Earlier today, the IRS issued Notice 1036, which updates the tax tables and withholding rates for 2018 to reflect the new marginal income tax rates implemented under the Tax Cuts and Jobs Act.
The flat rates that apply to supplemental payments are updated as follows:
For employees who have received $1 million or less in supplemental payments during the calendar year, the flat rate is 22% (the third lowest income tax rate).
For employees who have received more than $1 million in supplemental payments during the calendar year, the flat rate is 37% (the maximum individual tax rate).
As under prior rules, for employees who have received $1 million or less in supplemental payments, the company can choose to withhold at either the flat rate or the W-4 rate (which also changes as a result of Notice 1036). Where employees have received more than $1 million in supplemental payments, this choice is not available; the company must withhold at the specified flat rate (now 37%).
While companies have until February 15 to implement the new rate tables, the IRS encourages companies to implement them as soon as possible and I expect that many companies will switch to the new flat rates immediately. Where shares are being withheld to cover taxes, withholding at greater than 37% could now trigger liability accounting.
– Barbara
P.S. Thanks to Andrew Schwartz of Computershare for alerting me to the IRS’s announcement.
We are pleased to bring back our popular “Meet the Speaker” series, featuring interviews with speakers at the 24th Annual NASPP Conference. These interviews are a great way to get to know our many distinguished speakers and find out a little more about their sessions in advance of the Conference.
For our first “Meet the Speaker” interview, we feature Deborah Walker of Cherry Bekaert, who will lead the session “The IRS and Treasury Speak.” Here is what Deborah had to say:
NASPP: Why is your topic particularly timely right now?
Deborah: Our presentation features IRS and Treasury speakers involved in regulatory and legislative initiatives involving equity compensation. This is a chance to hear the government’s enforcement focus and new guidance that could affect your equity plans and programs. In prior years, the session has been interactive, giving you a chance to question the government officials about an issue that concerns you and discuss their response, often giving the government ideas for ways to approach various issues that are less obtrusive than what the government may think about. We look forward to another interactive session this year in Houston.
NASPP:What is one best practice companies should implement?
Deborah: The IRS is implementing new computer audit procedures, enabling them to determine that withholding taxes are unpaid in a matter of days rather than in a matter of months. To avoid unnecessary intrusions in the form of “soft letters” from the IRS, you should review your payroll tax withholding and deposits for equity compensation, focusing particularly on the timeliness of deposits for the vesting of restricted stock and the exercise of non-qualified stock options. This should be done on a regular basis. Correction of failure to deposit amounts should be done as soon as possible.
NASPP:What is something companies should know about penalty assessments from the IRS?
Deborah: As the IRS computer systems are becoming more modern, there is an increase in penalty assessments. If you are assessed an IRS penalty, the IRS has a program allowing for the waiver of penalties when a penalty notice is a first time assessment. The program is only available to those who have had no penalties in the prior three years. There is no limit on the amount that can be waived. If this program is not available to someone when a penalty has been assessed, the taxpayer or their representative should always ask for waiver of the penalty for reasonable cause.
NASPP:What is something people don’t know about you?
Deborah: I had a speaking part as a terrified nun in the Three Stooges movie produced in 2012 by 20th Century Fox and directed by the Farrelly brothers.
The 24th Annual NASPP Conference will be held from October 24-27 in Houston. This year’s program features close to 100 sessions on today’s most timely topics in stock and executive compensation; check out the full agenda and register today!
I’ve been getting a lot of questions about what tax withholding rate can be used for federal income tax purposes, now that the FASB’s update to ASC 718 is final and companies are free to adopt it. So I thought I’d take a blog entry to clarify what’s changed and what hasn’t.
Who’s the Decider on Tax Withholding Procedures
One thing that a lot of folks seem to have forgotten is that the FASB doesn’t determine tax withholding procedures; they just determine how you account for situations in which tax is withheld. The ultimate authority on how much tax you should (and can) withhold in the United States is the IRS, not the FASB.
Tax Withholding for Supplemental Payments
I’ve blogged about the rules for withholding on supplemental payments, which include stock plan transactions, quite a bit (search on the term “Excess Withholding” in the NASPP Blog). There are two choices when it comes to withholding taxes on stock plan transactions for employees who have received less than $1 million in supplemental payments for the year:
Withhold at the flat rate (currently 25%). No other rate is permissible.
Withhold at the employee’s W-4 rate. Here again, no other rate is permissible.
If employees want you to withhold additional FIT, they have to submit a new W-4 requesting the withholding (as a flat dollar amount, not a percentage) and you have to agree to withhold at the W-4 rate. This is stated in IRS Publication 15 and even more emphatically in IRS Information Letter 2012-0063. Whether you are using method 1 or 2, you can’t arbitrarily select a withholding rate.
Where Does the FASB Come Into This?
The FASB has no authority over these requirements and they didn’t amend ASC 718 to make is easier for you to ignore the IRS requirements. They amended ASC 718 to make it easier for companies that grant awards to non-US employees to allow those employees to use share withholding. Other countries don’t have a flat rate, making it challenging for the US stock plan administration group to figure out the correct withholding rate for non-US employees. This would allow companies to withhold at the maximum rate in other countries and refund the excess to employees through local payroll (who is more easily able to figure out the correct withholding rate).
The only change for US tax withholding procedures is that if you want to use the W-4 rate to withhold excess FIT, withholding shares for the excess payment will no longer trigger liability treatment once you adopt the update to ASC 718. But if you want to withhold excess FIT, you still have to follow the IRS procedures to do so. Previously, even if you had followed the IRS W-4 procedures, withholding shares for an excess tax payment would have triggered liability treatment.
Why Not Use the W-4 Rate?
No one wants to use the W-4 rate because it is impossible to figure out. You have to aggregate the income from the stock plan transaction with the employee’s other income for the payroll period, which the stock plan administration group doesn’t have any visibility to. The rate varies depending on the number of exemptions the employee claims on Form W-4. And the rate is complicated to figure out. I count at least seven official methods of figuring out this rate and companies can make up their own method (but if they make up a method, they have to apply it consistently, the stock plan administration group can’t make up a method that is different than the method the payroll group uses).
The upshot is that you literally can’t figure it out. You would have to run the income through your payroll system to figure out what the tax withholding should be. And that’s a problem because your stock plan administration system is designed to figure out the withholding and tell payroll what it is, not the other way around.
What’s the Penalty?
Members often ask me what the penalty is for withholding extra FIT without following the IRS procedures. Generally there isn’t a penalty to the company for overwithholding, provided there’s no intent to defraud the IRS (if you don’t understand how overwithholding could involve tax fraud, see “Excess Withholding, Part 2“) and the withholding is at the request of the employee. Doing this on a one-off basis, at the occasional request of an employee, probably won’t result in substantial penalties to the company, especially if the employee has appropriately completed Form W-4 for his/her tax situation. (Note, however, that I’m not a tax advisor. You should consult your own advisors to assess the risk of penalty to your company.)
But I’ve encountered a number of companies that want to create a system to automate electing a higher withholding rate without following the W-4 procedures (in some cases, for all of their award holders). I think that it could be problematic to create an automated system that circumvents the W-4 process, especially in light of Information Letter 2012-0063. That system is likely to be noticed if the company is audited, and I think it could have negative ramifications.
A recent IRS Chief Counsel Memorandum indicates that smaller reporting companies must treat their CFO as a covered employee under Section 162(m) if he/she is one of the top two highest paid executives other than the CEO.
Wait a Minute! The CFO Isn’t Subject to 162(m)?
Yep, that’s right. For larger reporting companies, it may seem crazy, but the CFO isn’t ever a covered employee under Section 162(m). This is because the definition of a named executive officer under Item 402 of Reg S-K for purposes of the executive compensation disclosures in the proxy has evolved and the definition of a covered employee under Section 162(m) hasn’t kept pace.
Section 162(m) applies to the following executives:
The CEO
The top four highest paid executives other than the CEO, as determined for proxy disclosure purposes.
Back when 162(m) was adopted, this was the same group of people that were considered NEOs for purposes of the proxy disclosures. But in 2006, the SEC changed Item 402 to carve out a separate requirement for CFOs. So now, the NEOs in the proxy are:
Anyone serving as CEO during the year
Anyone serving as CFO during the year
The top three highest paid executives other than the CEO and the CFO.
Up to two additional executives that would have been in the top three except that they terminated before the end of the year.
Unfortunately, only Congress can change the statutory language under Section 162(m), so the IRS can’t modify the definition of a covered employee to match the SEC’s new definition of an NEO. (When Congress drafted Section 162(m), they probably should have just said that it applies to all NEOs as determined under Item 402 of Reg S-K.)
All the IRS can do is interpret the requirement under 162(m) in light of the SEC’s definition. Their interpretation is that the SEC’s change exempts CFOs from Section 162(m) (see the NASPP alert “IRS Issues Guidance on ‘Covered Employees’ Under Section 162(m),” June 9, 2007). (If you are wondering, former employees are also not subject to Section 162(m); this is another evolution in the SEC definition that hasn’t been implemented in the tax code.)
What Gives With Smaller Reporting Companies?
Smaller reporting companies are subject to abbreviated reporting requirements, including fewer NEOs for proxy reporting purposes. Thus, the SEC’s new definition in 2006 never applied to smaller reporting companies. Instead, NEOs in smaller reporting companies are defined as:
The CEO
The top two highest paid executives other than the CEO.
Per Chief Counsel Memorandum 201543003, because the CFO isn’t separately required to be included in the proxy disclosures for smaller reporting companies, he/she is still a covered employee for Section 162(m) if he/she is one of the top two highest paid executives other than the CEO.
In just a couple of weeks, employees will begin receiving Forms 1099-B for sales they conducted in 2015. Here are five things they need to know about Form 1099-B:
What Is Form 1099-B? Anytime someone sells stock through a broker, the broker is required to issue a Form 1099-B reporting the sale. This form is provided to both the seller and the IRS. It reports the net proceeds on the sale, and in some cases, the cost basis of the shares sold. The seller uses this information to report the sale on his/her tax return. [Same-day sale exercises can be an exception. Rev. Proc. 2002-50 allows brokers to skip issuing a Form 1099-B for same-day sales if certain conditions are met. But your employees don’t need to know about this exception unless your broker isn’t issuing a Form 1099-B in reliance on the Rev. Proc.]
The Cost Basis Reported on Form 1099-B May Be Too Low. For shares that employees acquire through your ESPP or by exercising a stock option, the cost basis indicated on the Form 1099-B reporting the sale is likely to be too low.
Sometimes Form 1099-B Won’t Include a Cost Basis. If employees sold stock that was acquired under a restricted stock or unit award, or if they acquired it before January 1, 2011, the Form 1099-B usually won’t include the cost basis (although procedures may vary, so check with your brokers on this).
What To Do If the Cost Basis Is Incorrect (or Missing). If the cost basis is incorrect, employees will need to report an adjustment to their gain (or loss) on Form 8949 when they prepare their tax returns. If the basis is missing, they’ll use Form 8949 to report the correct basis.
An Incorrect Cost Basis Is Likely to Result in Employees Overpaying Their Taxes. It is very important that employees know the correct basis of any shares they sold. They will subtract the cost basis from their net sale proceeds to determine their taxable capital gain (or deductible capital loss) for the sale. Reporting a cost basis that is too low on their tax return could cause them to pay more tax than necessary. In some cases, this doubles their tax liability. The only person who wins in this scenario is Uncle Sam; your employees lose and you lose, because no one appreciates the portion of their compensation that they have to pay over to the IRS. Your stock compensation program is a significant investment for your company; don’t devalue the program by letting employees overpay their taxes.
Employees should review any Forms 1099-B they receive carefully to verify that the cost basis indicated is the correct basis. If it is missing or incorrect, they should use Form 8949 to report the correct basis.
The Portal also has examples and flow charts, all of which have been updated for the 2015 tax forms. [In case you are wondering, there were no significant changes to Form 1099-B, Form 8949, or Schedule D in 2015.]
The Social Security Administration has announced that the maximum wages subject to Social Security will remain at $118,500 for 2016. The rate will remain at 6.2% (changing the tax rate requires an act of Congress, literally), so the maximum Social Security withholding for the year will remain at $7,347.
As noted in the SSA’s press release, increases in the Social Security wage cap are tied to the increase in inflation as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers. The Bureau of Labor Statistics found no increase in inflation over the past year based on this index, so there are no cost of living adjustments to Social Security benefits or the wage cap.
For those of you keeping score, the last time the Social Security wage base remained the same for a two years in a row was 2010 to 2011 (see “Social Security Wage Base Will Not Increase for 2011“), but in that year the Social Security tax rate was temporarily reduced.
A few other things that currently are not scheduled to change for next year:
The Medicare tax rates remain the same and there’s still no cap on Medicare. The wage threshold at which the additional Medicare tax must be withheld is still $200,000.
The flat supplemental rate is still 25% and the maximum individual tax rate is still 39.6%.
The threshold at which supplemental wages become subject to withholding at the maximum individual tax rate is still $1,000,000.
The compensation threshold at which an employee is considered highly compensated for purposes of Section 423 will remain $120,000.
Note that all of the above items can be changed by Congress and Congress has been known to sometimes make changes to next year’s tax rates very late in the year (e.g., see the 2011 alert noted above). But as things stand now, you have one less thing to worry about on your year-end checklist (but don’t forget that you still need to reset year-to-date wages/withholding back to $0 after December 31).
In case you were wondering (in your spare time), the IRS now has a techniques guide for auditing equity compensation. The “guide” is actually an instruction to internal IRS auditors on how to evaluate equity compensation during an “examination” (fancy word for “audit”). The guide, published in August 2015, is available on the IRS web site. I’ll try to summarize some of the more interesting points in today’s blog.
The Angles of Audit
Before I dive into what the guide says, I want to cover a thought that came to me as I was reading the guide. Stock Plan Administrators and their vendors are focused on tax compliance relative to the company’s corporate tax obligations (reporting, withholding, etc.). However, it’s important to remember that as compliant as we may be from a issuer standpoint, there is still audit exposure potential from the individual angle of tax compliance. An employee may get audited, even if the company is not being audited. The company’s documentation may be requested from the IRS as part of that audit. It’s important that issuers are aware that there are a variety of audit angles that could attract attention to their equity compensation record-keeping and disclosures at any given time, and the IRS guide seems to support that thought – providing detailed information on the types of transactions and potential tax issues that could arise. With that detail comes guidance on how to source documents attached to equity compensation. According to a blog dedicated to explaining the guide by Porter Wright Morris & Arthur LLP,
“Interestingly, the Guide devotes a fair amount of detail to explaining where auditors may find these documents, encouraging them to review Securities and Exchange Commission (“SEC”) filings as well as internal documents. As such, the Guide serves as an important reminder to employers to be mindful that the IRS (or other third parties) someday could seek to review their corporate documents. ”
Documents Galore
Let’s cut to the chase. Where are auditors instructed to look?
SEC documents – This is an obvious one, but it’s where the IRS recommends their auditors start. Disclosures such as the 10K (Form 10-K), proxy statement (DEF 14A) and Section 16 reports of changes in beneficial ownership (Form 4) are places to identify types of plans and awards, as well as detailed compensation data for named executive officers and directors. The IRS recommends comparing data from these disclosures to individual Form W-2s and 1099-MISCs to verify proper tax withholding and reporting. If discrepancies surface, the IRS recommends expanding the audit (yikes).
Internal Documents – Types of internal documents subject to scrutiny include employment contracts, and meeting minutes from Board of Director and Compensation Committee meetings.
The Porter et al blog summarized this into some key awareness factors for employers:
“Employers should be aware of these instructions. Often times, it is easy for someone to prepare internal documents using jargon or short-hand that is familiar among people at the company but that may be difficult to explain to a third party or worse could be misleading. The Guide demonstrates that internal documents may not be restricted to internal personnel. Instead, the IRS very well could review these internal documents. As such, employees and advisers who prepare these documents should be mindful of both the information contained in the documents and how they present that information.”
Takeaways
When preparing documentation or disclosures (including supporting documents for those disclosures), it’s good to look at the process as if a third party will eventually come in and evaluate the information. The Porter blog made a great point – often times records are maintained in manner that internal parties may easily understand, or there’s someone on hand who can “interpret” that scrawl made by a board member. However, once that information is subject to review by an auditor, questions can arise. Companies should be aware of the IRS audit instructions relatives to equity compensation and maintain their records in a way that will make it easy to explain if audited.
A riddle: what do the Trade Adjustment Assistance Program, the African Growth and Opportunity Act, and HOPE for Haiti have to do with Forms 3921 and 3922? You might think “not much” but then you aren’t a member of Congress. The Trade Preferences Extension Act, which includes provisions relating to those three things and a couple of other global trade-related items, also increases the penalties for failure to file Forms W-2 and forms in the 1099 series, which includes Forms 3921 and 3922 (why forms 3921 and 3922 are considered part of the “1099” series is another riddle for another day).
The New Penalties
Timing of Correct Filing
New Penalty (Per Failure)
New Annual Cap
Old Penalty (Per Failure)
Old Annual Cap
Within 30 days
$50
$500,000
$30
$250,000
By Aug 1
$100
$1,500,000
$60
$500,000
After Aug 1 or never
$250
$3,000,000
$100
$1,500,000
With intentional disregard,
regardless of timing
Min. of $500
uncapped
Min. of $250
uncapped
Make That a Double
The penalties apply separately for returns filed with the IRS and the statements furnished to employees. If a company fails to do both, both the per-failure penalty and the cap is doubled. Thus, if both the return and the employee statement are corrected/filed/furnished after Aug 1, that’s a total penalty of $500, up to a maximum of $6,000,000. If intentional disregard is involved, that’s a minimum total penalty of $1,000 (and this amount could be higher) with no annual maximum.
Effective Date
The new penalties will be effective for returns and statements required after December 31, 2015, so these penalties will be in effect for 2015 forms that are filed/furnished early next year.
Penalties At Least As Interesting As the Trade Provisions?
Interestingly, when I Googled “Trade Preferences Extension Act,” so I could figure out what the rest of the act was about, the first page of search results included as many articles about the new penalties as about the trade-related provisions of the act.
If you want to know what the rest of the act is about, here is a summary from the White House Blog. There’s not a lot more to say about the penalties but if you want to spend some time reading about them anyway, here are summaries from Groom Law Group and PwC.
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.