during the company blackout window, you could have a situation on your hands.
Fair Market Value
The fair market value for both grants and transactions can be pretty much any reasonable definition, which means that companies may set fair market value differently. Non-market days can be blind spot when it comes to restricted stock vests. Another tricky situation may arise if your FMV is defined in such a way that it is possible for someone to exercise an underwater option. For example, if your company uses the prior day’s closing price as the FMV for option exercises, an employee could exercise barely-in-the-money options and end up with an exercise price that is higher than the defined FMV.
Terminations
Your company can treat all terminations equally, but most companies do not. Voluntary, involuntary, for cause, death, disability, and retirement are all on the list of potentially unique termination reasons with varying impact to equity compensation. Of course, you want to have each reason clearly defined, but the blind spot could be what happens if the circumstance combines more than one reason. For example, what if an employee leaves the company and subsequently passes away during the post-termination grace period?
Take Charge
For larger issues regarding plan design and policy, there are a number of resources on the NASPP site to provide essential guidance. Our April 2010 webcast, “25 Ways to Improve Stock Plan Documents,” details more than 25 plan design issues that you need to be aware of and we have an entire portal dedicated to plan design with a host of resources under multiple topics.
Finally, don’t overlook your opportunities to learn from others. The NASPP has over 30 local chapters planning regular meetings. Making sure you attend your chapter’s meetings gives you access not only to timely topics and great speakers, it also gives you the networking opportunity to discover which issues are most important to your peers and how they are dealing with them. We also have an active Discussion Forum where you can browse, search, and even subscribe to the topics that matter most to you.
What do you do when someone has inadvertently been omitted from the grant approval process? You really can’t just slip the grant into the approval documentation, fully disclosed or clandestinely, and write it off to an “administrative error.” The bad news is that each situation has the potential to be unique, which makes it unlikely that you can create a standard response to a missed grant. For this reason, your grant policy probably can’t (even shouldn’t) attempt to address every potential circumstance surrounding a missed grant. The good news is that you can prepare yourself to evaluate the responses available to you in the event you do find a missed grant. These are my top five considerations:
Vesting
If a grant is left out of the approval process and needs to be approved at a later date, you need to know if the delay in approval will impact vesting. If your plan or grant policy already bases the vesting off a date other than the approval date or is flexible on the issue, it is possible that the grant can maintain the intended vesting dates.
Approval
It’s important to have a solid understanding of your plan and approval process under any circumstance, but when it comes to a missed grant, there are additional considerations. If the delayed approval will result in a grant that is different from your typical grants either in size or vesting schedule, you need to know who has the authority to approve the grant. If standard grants are approved by an officer, such as the CEO, it’s likely that a modification to standard terms will cause the grant to fall outside the parameters of the officer’s approval authority and may need to be referred to the compensation committee for approval.
Stock Price
If the grant in question is an option, then the stock price has likely moved on since the original approval date. If the price has dropped, it is easy to sell your employee on a grant of equal size and vesting with a better exercise price, but it may not be advisable to provide a disproportionately advantageous position to just one employee. Provided your plan permits it, it is possible to approve the option with the intended (i.e., higher) grant price.
If the stock price has increased, you have the opposite issue to contend with–the employee really shouldn’t be penalized for an administrative error. However, approving the grant at the lower exercise price would most likely result in a discounted option, making it subject to 409A. You can, however, develop a policy on how the company may compensate for this change in FMV such as increasing the number of shares or providing a cash payment to make up the difference.
If an RSU has slipped through the cracks in your approval process, making up for lost time can be less of a burden provided you have the flexibility in your plan to keep the intended vesting schedule. But, make sure that if your grant policy doesn’t lock in grant size based on the date of approval (e.g.; a value of $1,000 based on the FVM on date of approval).
Timing
Ideally, you never have to deal with a missed grant. Hopefully, if you do encounter one, the error is discovered virtually immediately. However, it is a good idea to think about what the company can do if a significant amount of time has passed between the date the grant should have been approved and the discovery.
One possible issue is vesting; if the grant should have already vested by the time the error is discovered. Like compensating for a higher exercise price, the company could choose to increase the number of shares or provide a cash payment to compensate for a missed sale opportunity. This is risky business because you are using counterfactual history–there is no way to know at what point the employee would have sold the shares.
Another issue comes up for companies that use a “total rewards” type compensation standard and one or more annual grants have been approved before the original missed grant is discovered. In a total rewards model, annual grant size would typically be based on a target total equity value or total compensation level. If the missed grant is not included in the calculations, then an annual grant approved after the error is likely to be larger to accommodate the value “missing” from that employee’s total equity value or compensation level.
Communication
Regardless of the circumstances leading up to a missed grant, communication is going to be key. No matter how you cut it, employees don’t appreciate being left out and bristle at the idea of being penalized for an administrative error, whether that idea is well-founded or not. This might sound a little like running a customer service call center, but it’s not a bad idea to have some apology verbiage ready that can fit most administrative issues; something that can help to reassure the employee that the company will “make it right” without actually obligating the company to provide recompense it isn’t prepared or able to accommodate. Whatever your response is to a missed grant, keep the employee abreast of the process as much as possible. Also, it’s probably best to avoid detailing the circumstances of the oversight even if you are trying to reassure the employee.
