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.
Last week I blogged about the SEC’s agenda for this year, which includes a heavy focus on continued enforcement actions. While this is certainly one area on our radars, I’m reminded that there are other areas of “action” that could cast scrutiny on our practices. One such area is litigation. A few months ago, I blogged about one type of litigation that had taken hold – the shareholder driven lawsuits that challenged proxy disclosures. What I didn’t explore was all of the other areas where we’ve seen “action” in the form of enforcement or litigation. In today’s blog I’ll explore other areas (including some you may not have thought about) that have been the subject of a lawsuit.
I had a great aid in preparing this blog. Thanks to Executive Pay and Loyalty, I was able to access a “cheat sheet” that literally organizes stock award litigation by topic, complete with corresponding court cases. The full document is available on our web site.
Litigation Lessons Learned
What lessons have been learned from litigation in recent years? Here are a few of them:
Termination of Employment: This is a sensitive area, one that I’m betting is ripe for litigation. Not so much because an employee is terminated (that’s more of an HR concern), but if the employee misses the opportunity to exercise vested in-the-money stock options, they may come forward wanting restitution or compensation. The filing of a lawsuit doesn’t automatically make it a valid claim, or mean that the company will lose. We are reminded that sometimes there are “nuisance” cases – particularly if an employee simply “missed” the key pieces of information that would explain post termination provisions. Whether or not the claim is a solid one, any litigation takes time, money and focus away from more constructive activities. I see a couple of ways to minimize litigation opportunities in this situation – one is an “auto-exercise” of the vested stock option (See my recent blog on “The Case for Auto-Exercise”, January 16, 2014); another is to proactively send terminated employees the key documents that remind them of post employment provisions.
Defining Plan Terms: The more defined your plan terms are, the better. According to Executive Pay and Loyalty, it is better to have a longer plan document with explicit definitions than not. Litigation involving ambiguities is likely to be resolved against the employer. If you’re seeing a plan provision that is repeatedly the subject of questions or challenge from employees, this may be something to raise to your legal counsel to see if further clarification is needed.
Option Expiration During Blackout Period: The cheat sheet I mentioned suggests that employers be wary of stock options that expire during a blackout period. It is a best practice for plans to expressly address this in order to avoid angering employees and former employees who lose value due to a black-out period that interferes with their final time to exercise a stock option. I have actually seen several plan documents that are silent on this issue, so if your plan is up for amendment or overhaul, this may be a good area to document a defined practice. If it’s not in the plan document, at minimum identify a consistent approach or procedure for options expiring during a blackout and communicate it to employees in writing.
The Bottom Line
All of the issues described above have been the subject of court cases, and the suggestions I outlined are based on the result of those lawsuits. For more information on specific cases and a list of the other areas affected by litigation (including 162(m), and director compensation), check out the full Stock Plan and Award Litigation: Risk Management Checklist I mentioned as the basis for this blog.
We know we’re entrenched in a world that is highly regulated, scrutinized, audited and evaluated. The more we evolve our practices to be preventative, the better equipped we’ll be to stand up to investigations, enforcement actions, lawsuits and other nuisances.
As is often the case at this time of the year, a lot of tax related questions have been popping up in the NASPP Q&A Discussion Forum lately. For today’s blog entry, I try to quickly answer some of the questions I’ve seen the most frequently.
Former Employees You have to withhold taxes on option exercises by and award payouts to former employees and report the income for these stock plan transactions on a Form W-2, no matter how long it has been since they were employed by the company. The only exceptions are:
ISOs exercised within three months of termination (12 months for termination due to disability).
RSAs paid out on or after retirement (because these awards will have already been taxed for both income tax and FICA purposes when the award holders became eligible to retire). Likewise, RSUs paid out on or after retirement that have already been subject to FICA are subject to income tax only.
If the former employees did not receive regular wages from the company in the current year or the prior calendar year, US tax regs require you to withhold at their W-4 rate, not the supplemental rate. In my experience, however, few companies are aware of this and most withhold at the supplemental rate because the W-4 rate is too hard to figure out.
Changes in Employment Status Where an individual changes status from employee to non-employee (or vice versa) and holds options or awards that continue to vest after the change in status, when the option/award is exercised/paid out, you can apportion the income for the transaction based on years of service under each status. Withhold taxes on the income attributable to service as an employee (and report this income on Form W-2). No withholding is necessary for the income attributable to service as a non-employee (and this income is reported on Form 1099-MISC).
Any reasonable method of allocating the income is acceptable, so long as you are consistent about it.
Excess Withholding I know it’s hard to believe, but if you are withholding at the flat supplemental rate, the IRS doesn’t want you to withhold at a higher rate at the request of the employee. They care about this so much, they issued an information letter on it (see my blog entry “Supplemental Withholding,” January 8, 2013). If employees want you to withhold at a higher rate, you have to withhold at their W-4 rate and they have to submit a new W-4 that specifies the amount of additional withholding they want.
Also, withholding shares to cover excess tax withholding triggers liability treatment for accounting purposes (on the grant in question, at a minimum, and possibly for the entire plan). Selling shares on the open market to cover excess tax withholding does not have any accounting consequence, however.
ISOs and Form 3921 Same-day sales of ISOs have to be reported on Form 3921 even though this is a disqualifying disposition. It’s still an exercise of an ISO and the tax code says that all ISO exercises have to be reported.
On the other hand, if an ISO is exercised more than three months after termination of employment (12 months for termination due to disability), it’s no longer an ISO, it’s an NQSO. The good news is that because it’s an NQSO, you don’t have to report the exercise on Form 3921. The bad news is that you have to withhold taxes on it and report it on a Form W-2 (and, depending on how much time has elapsed, it might have been easier to report the exercise on Form 3921).
FICA, RSUs, and Retirement Eligible Employees This topic could easily be a blog entry in and of itself, but it doesn’t have to be because we published an in-depth article on it in the Jan-Feb 2014 issue of The NASPP Advisor (“Administrators’ Corner: FICA, RSUs, and Retirement“). All your questions about what rules you can rely on to delay collecting FICA for retirement eligible employees, what FMV to use to calculate the FICA income, and strategies for collecting the taxes are covered in this article.
A policy is only as solid as its exceptions. You may have a well-defined plan or policy for your company’s current situation that has bare spots that may not stand the test of time–and unusual circumstances. It’s difficult to cover all your bases when you are creating a new policy or plan, but it’s even more difficult when you jump into managing an existing plan under inherited policies.
The problem is that it is rare that a stock plan manager has time to pick through every piece of every plan document and policy and play out every scenario to determine if there are cracks that need to be exposed. This is where experience really counts; whether it is your own personal experience or experience you picked up second hand by listening to the holes other stock plan administrators have encountered. Whenever you are networking, attending a presentation, or perusing a discussion forum and you hear a new predicament, run–don’t walk–back to your desk and check to see if your company could potentially run into the same issue.
Just to give you a taste, here are three problems to think about:
Insider Trading Policy
Generally speaking, insider trading policies restrict the transactions of individuals deemed to be in possession of insider information. They help to protect both the company and the individuals by preventing transactions that would either be or appear to be insider trading. However, there are a couple places where ambiguity could trip you up. For example, if your insider policy doesn’t detail what constitutes a transaction, you could find yourself up against (or in the middle of) a blackout period scrambling to determine the correct course of action. Cash exercises and trading shares to cover tax liability on restricted stock vests are the most common sources of contention. Even if you’ve covered yourself by getting all your insiders into Rule 10b5-1 trading plans, there could still be an issue when someone not normally considered to be an insider is marked for a particular blackout period because she or he is either recently promoted or currently in the middle of a project that provides access to nonpublic information. If that same person has, for example, a restricted stock vest during the company blackout window, you could have a situation on your hands.
Fair Market Value
The fair market value for both grants and transactions can be pretty much any reasonable definition, which means that companies may set fair market value differently. Non-market days can be blind spot when it comes to restricted stock vests. Another tricky situation may arise if your FMV is defined in such a way that it is possible for someone to exercise an underwater option. For example, if your company uses the prior day’s closing price as the FMV for option exercises, an employee could exercise barely-in-the-money options and end up with an exercise price that is higher than the defined FMV.
Terminations
Your company can treat all terminations equally, but most companies do not. Voluntary, involuntary, for cause, death, disability, and retirement are all on the list of potentially unique termination reasons with varying impact to equity compensation. Of course, you want to have each reason clearly defined, but the blind spot could be what happens if the circumstance combines more than one reason. For example, what if an employee leaves the company and subsequently passes away during the post-termination grace period?
Take Charge
For larger issues regarding plan design and policy, there are a number of resources on the NASPP site to provide essential guidance. Our April 2010 webcast, “25 Ways to Improve Stock Plan Documents,” details more than 25 plan design issues that you need to be aware of and we have an entire portal dedicated to plan design with a host of resources under multiple topics.
Finally, don’t overlook your opportunities to learn from others. The NASPP has over 30 local chapters planning regular meetings. Making sure you attend your chapter’s meetings gives you access not only to timely topics and great speakers, it also gives you the networking opportunity to discover which issues are most important to your peers and how they are dealing with them. We also have an active Discussion Forum where you can browse, search, and even subscribe to the topics that matter most to you.
With the year-end quickly approaching, I thought that the final versions of Forms 3921 and 3922 would surely be waiting upon my return from my vacation last week, providing foddor for the NASPP blog (the IRS, along with the SEC and FASB, seem to have a knack for releasing stuff when I’m on vacation). But, to my surprise, the final forms still aren’t available. So instead, this week I blog about a recent case in the Maryland Court of Appeals relating to a company’s right to cancel options upon an executive’s resignation, which reminded me of a few best practices to ensure that, when employees terminate, stock awards receive the treatment the company intends.
Forfeiture of Awards Upon Termination of Employment: Not Always As Clear Cut As You Think The case involved an executive who voluntarily resigned but continued to work while severance negotiations were ongoing. The negotiations failed and the company terminated the executive–just eleven days prior to when his options would have vested. The county court (where the case was initially tried) assigned a value of around $850,000 to the options, presumably based on the spread on the vesting date or the date the executive tried to exercise the options. Given the sum involved, I can only imagine that the eleven days ate at the executive–resulting in his lawsuit claiming that the options were “wages” owed to him under Maryland’s Wage Payment and Collection Law.
To those of us in the business, this might seem like a no-brainer in favor of the company, but the court in which the case was initially tried found in favor of the executive. It all worked out in the end, at least from the company’s perspective, because the appellate court decided against the executive. Even so, lawsuits are expensive, especially those that end up in appeals, so this wasn’t exactly a landslide for the company. The case brings to mind a few best practices.
Dot the I’s and Cross the T’s
Proper documentation is key. This lawsuit is exactly why your attorneys want you to require employees to sign their grant agreements–so that, if necessary, the company can prove that employees knew the terms and conditions of their grants. I’ve read about numerous lawsuits relating to the treatment of stock compensation upon termination and a large percentage of them hinge on whether or not the employee was informed of the vesting and forfeiture conditions.
In addition to having a signed grant agreement, retain copies of any communications to employees that notify them of the terms of their grants and, in particular, any communications relating to their stock compensation that are provided at the time of termination. I’ve read about one case disputing termination provisions where there wasn’t a signed grant agreement on file, but where the subsequent communications that the company was able to produce were sufficient to decide the case in the company’s favor.
Proper documentation is especially important in sensitive circumstances, such as when an executive is leaving on bad terms (as in this case), an employee is terminated for cause, or a reduction in force.
Don’t Be Late
It is critical that stock plan administration receive timely notice of terminations. In this case, the executive actually tried to exercise his options and wasn’t able to because a block had been placed on his account. If the notice of termination had been received just a couple of weeks late, the exercise might have been permitted. Trying to unwind that transaction and force the executive to disgorge the amounts realized on it would have made things infinitely more complicated (and that much more expensive for the company).
Be Prepared
When a reduction in force is planned, it’s a good idea to check for vesting dates that occur shortly after the expected last date of employment. In this case, the employee was voluntarily resigning, so this wasn’t as much of an issue. But where employees are involuntarily terminated, forfeiture of awards that would have vested shortly after their termination date can be problematic. At best, it leaves everyone feeling even worse than they already do. At worst, it can look like the company purposely terminated employees to avoid having to pay out the awards–especially if a large group of the terminated employees had awards vesting on the same date. It might be best to accelerate vesting of the awards in question.
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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.
A new Section 16 insider (officer, director, or 10% shareholder) must file a Form 3 within 10 calendar days to report all equity securities of the company that he or she beneficially owns. But, what must be done when that person terminates their insider status?
Form 4 and Form 5
Both Form 4 and Form 5 have a box that, when checked, indicates that the filer is no longer subject to Section 16 at the time of filing. Although this “exit box” should be checked for all required post-termination filings, the SEC does not actually require the insider to report his or her change in status. However, if the insider feels that it is important to make a public declaration that he or she is no longer subject to Section 16, the SEC will accept a blank Form 4 or Form 5 with the exit box checked.
Post-Termination Transactions
It is important to be sure that the transaction is actually post-termination. If the termination triggers a transaction (like an acceleration of vesting for restricted stock), then the transaction may be deemed to have occured pre-termination. Only officers and directors are subject to the post-termination filing requirements of Rule 16a-2(b). So, if a 10% shareholder ceases to hold 10% of the outstanding shares, then no further filing is required. Officers and directors may need to report certain transactions for up to six months from the termination of their insider status.
In order for a post-termination transaction to be reportable, it must be subject to Section 16(b) and take place within six months of a pre-termination opposite-way transaction that is also subject to Section 16(b). If the officer or director did not engage in any non-exempt transactions in the six months leading up to his or her termination, then post-termination transactions will not need to be reported on an Form 4 or Form 5. This does mean, however, that if the post-termination transaction is reportable, it is also potentially subject to short-swing profit recovery. Two post-termination transactions should not be matched against each other.
Delinquent Filings
Of course, if there are any reportable transactions prior to the termination date that the insider failed to report, the obligation to report the missed transactions still stands after termination. If the insider did not engage in any transactions in the six months leading up to his or her termination, the company should obtain a statement from the insider upon termination that all reportable transactions have been reported. Otherwise, the company should obtain a “no filing due” certification from the former insider at the end of the fiscal year to ensure that no Form 5 is required.
8-K
When directors, and certain officers of the company, leave their position, the company is required to report their departure by filing a Form 8-K under Item 5.02.