Whether you’re new to the industry or have been involved in stock compensation for a while, chances are you’ve run into some retirement provisions as part of managing equity programs. What makes these provisions a bit different and often more tricky to administer compared to other situations, such as termination, is that some plans treat the mere act of becoming eligible for retirement as an event, regardless of whether or not retirement actually occurs. In today’s blog I examine some of the more challenging aspects of managing retirement provisions.
Timing is Everything
Ah, it would be so easy if people became eligible for retirement and then retired on the same day. Somehow I think the forces of the universe would think that’s letting us off the hook way too easy. So, instead, many companies increase or guarantee benefits once someone becomes eligible to retire, even if it’s months or years before the actual retirement will occur. Stock compensation is certainly one of those “benefits” that can be affected upon retirement eligibility.
Restricted Stock and Restricted Stock Units are two award types that are often affected by retirement eligibility provisions. Two common scenarios include acceleration of vesting upon retirement eligibility, or simply removal of the “substantial risk of forfeiture” conditions on the award. An example of the latter would be a provision that says that although no acceleration of vesting will occur upon retirement eligibility, the employee will be guaranteed to continue to vest in their shares until retirement.
One tricky aspect of administering the above provisions is tax withholding. Both RSAs and RSUs are subject to FICA taxes once the risk of forfeiture no longer exists. If the shares are not released to the employee at that time (let’s say that vesting will occur in the future, after the retirement eligible date, even though the risk of forfeiture no longer exists), then selling or withholding shares to pay for the FICA withholding is not an option. Many companies do rely on the IRS’s “rule of administrative convenience”, which allows FICA withholding to occur by 12/31 of the year of the triggering event. This means that companies can delay the mechanics of actually withholding until the end of the year, when many employees may have already met their annual FICA limit. In this case, no additional FICA withholding would be necessary and the company is off the hook in terms of having to figure out how to collect FICA on the shares. However, if the employee hasn’t met their FICA limit as year end approaches, then an appropriate amount of FICA will still need to be withheld. As such, the stock plan administrator needs to work with Payroll to ensure close coordination and monitoring of FICA status.
We’ve talked about FICA, but other taxes cannot be forgotten as well. Depending on award type (RSA or RSU) and the type of retirement eligibility event (accelerated vesting? guaranteed vesting in the future?), the timing of withholding for federal, state and medicare taxes may be different than the timing of FICA withholding.
Don’t Forget 409A
For companies with RSUs that vest upon retirement eligibility, the RSU will be considered “deferred compensation” under 409A if the shares will be released within a year of the retirement eligible (vest) date. In that event, 409A payout rules and deadlines need to be followed.
Evaluate Your Practices
I’ve highlighted a few of the considerations around retirement eligibility provisions and have just scratched the surface. Our newest Compliance-O-Meter on Retirement Practices gives you an opportunity to rate your retirement practices and see how other companies are handling these situations.
The details surrounding exactly when tax deposits are due on stock compensation come up regularly in the NASPP Discussion Forum. In honor of our NASPP Ask the Expert’s webcast today on Restricted Stock and Unit Awards, I’d like to summarize the issue.
IRS $100,000 Deposit Rule
Most public companies that offer stock compensation are semi-weekly filers, meaning they must make tax deposits with the IRS two times each week. These deposits are due within three business days after the deposit period. For example, if your period includes Tuesday, Wednesday, and Thursday, then the tax deposit for those three days would be due the following Wednesday. This is the company’s normal deposit schedule.
However, once the total tax liability reaches $100,000 for any corporate entity the deposit is due the next business day. (See IRS Publication 15.) For example, if the entity’s total tax liability reaches $100,000 on a Tuesday, the IRS would expect that deposit to be made on Wednesday of the same week. For those of you keeping score, the total tax liability to the IRS includes all taxes that get reported on the company’s quarterly tax return–Form 941. That is the total of income tax and both employee and employer Social Security and Medicare after adjustments, although that is more of a detail for the payroll team than for stock plan managers. Also, the liability only accumulates beginning after a deposit period. For example, if your deposit period includes Tuesday, Wednesday, and Thursday, then you do not need to combine Thursday’s liability with Friday’s liability.
T+4
The IRS issued a Field Directive in 2003 instructing IRS auditors not to challenge tax deposits from “broker-dealer trades” (i.e., broker-assisted cashless exercises) made the business day after the settlement of the exercise, provided the settlement is no longer than three days. This doesn’t change companies’ tax deposit timeframe; it simply instructs auditors not to challenge these deposits. In spite of this technicality, most companies rely on this Field Directive for remitting taxes to the IRS on all same-day sale NQSO exercises.
Restricted Stock
RSUs and RSAs are where stock compensation and tax deposit liability get really tricky. There isn’t any specific rule, regulation, or even Field Directive or instruction that specifically addresses how to handle the timing of the tax deposit due on restricted stock. Rather, it’s the fact that it isn’t addressed as an exception that is most important. Until or unless it is addressed, it’s safest for companies to assume that the income for deposit timing purposes is paid out on the vest date. If the vest date falls on a day when the total tax deposit liability reaches $100,000 or more, the taxes from that vesting event are due to the IRS no later than the following business day.
Penalties
Yes, there are penalties for late deposits. Yes, the IRS does audit this. It is true that there are companies who still do not make timely deposits intentionally because they either can’t figure out how or have determined that the cost of compliance is higher than the potential fines. However, the penalties range from 2% to 15% of the late or unpaid tax amount, which could be very expensive if late deposits are a regular occurrence. Remember that the late deposit is the entire amount due, not just the amount in excess of $100,000. Of course, there are a litany of approaches to try and get the penalties reduces or recalculated. However, even if your company is successful at reducing the amount due it still has to pay someone to negotiate with the IRS and that does not come cheaply, either.
Time Crunch
The reality is that your payroll department needs processing time and your payroll service provider requires processing time. There is pretty much no way for you to send tax amounts to your payroll team after the close of market on the day that restricted stock vesting events have created a next-day deposit liability for your company and actually have that deposit made to the IRS before the close of business the next day.
So, aside from defining the FMV for restricted stock vests as some component of trading value three days prior to the vest, how do you make a timely tax deposit and avoid the penalties? Although it isn’t the only possible approach, the most common method for compliance according to the NASPP’s most recent Quick Survey on Restricted Stock is to estimate the tax liability in advance of the vesting event and then make corrections after the actual tax liability is known.
Companies impose trading blackouts prior to the public release of information that could influence trading decisions on company stock as a safeguard to avoid questionable trading in advance of significant corporate developments. Typically, these trading blackouts will regularly occur in advance of quarterly financial disclosures, but may also be imposed in advance of potential corporate transactions.
There are several situations where the blackout period could be problematic for both the company and employees–other than the obvious inconvenience of having to wait for an open trading window. One of these issues is what to do about restricted stock vests. When a restricted stock unit or award vests, taxes are due on the income from that vest. If trading is absolutely prohibited during the blackout, the issue of how to cover the taxes due becomes a problem. There are, however, a few solutions to consider.
First, you can try to ensure that no vesting ever takes place in a blackout. This means not only timing your vesting, but ensuring the vesting is never modified by a leave of absence or change in status. This also doesn’t help if you have an unscheduled trading blackout. However, this strategy is still a good idea in general even if your company is employing other approaches because it will reduce the number of instances where restricted stock is vesting in a blackout period.
Second, you can require employees to remit shares back to the company to cover the tax obligation, either for every vest or only for vests that take place in a blackout period. It is easier to get your legal counsel and auditors to be comfortable with a required share withholding because there is no market transaction. There are, of course, considerations for this tax remittance such as calculating minimum statutory tax rates and the availability of cash that may make this an undesirable choice for your company.
Third, you can disallow any choice in the tax withholding method. You may or may not want to also have Rule 10b5-1 language built into your grant agreements to help secure an affirmative defense against allegations of insider trading. If you allow a choice it is conceivable that this could be manipulated, particularly if the company permits a choice between paying cash for the taxes and another method. For example, if a person knows that the company stock will fall as a result of an upcoming announcement and happens to have restricted stock vesting, she could choose to sell or trade shares for taxes instead of pay cash knowing that this would be the best price she’ll get for the shares for a while. More likely, however, is that an employee would make that decision based on personal circumstances like an unexpected expense. If an employee changed from paying cash to selling shares and then the stock happened to fall drastically after financial disclosures, there would be a risk of the appearance of making that decision based on inside information. By removing the choice, you help to eliminate the appearance of insider trading.
You may also have a combination of these methods, such as having a default tax payment method, but not permit any change inside a blackout period. This may work for your non-insiders, but may require special attention for your Section 16 insiders. If this isn’t enough for your legal team or auditor, consider requiring Section 16 insiders to include the restricted stock vests as part of a Rule 10b5-1 trading plan.
Also, whatever your approach is, don’t forget to check the verbiage in your insider trading policy. If you will be permitting remitting selling shares to cover taxes in a blackout period, it’s best if your insider trading policy clearly indicates this exception.
Don’t miss our Ask the Experts: Restricted Stock and Unit Awards webcast on May 26th for all your restricted stock questions. In fact, it’s not too late to submit a question for our experts to address!
I recently attended a San Francisco NASPP chapter meeting that featured a presentation by Yana Plotkin of Towers Watson on trends in equity compensation. Yana included some data from the Towers Watson “2010/2011 Report on Long-Term Incentives, Policies and Practices.” Here are a few highlights:
Portfolio Approach
More companies are granting at least two types of awards–73% of respondents indicated this practice, an increase of 10% from 2009. Larger companies are more likely to utilize three types of awards than smaller companies.
Pay for Performance
Towers Watson is seeing a strong trend towards performance awards, which are now the second most common type of long-term incentive offered by survey respondents, ahead of stock options. Full value shares (RS/RSUs) were the most common type of LTI offered. In the NASPP’s 2010 Stock Plan Design and Administration Survey (co-sponsored by Deloitte), we also saw a strong trend towards performance awards, although we did not see them outpace the usage of stock options.
Full Value Awards
Towers Watson reports that full value awards have outpaced stock options for grants to employees at the manager/individual contributor level. In the NASPP survey, we also saw an increase in full value awards and even performance awards to employees at these levels, but many respondents were still granting stock options.
Award Sizes
For employees earning under $200,000, award sizes (as a percentage of salary) remained flat from 2009 to 2010 in the Towers Watson survey. But for employees at higher salary levels, award sizes increased, although not quite to 2008 levels.
Award Design
In terms of performance award design, Yana mentioned that they are seeing interest in awards with shorter performance periods, e.g., two years, and some sort of trailing service requirement after the performance goals have been met. I am a proponent of this design; for executives, it helps facilitate compliance with ownership requirements and clawback provisions and, for everyone, it can simplify tax withholding procedures.
Interestingly, Towers Watson reports that 35% of respondents to their survey measure performance relative to peers or a market index. For the NASPP survey, this was about the same (41% of respondents). Both surveys also agree on how commonly TSR is used as a performance metric (25% of respondents in the Towers Watson survey, 29% of respondents in the NASPP Survey). Yana indicated that Towers Watson is seeing more companies use TSR than in the past and that certainly aligns with the buzz I am hearing from compensation consultants, etc.
Performance Awards Are the Future
The biggest takeaway I got from Yana’s presentation is that the Say-on-Pay, the disclosures required under the Dodd-Frank Act, and shareholder expectations are making performance awards the hottest thing going today in terms of equity compensation. If you aren’t fully up to speed on them, don’t miss the pre-conference session, “Practical Guide to Performance-Based Awards,” to be held on November 1 in San Francisco, in advance of the NASPP Conference. Register by May 13 for the early-bird discount!
Online Fundamentals Starts in Two Weeks–Don’t Miss It! The NASPP’s acclaimed online program, “Stock Plan Fundamentals,” begins on April 14. This multi-webcast course covers the regulatory framework and administrative best practices that apply to stock compensation; it’s a great program for anyone new to the industry or anyone preparing for the CEP exam. Register today.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Register for 19th Annual NASPP Conference (November 1-4 in San Francisco). Don’t wait; the early-bird rate is only available until May 13.
Today we have a fabulous installment in our Ask the Experts series of webcasts, “Tax Reporting for Stock Compensation.” I thought I’d shake things up and take a look at tax filing from the employee’s perspective.
Income and capital gains associated with equity compensation can be pretty daunting for the average employee. These are my top five reporting mistakes. Your personal top five may differ based on your company’s equity compensation program and the education you provide around taxation.
No Schedule D
Employees who do not understand capital gains at all could have this problem when it comes to reporting any sale. However, it’s much more common when there is a cashless exercise or sell-to-cover transaction, particularly if the company defines the FMV as the sale price. The employee may know that the income is reported and the associated taxes are withheld by the company, assume that the exercise (or vest) and the sale are the same transaction because they happened simultaneously and not even consider the need to report the sale. Alternatively, the employee may understand that the sale price and the FMV on the exercise or vest date is the same and assume that there is nothing to report.
Partial Sale Confusion
When an employee sells only some of the shares from an option exercise or restricted stock vest, it is surprisingly easy to misunderstand what should go on the Schedule D. This is more of a problem for employees doing a sell-to-cover transaction, but can happen even if the sale is from held shares. When referencing the exercise or vest statement, the employee reports all exercised/vested shares as being sold and/or reports the cost basis for the total shares acquired as the cost basis for the shares that were sold. The most likely result is a calculation on the Schedule D that shows a sizable capital loss on the sale. Hopefully, cost basis reporting will eventually help prevent this error.
ESPP – Qualifying Disposition
Qualifying dispositions of ESPP shares are confusing because there is still (in most cases) an income element if there was a discount at purchase. Unfortunately, the most common mistake for employees is not reporting that ordinary income when or if the company fails to do so. The income element of a qualifying disposition is the lesser of the discount as if the purchase took place at the beginning of the offering period (which should now be reported to employees on Form 3922) or the spread between the purchase and sale prices. Failure by the company to report that income doesn’t exempt the employee from reporting it.
The exception is that when the sale price is lower than the purchase price, there is no ordinary income on the qualifying disposition–and that means that employees in this unhappy situation are actually more likely to report it correctly.
Reporting Gain Twice
The most common reason for this error is a misunderstanding of restricted stock vests. The employee reports $0 as the cost basis, effectively reporting the spread at vest twice: once as income and once as capital gains. This can happen with options as well if the employee uses the exercise price as the cost basis for the shares when reporting the sale. Double reporting may also happen if an employee doesn’t realize that the income resulting from a disqualifying disposition of ISO or ESPP shares is already included in the Form W-2 (assuming your company is aware of the disposition and reports it correctly).
Failure to Report an ISO Cash Exercise
Employees with ISO grants have a host of tax concepts to familiarize themselves with, but none is quite as mysterious as the issue of AMT. AMT is such a nebulous issue for most people that it is often given only a brief explanation in equity compensation communications.
Many employees hear the words “no income” and assume that is synonymous with “no reporting obligation.” However, any exercise of ISOs (assuming the shares are held at least through the remainder of the tax year) means that the employee must complete and attach Form 6251 to their tax return, even if she or he is not subject to AMT. If the employee is subject to AMT and fails to report the exercise, this is (of course) potentially a much bigger issue than if the employee simply fails to prove she or he is not subject to AMT.
So, what’s the top five for your company? If you don’t know, start thinking about it now.
Here’s a better question: How do you figure out what mistakes your employees are making? First, anything that you don’t personally understand 100% is bound to be even more difficult for employees. Also, anything comes to you as a question is a potential for a reporting problem. Keep your ears open for horror stories–if it’s happened to one person, it could happen to your employees. Finally, if you’re really ambitious, you could survey a sample of your employees with example scenarios to see if they know how to report different transactions.