Leap year can make things complicated. For example, if you use a daily accrual rate for some purpose related to stock compensation, such as calculating a pro-rata payout, a tax allocation for a mobile employee, or expense accruals, you have to remember to add a day to your calculation once every four years. Personally, I think it would be easier if we handled leap year the same way we handle the transition from Daylight Saving Time to Standard Time: everyone just set their calendar back 24 hours. Rather than doing this on the last day of February, I think it would be best to do it on the last Sunday in February, so that the “fall back” always occurs on a weekend.
In a slightly belated celebration of Leap Day, I have a few tidbits related to leap years and tax holding periods.
If a holding period for tax purposes spans February 29, this adds an extra day to the holding period. For example, if a taxpayer buys stock on January 15, 2015, the stock must be held for 365 days, through January 15, 2016 for the sale to qualify for long-term capital gains treatment. But if stock is purchased a year later, on January 15, 2016, the stock has to be held for 366 days, until January 15, 2017, to qualify for long-term capital gains treatment. The same concept applies in the case of the statutory ISO and ESPP holding periods–see my blog entry “Leap Year and ISOs,” (June 23, 2009).
Even trickier, if stock is purchased on February 28 of the year prior to a leap year, it still has to be held until March 1 of the following year for the sale to qualify for capital gains treatment. This is because the IRS treats the holding period as starting on the day after the purchase. Stock purchased on February 28 in a non-leap year has a holding period that starts on March 1, which means that even with the extra day in February in the year after the purchase, the stock still has to be held until March 1. See the Fairmark Press article, “Capital Gains and Leap Year,” February 26, 2008.
Ditto if stock is purchased on either February 28 or February 29 of a leap year. In the case of stock purchased on February 28, the holding period will start on February 29. But there won’t be a February 29 in the following year, so the taxpayer will have to hold the stock until March 1. And if stock is purchased on February 29, the holding period starts on March 1. Interesting how none of these rules seem to work in the taxpayer’s favor.
The moral of the story: if long-term capital gains treatment is important to you, it’s not a bad idea to give yourself an extra day just to be safe–especially if there’s a leap year involved.
To start off the new year, I have a few reminders for Section 6039 filings for ISO and ESPP transactions.
Deadlines
Participant statements need to be furnished by February 2, 2015 (normally the deadline is January 31, but that’s a Saturday). Paper returns need to be filed with the IRS by March 2 (February 28, the normal deadline, is a Saturday) and electronic returns need to be filed by March 31 (this deadline applies regardless of whether electronic filing is on a mandatory or voluntary basis).
Extensions
It’s easy to get an extension for filing the returns with the IRS; log into the IRS Fire system and complete Form 8809. So long as you do this by the deadline, you get an automatic 30-day extension—no questions asked. It is harder to get an extension for the participant statements. You can’t use Form 8809 for this; you have to write a polite letter to the IRS explaining why you need the extension and hope that they grant it to you. See pg 13 of the “General Instructions for Certain Information Returns” for details of what you need to say in the letter and where to send it. The extension is not automatic, so you’d best get on this right away if you think you’ll need one.
Substitute Participant Statements
You can create a substitute statement for participants that lists all their transactions on one page, rather than a separate form for each transaction. You still have to use the IRS terminology, but you can include your own statement that explains what all the words mean (or even annotate the statement itself). But you can’t include any slogans or taglines on the form and if you are going to include your company logo, you have to comply with specific guidelines explained in IRS Publication 1179 (see pg 6). The IRS is serious about this—they are worried your logo might make the form look like junk mail—so it might be best to skip the logo.
Rounding
Shares and dollar amounts have to be rounded in electronic filings (to the nearest whole share or penny, respectively). The IRS says to use a true round for share amounts (that’s rounding down for .4 and under, up for .5 and above). They don’t specify how dollar values should be rounded but since they recommend a true round for share amounts, it’s probably reasonable to use the same approach for dollar values (that’s also how dollar values are rounded on other tax forms (e.g., tax returns). But other approaches might be reasonable as well; I’m fairly certain the IRS isn’t that concerned about how you round. Just be consistent.
Employee ID Number
This needs to be the employee’s tax ID number. Also, you can’t truncate it or mask it on the participant statements. The IRS eventually checks to make sure the number is correct and you’ll have to pay a fine if it is wrong. But they won’t get around to checking until you are in the maximum penalty period. So be smart and run a TIN matching program on your returns before you file them with the IRS.
Account Number
For our purposes, think of this as a transaction number. You can use any system you want to come up with the number (and it can include letters as well as numbers), but you need to assign a unique number to every transaction reported. If you later have to file a correction, this number is how you will identify the transaction being corrected.
Names
Don’t include any special characters in employee names other than hyphens and ampersands.
Just a Few Filings?
Even though you only have a handful of filings, you cannot download the form from the IRS website and fill it out or gin up a form that looks similar in Word and use that to file your returns. The IRS has all sorts of fussy requirements for returns filed on paper, including that they be printed on special paper with special ink. If you don’t want to pay a third party to help with this, you have to order the paper forms from the IRS and wait for them to send them to you. Then you need to scare up a typewriter or print very very neatly. There are tools that are quite affordable that can be used to file even just a handful of forms—personally, I think this approach would be easier than finding a typewriter. Email me and I can send you a list.
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.
When the NASPP conducted our quick survey on Section 6039 back in October, there were a lot of “undecided” responses. So we conducted another survey last month. The results are in and decisions have been made.
Filing Section 6039 Returns with the IRS
Electronic filing is the clear winner here, with 78% of respondents filing the returns for ISOs electronically and a landslide 90% filing electronically for their ESPP transactions. Surprisingly, 5% of respondents are planning to file ESPP returns on paper; they must be from very small companies or have very low participation rates in their ESPP to manage this. I can’t imagine trying to file the returns on paper–my handwriting would never pass muster with the IRS and I have no idea where to scare up a typewriter these days.
In terms of getting the job done, the trend is towards outsourcing. Only 23% of respondents are preparing and filing in-house for ESPP returns; more–41%–are handling the job in-house for ISOs. When we asked this question back in October, 29% were undecided, but now that the deadline looms near, almost everyone has made a decision: only 2% remain undecided about outsourcing for ISO returns and only 5% are undecided for ESPP returns.
Participant Statements
More companies than I expected were planning on distributing copies of the actual Forms 3921 and 3922 to their employees: 32% of respondents for ISOs and 26% of respondents for ESPPs. Of course, as I’m sure all of these folks know, the IRS did not make the forms available in time for this, so these folks most likely ended up distributing substitute statements (unless they requested an extension from the IRS).
Most of the rest of the respondents distributed substitute statements that aggregated multiple transactions on one page: 58% of respondents for ISOs and 64% of respondents for ESPPs.
Back in October, 50% of respondents were on the fence about including an explanatory letter with the statements. I’m pleased to see that the majority decided to go with the more-information-rather-than-less approach: 86% of respondents ended up including an explanatory letter with ISO statements and 88% did so for ESPP statements.
Decisions went the opposite way on distributing the statements electronically. 24% of respondents were considering this back in October, but the majority (90% for ISO statements, and 87% for ESPPs) ended up distributing the statements on paper. Not surprising, given the onerous requirements for electronic distribution. It will be interesting to see how many companies move towards electronic distribution in the next few years.
More Information
For everything you need to know about Section 6039, check out the NASPP’s Section 6039 Portal.
A More Social NASPP The NASPP is networking socially: you can now follow us on Twitter or like us on Facebook. We’ll be posting announcements whenever we post new content on Naspp.com–it’s a great way to keep up with all the content we have on the website.
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.
Although incentive stock options (ISOs) were created under the Economic Recovery Tax Act of 1981, many of the ISO characteristics and limitations as we know them now were a part of the Tax Reform Act of 1986. This includes the $100,000 limitation. However, we do still see questions about the application of the $100,000 limit come up periodically in our Discussion Forum. So, I’d like to take this opportunity to elaborate a bit on the ISO $100,000 limitation.
The $100,000 Limitation
Under Section 422(d) of the Internal Revenue Code, the total aggregate fair value of ISOs that become exercisable for an individual employee for the first time within a calendar year under all plans may not exceed $100,000. The fair value of the shares for the purposes of determining the aggregate value of shares within a calendar year is the value as of the grant date. Any shares that become exercisable within a calendar year that cause the value of the aggregate number of shares vesting to exceed $100,000 will no longer qualify for preferential tax treatment as ISO shares.
The $100,000 limitation applies to the shares as the first become exercisable. This distinction in the language makes the most sense when considering an ISO grant with an early exercise provision. You calculate the value of the shares as they first become exercisable, regardless of when they vest or are actually exercised. If the entire grant is eligible for early exercise, then the full value of the grant is applied against the $100,000 limitation for the year in which it was granted.
However, it is not a common practice for companies to include early exercise in an ISO grant. So, in most cases, the shares “become exercisable for the first time” per the vesting schedule. For these grants, only the shares that are vesting (becoming exercisable) in any given year are included in the calculation. The full value of the grant, or the number of shares in the grant, is not directly relevant.
For example, an ISO grant of 40,000 shares granted on a day when the FMV is $10 would have a total value of $400,000, regardless of whether or not the shares are exercised or how much income is realized from any transaction(s). Although the full value of this grant exceeds $100,000, this entire grant could be an ISO if only 10,000 shares vest and become exercisable each year and the employee holds no other ISOs that become exercisable in the same years.
Keep in mind that the ISO grants under all plans of your company, parent company, and subsidiaries should be aggregated together to determine the value of the shares that become exercisable. If you are using a stock plan administration software that does not aggregate between plans, or if you track grants from a plan or subsidiary outside of your stock plan administration software, then you will need to pay special attention to the $100,000 limitation.
When the ISO Grant Exceeds $100,000
Portions of ISOs that exceed the $100,000 limitation are taxed as if they are non-qualified stock options. You will need to withhold taxes and report the gain on any exercise of shares that exceeds the limit. This includes your company’s matching FICA and FUTA payments (if applicable). Penalties for not withholding the appropriate taxes can be up to 100% of the amounts that should have been withheld, can include interest and other administrative fees, and, in extreme cases, can involve criminal penalties. Additionally, by not properly reporting the income realized by employees upon exercise, your company won’t be able to claim the tax deduction on that income.
This does not mean that you need to have two separate grants approved and awarded to your employee. Even if you know that an ISO will exceed the $100,000 limitation, it should be approved as one ISO grant. Most stock plan administration softwares will bifurcate the grant for you, but this should be for tracking purposes only.
What to Include in Grant Agreements
All ISO grant agreements should include language indicating that an exercise of any portion of the grant exceeding the $100,000 limitation will be subject to income reporting and withholding. This allows employees to make informed decisions about their exercise strategies for their ISOs and avoids unpleasant surprises when they do engage in option exercises. Additionally, including this language even if you don’t believe any portion of the grant exceeds the limitation will help to protect the company if the initial calculation turns out to be incorrect.
Cancellations
The Final ISO Regulations address the cancellation of incentive stock options. If an ISO grant is cancelled prior to the calendar year in which it first becomes exercisable, then the value of the shares no longer needs to be counted against the $100,000 limitation.
This means that if there is a more recent ISO grant held by the employee that exceeded the $100,000 limitation prior to the cancelation, then a larger portion of that grant may now be treated as an ISO. Or, if a new ISO is granted to the employee, then the cancelled grant should not impact the $100,000 limitation as it is applied to that new grant. You may not, however, go back in time and change a non-qualified stock option to an ISO because of the cancellation.
The trickiest part of this rule is the case of a grant that is cancelled prior to vesting, but within the calendar year of the vest date. The value of the shares that would have vested still counts toward the $100,000 limitation for that calendar year. For example, if a grant should vest in October, but is cancelled in the preceding June, the value of that vest must still be included in the calculation for that year. This is especially important if your company is executing an options exchange program that includes unvested incentive stock options.
Accelerations
If the vesting/exercisability of an ISO is accelerated, then the application of the $100,000 limit must be reviewed for the new vesting schedule. Grants should be considered in the order in which they were granted. Therefore, if multiple grants are accelerated simultaneously (in the case of an acquisition, for example), you should review the new vesting schedules beginning with the oldest grant first.