I had a different blog topic in mind for today, but as I was literally putting this to bed, Congress voted to end the 16 day government shutdown and raise the debt ceiling – at least temporarily. We promised updates as things changed, so I’ll take this opportunity to assess the situation. Separately, there was a verdict yesterday in the high-profile insider trading civil case brought against billionaire celebrity Mark Cuban that will round out today’s news.
Government Back Online
As I write this, the word on the street is that the government will reopen “immediately”. I wasn’t quite sure what that meant, but based on news reports, it appears that “immediately” means today or at some point shortly thereafter. Since Congress voted late at night, I’m wondering if word will really get out that government workers need to return to work first thing today. But things should be back to the normal routine soon. I’ve heard that the National Zoo will be one of the last places to reopen, and they are presently saying Friday, October 18th will be the day. I guess we’ll know for sure that the government has reopened on a widespread basis when the panda cam at the zoo (which went dark in the shutdown – depriving many of us fans the ability to tune into the latest panda baby) is back on.
Areas where we’ll see some changes are:
The IRS should reopen and resume accessibility for taxpayer questions. Other pending activities, such as audits and refunds should move forward imminently as well.
The SEC’s filing systems were never shut down, so everything related to company filings should still be business as usual.
The poison ivy eating goats furloughed in New Jersey should be back to work soon. If you’re wondering what I’m talking about, see my blog on the Government Shutdown: Part 2 from a couple of weeks ago.
An Insider Trading Verdict
Billionaire Mark Cuban (owner of the Dallas Mavericks basketball team, star of TV’s Shark Tank) was found not guilty of insider trading by a jury yesterday. The SEC first initiated action against Cuban back in 2008, filing a civil suit alleging that he dumped his 6.3% stake in Mamma.com ahead of negative news, based on insider information. The initial lawsuit was dismissed by a judge, but the SEC persisted, and the case was revived on appeal in 2009. Cuban refused to settle and, after a tooth and nail 5 year fight in which Cuban refused to settle, the case went to trial, culminating with yesterday’s verdict. This case was part of a long string of cases brought by the SEC in recent years. The SEC has quite a track record of success in these cases. According to the SEC’s web site (yes, I obtained this information from their web site even in spite of the government shutdown), 161 entities and individuals have been charged with insider trading as of September 1, 2013, resulting in more than $1.53 billion in penalties. The Cuban verdict was one of few losses for the government in this long string of insider trading cases (though the SEC has lost some other high profile cases as well), which is part of what makes it newsworthy. Some prominent newspapers are already asking the question of whether this verdict will undermine the SEC’s movement to hold more individuals accountable for insider trading. It seems the SEC is not giving up, though. In a statement, the SEC spokesperson said that “while the verdict in this particular case is not the one we sought, it will not deter us from bringing and trying cases where we believe defendants have violated the federal securities laws.” All indications are that this long insider trading crackdown is yet to be over.
One message to employees continues to be that SEC action is not limited to larger cases like Cuban’s. In a recent blog, I highlighted another case that amounted to a mere profit of $7,900 for one guilty party, and consequences for an unintentional tipper that didn’t profit at all. While some cases get a lot of publicity, like Cuban’s case, it’s important to remember that no trade is too small or person too insignificant to escape SEC scrutiny.
I feel like I’ve been blogging about proposed and final cost-basis reporting regs for Form 1099-B for three years now. Wait, I have been blogging about this topic for that long–my first entry was on June 2, 2010 (“Cost-Basis Reporting: Complicating an Already Confusing Topic“). Over that period, we’ve seen several iterations of regulations–this was, after all, a three-phase project for the IRS. But we’re now at the end of phase three and the final set of final regulations have been issued.
Not the News You Were Hoping For
As my readers know (because you’re all so smart and also I’ve blogged on this to the point where you probably wish I’d just shut up about it), the cost basis of shares acquired under stock compensation arrangements includes two components: 1) the amount paid for the stock and 2) any compensation income recognized in connection with the arrangement.
Under the first set of regs that were released in 2010, brokers were temporarily relieved (until 2013) of the obligation to include #2 (the compensation income component) in the cost-basis reported on Form 1099-B. Brokers could, however, voluntary report the correct basis if they were able to (and, to my knowledge, several brokers did this). Then, in 2012, the IRS issued proposed regs that indefinitely extended this relief beyond 2013. In the final regs, not only is this relief made permanent but brokers are prohibited from even voluntarily including the compensation income in the basis.
Thus, for sales of any shares acquired under stock compensation arrangements after January 1, 2014, brokers are required to report only the amount paid for the stock as the cost basis on Form 1099-B. This basis will almost always be wrong (twenty points if you know the two circumstances for which it is the correct basis). Employees will then have to adjust the gain on Form 8949 when they file their tax return to avoid overpaying tax on their sales.
By prohibiting brokers from voluntarily reporting the correct basis, the IRS was hoping to achieve consistency on Form 1099-B. And, having written all the various iterations of flow charts for reporting sales that we have available in our Cost-Basis Reporting Portal, I have to say that I think consistency will be helpful. But I kinda wish the IRS had gone for consistency in the other direction–i.e., requiring brokers to report the correct basis, rather than an incorrect basis.
A Silver Lining
One bit of good news in the regs is that, beginning in 2014, brokers will be required to report sale proceeds net of fees on Form 1099-B. This small change will eliminate about two-thirds of the flow charts in the Cost-Basis Reporting Portal so I expect it also make your educational materials a little simpler as well.
In today’s blog I’m going to deviate a bit from our normal format and invite you to take a little quiz. Don’t worry, nobody’s keeping score except for you, so this is just for fun. Why a quiz, you ask? Have you ever wondered where to find something in the massive IRS Tax Code? Many of us have memorized the names and basics about various tax code sections that apply to stock compensation (e.g. Sections 421, 422, 423, 424, 83, 162 and so on). Or, you’ve heard of some pending regulations, but aren’t really sure whether there’s a pending regulation that covers your area of interest? I personally found it fairly straightforward to memorize the basics about all the major tax code sections, but what I find more challenging is keeping on top of all the subsequent revenue rulings and other guidance that emerges from the IRS. If you’re having the same challenge, you’ll want to be sure to visit our new Tax Code portal. It’s simple and concise – there’s a list and description of the various tax code sections, as well as related rulings and other interpretive guidance that apply to stock compensation. Call it a tax code crib sheet, if you may. Wait! Before you check it out, pause for a moment, in that spirit, to take the Tax Code Challenge!
Tax Code Challenge:
1. Where would you find information about the procedures to revoke an 83(b) election?
a. In Code Section 83(b)(2)
b. The IRS had not provided guidance on any specific procedures
c. Section 83 of the Code is clear that an 83(b) election may never be revoked for any reason
d. In Revenue Proc. 2006-31, which became effective June 13, 2006
2. Which revenue ruling provides guidance on the treatment of dividends and dividend equivalents on restricted stock and restricted stock units for 162(m) purposes?
a. There is no revenue ruling that covers dividends/dividend equivalents
b. Revenue Rul. 2012-19
c. Revenue Rul. 98-34
d. There is no revenue ruling, but there are proposed regulations pending on this topic
3. Which of the following reflect pending regulations?
a. Rules relating to the additional medicare tax
b. Rules related to valuing employee stock options that have been gifted for estate planning purposes
c. Rules regarding new information disclosures for Section 6039 related information returns
d. There are no pending revenue rulings that would affect stock compensation
The answers are listed below. If you knew all of the answers – great! You’re a tax guru. For the rest of us that may have been stumped by one or more questions, a visit to the Tax Code portal may help gain clarity in this area.
A court (Sutardja v. United States) recently confirmed that discounted stock options are subject to Section 409A. You probably didn’t even know that there was any question about this. But I guess when someone is slapped with the penalty tax under 409A, they are willing to try just about any argument. It certainly would have been big news if the plaintiff had prevailed.
As it stands, you probably think it’s hardly news worth blogging about. That’s because you don’t write a blog. If you had to come up with something pithy and timely to say every week, you’d know that anything is on the table. Which brings us to today’s blog entry…
Don’t Do That!
First, there are a couple of important lessons here:
Lesson 1) If you are thinking of taking the IRS on with regards to whether stock options are subject to 409A, the fact that a court has now backed the IRS on this matter makes it a lot less likely that you’ll succeed. It might be better to just cut your losses and deal with those discounted stock options that you granted accidentally.
Lesson 2) This issue arose out of a backdating investigation. The option in question was approved by the company’s compensation committee at one meeting and then later, at a subsequent meeting, the compensation committee ratified their earlier decision. When the company later conducted an investigation of its grant procedures, it decided that the grant date was when the decision was ratified at the second meeting. The FMV of the stock was higher on this date than at the earlier meeting, but the option price had been set based on the earlier FMV. As a result, the investigation deemed the option to have been discounted.
I’m not sure why the comp committee would approve the grant at one meeting and then ratify the decision at a second meeting (perhaps there was something wrong with the initial approval). Don’t do that! Approve options just once.
What About the Corrections Program?
Another interesting point in this case is that when the company’s internal investigation concluded that the options were discounted, they required the executive to pay the amount of the discount back to the company. If you’re keeping score, that means this guy has been dinged twice. He’s paid the higher (non-discounted) exercise price for the stock yet has also paid the 409A 20% penalty tax plus interest.
But wait–isn’t there some sort of corrections program for discounted stock options? If the exec has made up the difference in the exercise price, why wouldn’t the option be exempt under the corrections program? Why yes, Virginia, there is a 409A corrections program for discounted stock options–I even blogged about it back in 2009 (“Recent 409A Developments,” Jan. 13, 2009). I think there are several reasons why this option doesn’t qualify for the corrections program, however:
The events in this drama unfolded from 2003 to 2006, long before the corrections program–announced in late 2008–existed.
To be eligible for correction, the option can’t have been exercised yet. The executive in this case didn’t pay the additional cost to make up for the discounted option price until after he had already exercised the option.
Options granted to Section 16 insiders have to be corrected by the end of the calendar year in which they are granted. The options in this case were granted in 2003 but not corrected until 2006.
The grant documentation has to indicate that the option was intended to have price equal to FMV. I have no idea if this is an issue in this case, but it’s a good thing to make sure is specified in your own grant documentation. If you are ever in a situation where you need to rely on the 409A corrections program, you’ll be glad you did.
At this point, the case is not yet resolved. While the judge did agree that discounted stock options are subject to 409A, this decision was a partial summary judgment (meaning the judge thought that the IRS’s case was so obviously right that it wasn’t necessary to go to trial over this issue–something else to keep in mind if you were thinking of taking the IRS on). But the remaining question, which is whether or not the option was actually discounted, remains to be decided.
Is This Up to a Jury?
Coincidentally, I just got a jury duty summons, which got me thinking: are these sorts of tax law questions decided by a jury of my peers? Nothing against my peers, but most of ’em (except, of course, for my colleagues in stock compensation) don’t know beans about stock compensation or tax law. So if that’s the case, that’s a little scary. Also, how come when I’m called for jury duty, it’s never for cases that involve stock compensation? I think I’d have a lot to add as a juror for a case like this. Heck, I could probably even count it as “work.” You know, research for the blog…
For today’s blog, I have another exciting smorgasbord of random stock plan related tidbits.
IRS Issues GLAM on Stock Compensation Deductions and CICs In January, the IRS issued general legal advice memorandum AM2012-010 clarifying that when NQSOs and SARs are cashed out due to a change in control, the tax deduction is attributable to the acquired company. This is because the obligation to make the payments became fixed and determinable at the closing and the payments were for services performed prior to the acquistion.
Two things to note here:
This is unfortunate because chances are the target company isn’t all that profitable, making the deduction less than useful.
The acronym for this type of IRS pronouncement is GLAM. That makes the whole thing sound way cooler than it actually is.
For more information see the WSGR alert we posted on this development.
ISS Theme Song: Coming Around Again? I’m sure you’ve heard about this by now, but just in case, ISS has announced that it will replace the GRId analysis system with a new system called “QuickScore,” which does have the advantage of sounding niftier and friendlier. If you are thinking “what the heck, didn’t they just switch to the GRId system,” time must be flying by for you just as fast as it does for me. ISS switched to GRId back in 2010 (I blogged about it, see “Will ISS Red Light Your Stock Compensation?” March 23, 2010). Still, it does feel like ISS is changing systems almost as often as they change their name.
Under QuickScore, companies will receive a relative ranking from 1 to 10 (1 is good, 10 is bad) by region and industry, instead of the color coded (red, yellow, green) score companies received under GRId. Which is similar to ISS’s Corporate Governance Quotient system that was replaced by GRId. Sort like how ISS changed to RiskMetrics and then changed back to ISS.
Backdating Bad for Your Career A recent academic study found that CFOs that lost their job as a result of option backdating have had a tough time re-entering the workforce. Only 18.7% found a comparable position (compared to 35.1% of CFOs that had lost their job for other reasons) and only 48.4% found any full-time corporate position (compared to 83.8% of other CFOs).
Which was a little surprising to me because how would a potential employer even know that’s how you lost your job? You wouldn’t exactly put “falsifying corporate records to reduce expense” under the skills listed on your resume and, in my experience, companies don’t give out that kind of information about former employees. But I guess a quick Google search these days can be very revealing about job candidates.
Whether you’ve been in stock compensation for a short time or for years, you’re likely aware of the IRS regulations that require the timely deposit of taxes withheld from employees by employers. We often hear about the fact that penalties and interest may apply when tax deposits are late, but I rarely hear discussion about the specifics of just what those penalties and interest consequences translate to in real dollars and cents. Sometimes it’s good to have a context for just how much impact practice failures can have, so in today’s blog I will attempt to define the true financial consequences for missing tax remittance deadlines.
I’m in Stock Admin…Do I Really Need to Care About IRS Penalties?
In short, the answer is yes. Although the stock administration function in the organization typically does not, by virtue of job description, have a direct role in remitting tax withholdings to the IRS, the function certainly can have a material impact in generating those withholdings. The most common area where stock plan activity puts payroll deposits at risk of penalties is where those transactions (either as stand alone, or, in combination with the company’s other tax withholdings for that day) are in excess of $100,000 on a single day, triggering the requirement that those dollars must be remitted to the IRS within one business day. As a result, you should care about what happens if Payroll (or whomever is tasked with interfacing with the IRS) cannot meet the deadline in a timely manner. If the stock administration function has any role in the delay, then eyes are likely to turn towards to you as potentially significant dollars are spent on penalties and interest. It’s one thing to know that there are some abstract penalties involved, but when you put a quantity to it, the significance of it starts to set in.
Dollars and Sense
Here’s the bottom line about what could be levied by the IRS for late tax deposits:
Interest: Any underpayment of taxes due may trigger interest. Typically, the amount of interest is equal to the Federal short-term interest rate plus 3%. The 3% may increase to 5% in cases where the underpayment was in excess of 100k for periods after the IRS issues a notice of proposed deficiency. I’m told that it may be possible to avoid the interest part of the consequence if any underpayment of FICA or Federal tax withholdings is corrected by the due date of the Federal Form 941 relative to the period in which the underpayment error occurred.
Penalties: First off, the amount of the penalty will directly correlate to just how late the taxes are deposited with the IRS. If the deposit is made within 5 days of the deadline, the penalty is 2%. For periods more than 5 days to not more than 15 days, the penalty increases to 5%. Deposits more than 15 days late are subject to a 10% penalty. The amount could potentially increase to 15% if not paid within a certain time frame after the IRS notifies the company of the penalty.
Yikes! What’s a Stock Administrator to Do?
There are certain transaction types where the IRS has given directive that allows the company ample time to receive funds and make a deposit. For example, in the case of a non-qualified stock option exercise, the funds are due to the IRS within one business day of the settlement of the exercise (if a broker trade was involved, and provided the settlement occurs within 3 days of the exercise). This allows the company to actually receive the funds, and then turn around and remit them to the IRS. I should clarify that this interpretation stems from an IRS 2003 Field Directive that basically says that in absence of other guidance, the IRS auditors won’t challenge deposits made within that time frame (there is no regulation that actually says taxes can be paid on T+4). Most companies now operate in reliance on that directive.
Other transactions, such as those involving the vesting of restricted stock awards or units, do not have such a settlement period (at least not one clearly defined by the IRS – there simply is no guidance in this area). For this reason, most companies operate on the assumption that taxes must be deposited within one business day of the vesting date (when combined withholdings for the company are in excess of 100k on the vesting date). Since in most cases, the amount of tax due isn’t actually known by the company until the date of the vest (and this may be late in the day, after the stock market closes, depending on how you define the fair market value to be used in the calculation), it’s very challenging to meet the IRS’s requirement for one-business day deposits of those amounts in excess of $100,000. In considering the potential interest and penalties for failing to deposit on time, many companies have adopted the practice of estimating their tax deposits and then doing a subsequent true-up. One piece of advice: if you’re going to estimate taxes due – overestimate rather than underestimate. If you overestimate you avoid all potential penalties and interest. If you underestimate, you still may trigger penalties and interest. According to our NASPP Quick Survey (May 2011) on Restricted Stock Units and Awards, 38.9% of companies say they deposit restricted stock tax wtihholdings timely based on an estimate (compared to only 9.5% who were depositing on time using the actual liability instead of an estimate). Estimating deposits requires cash flow planning on the part of the company, but is a proactive way to avoid getting into a penalty situation with the IRS.
The Bottom Line
In short, failure to make timely tax deposits can become a costly situation for companies, particularly when repeat offenses or overly large deposits are involved. This is not an area where a simple $50 or $100 fine is slapped per occurrence. With penalties equivalent to a direct percentage of the tax deposit amount, and interest rates of more than 3%, the dollars can add up quickly. These consequences further underscore the need for Payroll and the Stock Plan function to have a close working relationship. To learn more about the inner-workings of Payroll and how to better forge that relationship, you may be interested in our upcoming webcast (February 26th) on Understanding Payroll Administration Related to Equity Compensation.
I’m sure that all of you are completely on top of this, but just in case you’ve gotten a little distracted by all the excitement over the new tax withholding rates and the American Taxpayer Relief Act, don’t forget that it’s time to file the returns and distribute the information statements required under Section 6039 for ISOs and ESPPs.
Section 6039 Deadlines Coming Up
The information statements need to be distributed to employees by January 31 and the returns need to be filed with the IRS by February 28 (if filing on paper) or April 1 (if filing electronically).
The returns are filed on Form 3921 for ISOs and Form 3922 for ESPPs. You can simply provide employees with a copy of the returns that will be filed with the IRS or you can provide them with a substitute statement, provided the statement complies with the IRS’s requirements (which aren’t terribly onerous despite what one law firm memo I’ve seen suggests).
What If You Did Forget?
Well, you’ve still got plenty of time on the returns that are filed with the IRS, especially if you file electronically, which is actually probably easier than trying to file on paper anyway. There are several providers than can take your data, whip it into shape, and file it electronically for you–see the NASPP’s webcast “Comparing Solutions for Section 6039 Compliance. Not only is the deadline (April 1–we get an extra day this year because March 31 is a Sunday) still several months off, but you can file for an automatic, no-questions-asked 30-day extension using Form 8809.
But you’d better get cracking on the employee statements. There’s no automatic extension available here–if you need an extension you need to write a letter to the Extension of Time Coordinator in the Information Returns Branch at the IRS, include a good excuse (the dog ate my information statements?), and hope the IRS is feeling generous. [A couple of thoughts come to mind: 1) How cool is that job title? I think it would be awesome to tell people that you are the “Extension of Time Coordinator.” I bet a lot of people want to be your friend. I wonder if this person also has the authority to suspend birthdays? And, 2) if you are in need of an extension, it’s nice to know that there are so many other people in the same boat that the IRS has actually created a position to handle all the requests.]
If any of my readers have requested (or have clients that requested) an extension on the employee statements I’d love to hear from you–how quickly did the IRS respond, was the extension granted, did they give you are hard time about it, etc.?
More Information
The NASPP has loads of resources on Section 6039–Section 6039 is practically our middle name! Our Section 6039 Portal brings together all of our great resources on this topic, including numerous blog entries we’ve written on the topic as well as many other articles we’ve collected and various IRS publications that relate to this reporting obligation.
New this year, we’ve posted the article “6039 Gotchas!” by My Equity Comp to the portal. And the article “Figuring Out Section 6039 Filings” answers every question you could possibly have on either the returns or the statements. If it doesn’t, let me know so I can update it.
In addition to the webcast on providers that I mentioned above, we have a “lessons learned” webcast on 6039 filings.
This week, I have a couple of updates on the tax rates and procedures for withholding federal income taxes on supplemental payments.
2013 Supplemental Withholding Rates When Jenn blogged about the American Taxpayer Relief Act last week, the ink was still wet on President Obama’s signature on the Act and we were all still trying to figure out exactly what it meant in terms of tax withholding in 2013. It now seems clear that the flat rate that applies to supplemental payments of $1 million or less per year will remain at 25% and the flat rate that applies to supplemental payments of more than $1 million has increased to 39.6%.
ADP has confirmed these rates and, while that isn’t quite the same thing as the IRS confirming them, my sense is that ADP knows what they are talking about, their confirmation agrees with my understanding of how these rates work, and it agrees with what I’ve heard from other practitioners (e.g., Baker & McKenzie), so I’m considering this issue put to rest.
No Other Rate is Allowed While we’re on the topic of supplemental rates, a question I get frequently is whether companies can permit employees to request that taxes on their stock plan transactions be withheld at a higher rate than the prescribed flat rate. This was a topic of two of my earliest blog entries (“Excess Tax Withholding,” December 1, 2008 and “Excess Tax Withholding – Part 2,” December 9, 2008).
In September of last year, the IRS issued Information Letter 2012-0063 confirming that when you are using the flat rate (regardless of whether you are choosing to use the flat rate over the employee’s W-4 rate on an optional basis or the employee has received over $1 million in supplemental payments for the year and you are required to withhold at the maximum rate), you are required to withhold at the specified rate (25% for optional flat rate withholding, 39.6% for mandatory flat rate withholding). From the IRS’s discussion of optional flat rate withholding:
“If the employer is using the optional flat rate withholding method, the employer must withhold at the optional flat rate and cannot take into account requests by the employee that the rate be increased or lowered. Only one rate applies for purposes of optional flat rate withholding on supplemental wages.”
Where employees have received more than $1 million in supplemental payments, you have to withhold federal income tax at 39.6% on their stock plan transactions–no other rate (either higher or lower) is permissible.
Where employees have recieved $1 million or less in supplemental payments, the only way to withhold federal income tax at a rate of other than 25% is to use the employee’s W-4 rate (which the IRS refers to as the “aggregate procedure”). In that case, you could have the employee complete a new W-4 requesting the higher rate for federal income tax purposes just prior to his/her stock plan transaction and then complete another W-4 resetting the FIT rate back to the prior rate after the stock plan transaction is concluded (without the second W-4, the higher rate will apply to all of the employee’s regular pay). But then you’d have to figure out the W-4 rate–good luck with that.
Where you don’t want to deal with the hassle of figuring out W-4 rates, you can offer employees two other alternatives when they are worried that the withholding on their stock plan transactions isn’t sufficient:
Increase the withholding on their regular pay (which does require a new W-4, but at least you don’t have to be involved).
Make estimated payments to the IRS.
The information letter doesn’t provide any information on what the penalties would be if you do withhold at a different rate without following the W-4 procedure or whether those penalties would apply to the company or the employee. For now, those mysteries remain unsolved.
The IRS has been busy on projects related to stock compensation lately (see “Dividends and Section 162(m),” July 10, 2012, and “Section 83 Update,” June 12, 2012). Their latest project is a sample Section 83(b) filing, something Stephen Tackney and Thomas Scholz, both of the IRS, had alluded to being in the works at last year’s NASPP Conference.
Rev. Proc 2012-29 provides a sample Section 83(b) election, along with examples clarifying the tax treatment that applies when the election is filed. See the NASPP alert “IRS Issues Sample 83(b) Election Form” for more information.
A Quick Review
Section 83(b) elections can be filed by employees when they receive stock that is subject to forfeiture and transferability restrictions. The most common arrangement in which employees would receive stock like this is a restricted stock award. A less common arrangement is an early-exercise stock option, under which employees are allowed and choose to exercise prior to vesting. Normally stock acquired under these arrangements is taxed at vest; filing a Section 83(b) election accelerates the taxable event to the grant/exercise date.
The election has to be made relatively quickly–within 30 days of when the stock is transferred to the employee–and must contain specific details about the transaction for which it is made. There’s not a lot of room for error here–miss the 30-day deadline and you are out of luck.
Incomplete Filings?
I was surprised at last year’s Conference to hear that the IRS was working on a sample 83(b) election. I had assumed most companies assisted employees wishing to make the election, ensuring that their elections are complete. But, given the Rev. Proc, now I’m not so sure.
I don’t know this for a fact, but I have to believe that the IRS issued the sample election because they receive a high number of incomplete filings and this is an effort to mitigate the problem. This is an area where you may want to take action to protect your employees. I think it’s a best practice for companies to provide a form that employees can use to make the election and to review their elections before they file them, just to make sure they’ve completed the form correctly. An incomplete or incorrect filing could be a mess if the error isn’t caught before the 30-day deadline. In a worst case scenario, the entire election could be considered invalid.
Note, however, that I never recommend that companies make the election on behalf of employees. Leave the responsibility for actually submitting the election in employees’ hands so that you don’t bear any responsibility if (or should I say “when”) elections aren’t mailed on time.
I’ll never forget a stock plan administrator telling me about starting a new job and opening a drawer in the prior stock plan administrator’s desk only to find a folder filled with Section 83(b) elections that the company had promised to file on behalf of employees over the past year and that had never been mailed. It was a private company and the elections were for early-exercise options that had been exercised at grant. If they had been filed on time as the company had promised, the employees would not have recognized any compensation income on their options. It still makes me a little sick to my stomach to think about it. Don’t do that! Make the employees mail their own elections.
More at the NASPP Conference
Attend the panel, “The IRS Speaks,” at the 20th Annual NASPP Conference to hear more about this Rev. Proc. as well as other rule-making activity that the IRS has completed this year–and hear what’s on tap for next year.
On June 21, 2012, the IRS issued Rev. Rul. 2012-19 to clarify the treatment of dividends paid on awards that satisfy the requirements to be considered performance-based compensation under Section 162(m). For today’s blog entry, I summarize this ruling.
Background on Section 162(m) (That You Probably Already Know But I Feel Compelled to Include Anyway, Just in Case)
Section 162(m) limits the tax deduction companies can claim for compensation paid to specified executive officers to $1 million per year. Performance-based compensation, as defined under the code and associated regulations, is exempt from this limitation. There are numerous conditions that must be met for awards to be considered performance-based, including that the awards must be payable only upon achievement of performance targets and cannot be paid out prior to certification (by the compensation committee) that the targets have been satisfied.
Treatment of Dividends Under Section 162(m)
Under the ruling, the dividends (and dividend equivalents) are viewed as separate awards–thus, they don’t taint the status of the underlying awards even if they will be paid to award holders before the performance conditions have been met (or will be paid even if the conditions aren’t met). But the dividends or equivalents themselves are considered performance-based compensation only if they also meet the requirements for this treatment under Section 162(m)–i.e., if they will be paid only upon attainment of performance targets and meet the other requirements specified under Section 162(m).
The easiest way to ensure that the dividends/equivalents will be considered performance-based under Section 162(m) is to pay them out only when the underlying award is paid out. If the award is forfeited, the dividends/equivalents accrued on it are forfeited as well. This is also a best practice for accounting purposes and from a shareholder-optics standpoint (ISS specifically identifies paying dividends on unvested performance awards as a “problematic pay practice”–see my December 15, 2010 blog entry, “ISS Policy Updates“).
Interestingly–in a grotesque-but-can’t-look-away sense–the ruling says that the dividends/equivalents don’t have to be subject to the same performance criteria as the underlying award–you could have one set of goals for the award and different goals for the dividends. That seems like a disaster just waiting to happen–a mess from both an administrative and participant education standpoint (as if your executives really need another set of goals to focus on, in addition to the award goals and the cash bonus plan goals). But now that the IRS has suggested it, I fear there is a compensation consultant already trying to design a plan that incorporates this feature. Just say “No!”
No Deduction for Dividends Paid on a Current Basis
Where the dividends will be paid out prior to satisfaction of the performance conditions–i.e., where they are paid to award holders at the same time they are paid to shareholders–the dividends are not considered performance-based compensation and are subject to the limit on the company’s tax deduction under Section 162(m).
This is just one more nail in the coffin for paying out dividends on a current basis. Even if the dividend payments aren’t that significant, I imagine trying to separate them from the original award for purposes of computing the company’s tax deduction will be a challenge. I have a headache just thinking about it.
No Surprises
My sense, from reading Mike Melbinger’s blog on CompensationStandards.com (“Code Sec. 162(m), RSUs, Dividends and Dividend Equivalents,” July 2, 2012) and the Skadden memo we posted on this, is that this is pretty much what everyone was doing anyway. It certainly seemed like common sense to me–if there is such a thing when it comes to the tax code. So, just like last month’s “Section 83 Update” (June 12, 2012), I’m a little surprised that the IRS doesn’t have anything more important to worry about. I’m sure this will be discussed at the IRS and Treasury Speak panel at the NASPP Conference–it will be interesting to hear why the IRS felt the need to issue this ruling.
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.
Don’t miss the Silicon Valley chapter all-day conference this Wednesday, July 11. Robyn Shutak and I will be presenting on life events and equity compensation, with Liz Stoudt of Radford–we hope to see you there!
Chapter meetings are also being held in Chicago, Los Angeles, NY/NJ, and Philadelphia. I’ll be speaking at the NY/NJ and Philadelphia meetings–be sure to stop by and say hello!