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.
At the same time that the IRS released regulations designed to clarify which restrictions constitute a substantial risk of forfeiture under Section 83 (see my blog entry “IRS Issues Final Regs Under Section 83,” March 4), a recent tax court decision casts doubt on the definition in the context of employees that are eligible to retire.
Background
As my readers know, where an employee is eligible to retire and holds restricted stock that provides for accelerated or continued vesting upon retirement, the awards are considered to no longer be subject to a substantial risk of forfeiture, and, consequently, are subject to tax under Section 83. This also applies to RSUs, because for FICA purposes, RSUs are subject to tax when no longer subject to a substantial risk of forfeiture and the regs in this area look to Section 83 to determine what constitutes a substantial risk of forfeiture.
Although there’s usually some limited risk of forfeiture in the event that the retirement-eligible employee is terminated for cause, that risk isn’t considered to be substantial. As a practical matter, at many companies just about any termination after achieving retirement age is treated as a retirement.
Austin v. Commissioner
In Austin v. Commissioner however, the court held that an employee’s awards were still subject to a substantial risk of forfeiture even though the only circumstance in which the awards could be forfeited was termination due to cause. In this case, in addition to the typical definition of commission of a crime, “cause” included failure on the part of the employee to perform his job or to comply with company policies, standards, etc.
Implications
Up until now, most practitioners have assumed that providing for forfeiture solely in the event of termination due to cause is not sufficient to establish a substantial risk of forfeiture, regardless of how broad the definition of “cause” is. Austin seems to suggest, however, that, in some circumstances, defining “cause” more broadly (e.g., as more than just the commission of a crime) could implicate a substantial risk of forfeiture, thereby delaying taxation (for both income and FICA purposes in the case of restricted stock, for FICA purposes in the case of RSUs) until the award vests.
On the other hand, there are several aspects to this case that I think make the application of the court’s decision to other situations somewhat unclear. First, and most important, the termination provisions of the award in question were remarkably convoluted. So much so that resignation on the part of the employee would have constituted “cause” under the award agreement. There were not any special provisions relating to retirement; all voluntary terminations by the employee were treated the same under the agreement. In addition, the employee was subject to an employment agreement and the forfeiture provisions of the award were intended to ensure that the employee fulfilled the terms of this agreement.
Finally, the decision notes that, for a substantial risk of forfeiture to exist, it must be likely that the forfeiture provision would be enforced. I think that, for retirees, this often isn’t the case–the only time a forfeiture provision would be enforced would be in the event of some sort of crime or other egregious behavior. Termination for cause is likely to be met with resistance from the otherwise retirement-eligible employee; many companies feel that, with the exception of circumstances involving clearly egregious acts, it is preferable to simply pay out retirement benefits than to incur the cost of a lawsuit.
Never-the-less, it is worth noting that 26% of respondents to the NASPP’s recent quick survey on retirement provisions believe that awards held by retirees are subject to a substantial risk of forfeiture.
As we head into the year-end season, I know many of you are going to be looking at your year-end communications to see which parts need to be updated. I thought it might be a good time to remind you that the regulations governing cost-basis reporting for shares acquired under stock options and ESPPs are changing as of January 1.
What’s Changing?
Beginning January 1, 2014, brokers will no longer be allowed to include the compensatory income recognized in connection with shares acquired under an option or ESPP in the cost basis reported on Form 1099-B. Instead, brokers are required to report only the purchase price as the basis and employees will have to report an adjustment on Form 8949 to correct the gain or loss they report on their tax return (see my blog entry, “Final Final Cost-Basis Reporting Regs,” May 7, 2013)
Until next January, brokers can voluntarily choose to include this income in the basis, but are not required to do so. Thus, we are going from a situation in which the cost basis reported on Form 1099-B is actually sometimes correct to a situation in which it will virtually always be wrong. Ten points if you can name a scenario in which the purchase price is actually the correct basis for shares that were acquired under a stock option or ESPP.
[Note that, technically, the regs will only apply to options acquired after January 1, 2014, but we think most brokers will apply them to all shares acquired after the date, even if the shares were acquired under an option granted prior to that date.]
How Does This Impact Forms 1099-B for Sales in 2013?
That is a good question! Right now, we are in a transition period. Brokers can continue to report under the old rules for 2013 or they can voluntarily change over to the new rules. A good first step to reviewing your year-end employee communications will be to check in with your brokers on this, so you know what they are planning to do and can adjust your communications appropriately, if necessary.
Does this Impact Restricted Stock and Units?
In most cases, it will not have any impact on restricted stock or RSUs. Arrangements in which employees don’t pay cash for the shares aren’t covered by the regulations so brokers don’t have to report any basis for them at all on Form 1099-B. That still applies under the regulations going into effect as of January 1, 2014. So I expect that most brokers aren’t reporting a basis for RS/RSUs now and still won’t report a basis once the new regs go into effect.
The only exception will be those brokers that are currently reporting a cost basis on a voluntary basis for RS/RSUs (which I understand to be few and far between). Brokers can still voluntarily report a basis for shares acquired under RS/RSUs, but for shares acquired after January 1, 2014, that basis cannot include any of the compensatory income recognized in connection for the award. In other words, the broker can still report a basis but the reported basis has to be $0. I hope that brokers don’t do that–I think it would be better to not report a basis at all than to report an incorrect basis of $0.
Can the NASPP Help?
Why, yes, we can! Our Cost-Basis Reporting Portal includes some great sample materials to help you explain all of this to your employees. We have sample tax forms, flow charts, and extensive FAQs. Check it out today and keep an eye on the portal; we will update it as new tax forms become available from the IRS.
Back in May, the Senate Finance Committee published a report of possible ways that the tax treatment of employee benefits might be changed as part of the tax reform project that the Committee is working on. Today I take a look at some of the strategies they are considering.
These strategies were suggested by witnesses at hearings that the Committee held, as well as by various bipartisan commissions, tax policy experts, and members of Congress. Not all members of the Committee agree on which direction constitutes “reform” for the tax code (e.g., whether tax reform should reduce the deficit or lower tax rates), so some of the ideas are contradictory. It’s sort of a grab bag of tax reform.
Section 162(m)
The report suggests expanding the group of employees whose compensation is subject to the deduction limit under Section 162(m); applying the limit to all stock compensation, including stock options; and reducing the maximum deduction companies are entitled to. If this all sounds familiar, it’s because it’s already happening for health insurance providers (see my blog “CHIPs: More Than a Cheesy TV Show“). If Congress goes in this direction, I have to believe that the IRS might take it one step further and implement the allocation rules that they have proposed for health insurance providers as well. This could have a pretty significant impact on stock plan administration.
An alternative suggestion to all of these ideas is to repeal Section 162(m) altogether. With all the media outrage over executive compensation, I’d be pretty surprised if this is the direction Congress takes. But, never say never–I’ve been surprised many times in my life.
Section 409A and Deferred Compensation
Despite the draconian rules under Section 409A, deferred compensation continues to be a point of controversy. The report suggests requiring all non-qualified deferred compensation to be taxed when earned. Which would make it “nondeferred compensation” or just regular compensation. Essentially the ability to defer taxation on any compensation outside of a tax-qualified plan would be eliminated. If deferrals aren’t eliminated entirely, then perhaps the amount of compensation that can be subject to deferral might be limited.
Or, rather than eliminating the ability to defer compensation, an alternative suggestion is to require companies to pay a special investment tax on earnings attributable to non-qualified deferred compensation. If the compensation hasn’t been paid out, then the company is presumably earning a return on the unpaid amounts and could be paying a special tax on that return. I can only begin to imagine the complicated rules that would apply to stock compensation under this approach. I foresee lots of NASPP Conference sessions.
The report also suggests repealing Section 409A altogether, repealing it for only private companies, or repealing the 20% penalty.
Stock Options
As noted above, the report suggests making stock options subject to Section 162(m) without exception. Use of full value awards had already outpaced usage of stock options–this would be just another nail in the coffin.
The report also suggests eliminating incentive stock options; I can’t see many public companies shedding a tear over this, but private companies might be bummed. Hopefully this idea wouldn’t be extended to include ESPPs, however.
And, you guessed it–Senator Levin’s proposal (“Senator Levin, Still Trying“) on limiting corporate tax deductions for stock options to the amount of expense recognized for them rears its ugly head in the report as well.
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.
For today’s entry, I have several follow-up items relating to a few of my recent blog entries.
Your Favorite Words 10 pts. to Sheila Jan of Life Technologies for accepting my challenge in “Holiday Fun” (December 18, 2012) and submitting her own favorite word with an example of how it might be used at a holiday gathering. Sheila’s submission:
Tranche: I’m going to help myself to a second tranche of the mashed potatoes!
A Little More on Excess Withholding Susan Eichen of Mercer reminded me that allowing employees to use share withholding to cover more than just the statutorily minimum required tax payment will trigger liability treatment under ASC 718, even if the proscribed W-4 procedures are followed (see my blog entry from last week, “Supplemental Withholding“). If the difficulty of the W-4 withholding process wasn’t enough, this makes one more reason to prohibit excess withholding for restricted stock and units (for NQSOs, where shares are generally sold on the open market, rather than withheld, to cover taxes, this is less of a concern).
Proposed Regs on New Medicare Tax The IRS has issued proposed regs on withholding the additional 0.9% Medicare tax that applies to wages in excess of $200,000 for individuals/$250,000 if married filing jointly. No surprises here, the procedures are as I described them back in August (“The Supreme Court and Stock Compensation“):
The company withholds the additional 0.9% tax on any wages in excess of $200,000 that are subject to Medicare, regardless of the employee’s filing status or wages paid to his/her spouse.
Any overpayments or underpayments as a result of the employee’s filing status/spousal income will be sorted out on the employee’s tax return. The company has no obligations here.
Employees can’t request that the company withhold additional Medicare tax (for example, if they have received wages of less than $200,000 but know that their wages, when combined with their spouse’s wages, will exceed $250,000). In this case, employees should submit a new Form W-4 to increase their withholding for federal income tax purposes. This will then offset the deficit in Medicare withholding when they file their tax returns.
Follow-up on Lawsuits Targeting Stock Plan Proposals On November 6 (“Martha Steward and Your Proxy Statement“), I blogged about a new type of shareholder lawsuit that seeks to extract plaintiffs’ attorney fees from companies by alleging that the disclosures in connection with their stock plan proposals (e.g., adopting a new stock plan or allocating shares to an existing plan) are inadequate. There now have been over 30 of these suits filed, with no end in sight as proxy season ramps up. We’ve posted a new alert, “Shareholder Lawsuits Target Stock Plan Proposals,” that collects several law firm memos on the suits as well as a interesting commentary on them from Stanford (“Shareholder Lawsuits: Where Is the Line Between Legitimate and Frivolous?“). It’s worth your time to catch up on this issue.
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.
Back in November, the IRS proposed additional regulations on cost-basis reporting. These regulations primarily relate to the third phase of implementation of the reporting requirements, which applies to options and debt securities. But there are a few areas in the regulations that are of interest to stock plan professionals.
You Win Some: Sale Proceeds to Be Reported Net of Fees
It will come as a relief to anyone that has reviewed any of my cost-basis reporting flow charts to know that the regulations would require all brokers to deduct the transaction fees from the sale proceeds reported on Form 1099-B. In my humble opinion, this is a requirement that is long overdue. The fees are usually a small amount, sometimes immaterial, but trying to explain how they are included in the tax return when the broker doesn’t deduct them from the sale proceeds (or worse, when you don’t know whether the broker has deducted them) is almost an insurmountable challenge. If the IRS adopts these regulations and requires all brokers to report the sale price net of fees, I’ll be able to reduce my 6039 flow charts from 14 pages down to a mere five pages.
You Lose Some (or The More Things Change, the More They Stay the Same)
Readers of prior NASPP blog entries (see “Four Questions to Ask Your Brokers,” Nov. 30, 2010) know that the current regulations, which have been in effect since January 1, 2011, allow brokers to exclude the compensation component from the reported cost basis until 2013 for shares acquired under stock compensation arrangements. The newly proposed regs not only retain this exclusion but remove the limitation that it is only available until 2013. Thus, it doesn’t look like brokers will be required to report the full basis of shares acquired under stock compensation arrangements for the foreseeable future. I guess the silver lining here is that now you will get more than two years of use out of all those great educational materials you’ve been creating to explain this to your employees.
The regulations state that the IRS is contemplating requiring brokers to indicate whether the shares sold were acquired under a compensatory arrangement on the Form 1099-B (and in transfer statements). Frankly, I’m not really sure this helps much. For most employees, even executives, the only stock of their employer that they own was acquired through compensatory arrangements. When they sell their employer’s stock, I think they probably already know that the stock was acquired through a compensatory arrangement.
The proposed regs also state that the IRS will update the instructions to Schedule D and Form 8949 to clarify that the basis for shares acquired under compensatory arrangements may be incorrect. I have to admit that I’m not confident this is going to help much, especially given how clear the instructions included with Forms 3921 and 3922 are.
I will be hauling my cost-basis reporting soapbox to the February Silicon Valley and Sacramento chapter meetings, where Larry Reynolds of E*TRADE and I will provide a just-in-time overview of cost basis and the new Forms 1099-B. I hope to see you there!
Get in the Game If you haven’t been playing the NASPP Question of the Week Challenge, now is a great time to join the game. A new challenge just started and you have until Feb 3 to answer all the questions posted in January (after that, you only have a week to answer each question). All the cool kids are doing it–sign up 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.
On June 23, the IRS and Treasury proposed new regulations under Section 162(m) relating to the requirements for options and SARs to be considered performance-based compensation and the transition period for newly public companies.
Not-So-Surprising Proposed Regs for Section 162(m) (Well, Maybe a Little Surprise for IPO Companies)
Section 162(m) limits the tax deduction public companies can take for compensation paid to specified executive officers to $1 million per year. As I’m sure you all know, however, performance-based compensation is exempt from this limitation.
The recently issued proposed regs are not nearly as controversial as the IRS’s 2008 surprise ruling on 162(m), but are still worth taking note of–especially since, as the Morgan Lewis memo we posted on the proposal points out, some of these clarifications are the direct result of compliance failures the IRS has encountered during audits.
Stock Options and SARs
Normally, for compensation to be considered performance-based, it must meet a number of rigorous requirements. At the time that Section 162(m) was implemented, however, at-the-money stock options and SARs were considered inherently performance-based, so the requirements applicable to them are significantly more relaxed (a decision I can only imagine regulators regret today, given current public sentiment towards stock options). The primary requirements are that the options/SARs be granted from a shareholder approved plan, individual grants are approved by a committee of non-employee directors, the exercise price is no less than the FMV at grant, and the plan states the maximum number of shares that can be granted to an employee during a specified period.
The proposed regs clarify that, for this last requirement, the plan must state a per-person limit; the aggregate limit on the number of shares that can be granted under the plan is insufficient (although, the stated per-person limit could be equal to the aggregate limit).
Disclosure
For all performance-based compensation, including stock options and SARs, the regs already require that the maximum amount of compensation that may be paid under the plan/awards to an individual employee during a specified period must be disclosed to shareholders. For stock options and SARs, it’s pretty hard to determine what the maximum compensation is, since this depends on the company’s stock price over the ten years or so that the grant might be outstanding. The proposed regs clarify that it is sufficient to disclose the maximum number of shares for which options/SARs can be granted during a specified period and that the exercise of the grants is the FMV at grant.
Newly Public Companies
For a limited “transition” period, Section 162(m) doesn’t apply to arrangements that were in effect while a company was privately held (provided that the arrangements are disclosed in the IPO prospectus, if applicable). This transition period ends with the first shareholders’ meeting at which directors are elected after the end of the third calendar year (first calendar year, for companies that didn’t complete an IPO) following the year the company first became public (unless the plan expires, is materially modified, or runs out of shares or the arrangement is materially modified before then).
For stock options, SARs, and restricted stock, the current regs are even more generous–any awards granted during this transition period are not subject to 162(m), even if settled after the transition period ends. The proposed regs don’t change this, but they do make it clear that RSUs and phantom stock are not covered by this exemption. My understanding from some of the memos we’ve posted in our alert on this is that this reverses a couple of private letter rulings on this issue (see the Morrison & Foerster, Morgan Lewis, and Edwards Angell Palmer & Dodge memos). The current regs specifically state that the exemption applies to stock options, SARs, and restricted stock, but are silent as to the treatment of RSUs and phantom stock–providing the IRS/Treasury with the leeway to exclude them now.
Subtle Changes
Several of the changes are pretty subtle–so subtle that when comparing the proposed regs to the current regs, I couldn’t figure out what had changed. So I used the handy-dandy document compare feature in Word to create a redline version of the new regs, which I’ve posted for the convenience of NASPP members.
Chickens, Stock Plan Administrators, and Whiskey The author of the joke that appeared in last week’s blog entry is John Hammond of AST Equity Plan Solutions (and poet laureate of the NASPP blog). Ten points to Erin Madison of Broadcom, who was the only person to email me the correct the answer. I can’t believe no one else figured it out!