Benefit Practice Portfolios, Employee Stock Purchase Plan Final Regulations (March 2010)

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1 Benefit Practice Portfolios, Employee Stock Purchase Plan Final Regulations (March 2010) Brian A. Benko 2010 CCH. All Rights Reserved. Brian A. Benko is an Associate with the law firm of McDermott Will & Emery LLP, Washington, DC. He is a member of the Benefits, Compensation, Labor & Employment Practice Group. Mr. Benko has written several book chapters and articles on employee benefits and executive compensation issues. As a member of the Tax Section of the American Bar Association, he is the Young Lawyer Liaison for the Executive Compensation Subcommittee. In addition, he is member the American Society of Pension Professionals and Actuaries, where he serves on the Government Affairs Committee. Mr. Benko previously worked in the Office of the Benefits Tax Counsel, Office of Tax Policy, U.S. Treasury Department, as the William F. Sweetnam, Jr. Scholar. For additional information please contact Brian A. Benko at bbenko@mwe.com or (202) The recently released final regulations under Internal Revenue Code (Code) Section 423 for Employee Stock Purchase Plans (ESPPs) provide guidance for the compliance requirements for options granted under an ESPP. The final regulations are effective on November 17, The final regulations apply to options granted under an ESPP on or after January 1, Statutory options granted prior to January 1, 2010 may rely on the final regulations. The ESPP final regulations affect whether an ESPP complies with the compliance requirements. In order to preserve favorable long term capital gains treatment for employees who sell stock purchased under an ESPP, ESPPs need to comply with the final regulations. This article offers an overview of the ESPP requirements and explains issues raised by the final regulations. In General An individual who sells employer stock transferred under an ESPP may be eligible for favorable tax treatment upon the sale. There are generally two conditions for receipt of favorable tax treatment. The first condition is that the terms of the plan through which options are offered must qualify as an ESPP. An ESPP is a plan that meets the following requirements: The plan provides that options are granted only to employees of the employer. The plan is approved by the stockholders of the granting employer within 12 months before or 12 months after the date of the plan's adoption. The plan terms must provide that an employee can be not be granted an option if, immediately after the option is granted, the employee owns stock with 5 percent or more of the total combined voting power or value of all classes of stock. The plan terms must provide that if an employer grants any options by reason of employment, then options must be granted to all employees, except that the following employees may be excluded: employees who have completed less than 2 years; employees whose customary employment is 20 hours or less per week; employees whose customary employment is for not more than 5 months in any calendar year; and highly compensated employees. The plan terms must provide that all employees who are granted options shall have the same rights and privileges. Under the terms of the plan, the option price cannot be less than the lesser of 85% of the fair market value of the stock at the time the option is granted, or 85% of the fair market value of the stock at the time the option is exercised. Under the terms of the plan, the option cannot be exercised: after 5 years past the grant date if the option price cannot be less than 85% of the fair market value of the

2 stock when exercised, or after 27 months past the grant date if the option price may be less than 85% of the fair market value of the stock when exercised but is at least 85% of the fair market value of the stock upon grant. Under the terms of the plan, no employee may be granted options which permits his rights to purchase stock to accrue at a rate which exceeds $25,000 of the fair market value of the stock as of the grant date for each calendar year in which the option is outstanding. In other words, the plan terms must provide that no employee may exercise options in a given calendar year in excess of $25,000 of the fair market value of stock as of the grant date. Under the terms of the plan, the options are nontransferable. The second condition is that an employee must satisfy two different waiting periods. An individual must wait for two years after the grant date before selling stock acquired by exercising the option. An individual must also wait for 1 year after exercising the option before selling the stock. Method of Interpretation The final regulations set forth the method for determining whether the terms of a plan satisfy the ESPP requirements. The IRS has clearly stated that the ESPP compliance requirements may be stated under both the plan and an offering under the plan. In drafting a plan, terms can be stated under both the plan document and each individual offering so long as the terms of the two together provide for all of the ESPP compliance requirements. In other words, a plan complies with the ESPP compliance requirements if plan and each offering under the plan satisfy the requirements. This method gives employers increased flexibility in offering options under an ESPP. Further flexibility is offered through rules related to offerings. Offerings can be consecutive or overlapping. In addition, an ESPP can offer different terms under different offerings. Employers are able to offer options to different segments of the workforce under different terms. The final regulations specifically provide that a parent may designate in each offering which subsidiaries may participate. Under each offering different terms may be provided to different subsidiaries. Offerings could be made with different terms while still complying with the ESPP requirements. Required Provisions under the Plan With increased flexibility, however, the method of interpretation creates potential compliance issues because certain terms must be stated under the plan and not an offering. The following are requirements which must be stated in the plan. Employees Only. The plan must provide that options can be granted only to employees of the employer corporation (or employees of its related corporations) to purchase stock in the employer corporation (or one of its related corporations). 1 Maximum Aggregate Number of Shares. The plan must provide the maximum aggregate number of shares which can be issued under the plan. 2 A plan cannot satisfy this requirement by providing that the number of shares that can be issued cannot exceed a certain percentage of shares outstanding at the time of each offering or grant. However, it may be stated in terms of a percentage of the authorized, issued, or outstanding shares on the date of the adoption of the plan. The plan may specify that the maximum aggregate number of shares may increase annually by a specified percentage of the authorized, issued, or outstanding shares at the time the plan is adopted.

3 Required Provisions under the Plan or Offering In addition to the requirements which must be stated under the plan, several requirements may be stated under either the plan or an offering under the plan. Equal Rights and Privileges The terms of the plan or offering must provide that all employees granted options have the same rights and privileges. 3 The final regulations provide for the application of this requirement using the plan plus offering method of determining whether the requirements are satisfied. In other words, each individual offering must provide all employees granted options the same rights and privileges under the offering. Each offering may provide different rights and privileges, but all rights and privileges under the offering must apply identically to all employees granted options under the offering. The failure to comply with this requirement disqualifies the plan, causing none of the options under the offering to receive the ESPP tax preference. Exceptions to the Rule The equal rights and privileges requirement generally applies to all of the ESPP compliance rules. The final regulations, however, provide for the following exceptions to the general rule. The amount of stock that an employee may purchase may be determined on the basis of a uniform relationship to the total compensation, or the basic or regular rate of compensation, of all employees. The plan or offering may provide that no employee may purchase more than a maximum amount of stock fixed under the plan or offering. The plan or offering may provide terms of an option granted to citizens or residents of such foreign jurisdiction that are less favorable than the terms of options granted under the same plan or offering to employees resident in the United States. The plan or offering may delay the grant of an option to any employee who is barred from being granted an option solely by reason of the employee failing to meet a minimum service requirement until the employee meets the minimum service requirement. Special Rule for Carrying Forward Amounts Previously Withheld The final regulations generally prohibit a plan or offering from allowing one or more employees to carry forward amounts that were withheld but not applied toward the purchase of stock under an earlier plan or offering and apply the amounts towards the purchase of additional stock under a subsequent plan or offering. In general, such a term violates the equal rights and privileges requirement. The final regulations provide the following exceptions to this rule: The carry forward of amounts withheld but not applied toward the purchase of stock will not violate the rights and privileges requirement if all other employees participating in the plan or offering may make direct payments to purchase shares under a subsequent plan or offering. The direct payments, however, may be no greater than an amount equal to the greatest amount which any employee is allowed to carry forward from an earlier plan or offering over the amount, if any, the employee will carry forward from an earlier plan or offering. Employees may carry forward amounts representing a fractional share, that were withheld but not applied toward the purchase of stock under an earlier plan or offering and apply the amounts toward the purchase of additional stock under a subsequent plan or offering.

4 Excludible Employees In general, the plan must cover all employees of any corporation whose employees are granted options by reason of employment with that corporation. 4 However, the following categories of employees may be excluded from coverage: Employees who have been employed less than two years; Employees whose customary employment is 20 hours or less per week; Employees whose customary employment is for not more than five months in any calendar year; and Highly compensated employees (within the meaning of Code Section 414(q)). In addition, under certain circumstances, employees who are citizens or residents of a foreign jurisdiction 5 may be excluded from coverage. The first situation is where the grant of an option under the plan or offering to a citizen or resident of the foreign jurisdiction is prohibited under the laws of the foreign jurisdiction of which the individual is a citizen or resident. The second situation is where compliance with the laws of the foreign jurisdiction would cause the plan or offering to violate the ESPP compliance rules. Grant Date Related Requirements The final regulations provide rules concerning when the grant date occurs. The grant date is an integral part of qualifying with the ESPP rules and gaining preferred tax treatment for individuals upon sale of stock. In particular, the grant date impacts the application of and compliance with the rules for setting the options price, the option exercise period, and the $25,000 annual accrual limit. Grant Date Determined by the Maximum Number of Shares Purchased by Each Employee The final regulations determine the grant date based upon whether the plan or offering designates the maximum number of shares that can be purchased. 6 The grant date is the first day of the offering if the plan or offering sets the maximum number of shares an employee may purchase during an offering. A plan or offering may designate a fixed, maximum number of shares, or it may incorporate a formula to determine, as of the first day of the offering, the maximum number of shares an employee can purchase during the offering. In other words, a maximum is set if the plan uses a fixed number or a formula for determining a fixed, maximum number of shares. Regardless of whether a plan or offering uses a fixed number or a formula, a maximum number of shares is set only if the maximum can be determined on the first date of the offering. The first day of the offering period is not the grant date if the maximum number of shares is not provided under the plan or offering and determinable as of the grant date. If the maximum number of shares is not determinable until the shares are actually exercised by an individual on the exercise date, then the grant date is the exercise date. Plans and offerings should be reviewed with care to determine the grant date because the grant date will affect whether other plan terms comply with the final regulations. Option Price The terms of the plan or offering must provide the price of the option. 7 The price of an option must fall within certain bounds to be eligible to receive tax preferred treatment upon sale. The option price can be no less than the lesser of 85% of the fair market value of the stock on the grant date or 85% of the fair market value of the stock on the exercise date. If an employee is granted

5 options under an offering that fail to comply with this requirement, then no options under the offering are eligible for the ESPP tax preference. The final regulations provide that the option price can be stated either as a percentage or as a dollar amount. There are potential issues with stating the option price as a dollar amount. The plan or offering must provide an option price term that is certain to satisfy the general option price rule. If the option price is stated as a dollar amount, the plan or the offering must state the price as no less than 85% of the fair market value of the stock as of the grant date. A failure to do so would cause the plan terms to not satisfy the option price requirement. So, if the price is set lower than such amount, the terms will fail to meet the option price rules and thus the plan will not qualify as an ESPP. For another example, the option price may be set as the fair market value as of the exercise date, not less than $80. Here, the option price term as stated in the plan is certain to satisfy the general option price rule. Option Period The final regulations provide rules for determining the amount of time after the grant date during which an individual may exercise options. 8 There are basically two different potential exercise expiration periods. They are distinguishable by the option price provided under the plan terms. First, the option period is determined based upon whether the terms of the plan or offering provide that the option price is not less than 85% of the fair market value of the stock at exercise. In the event the terms of the plan or offering has an option price term which permits the option price to be less than 85% of the fair market value of the stock at exercise, then the plan or offering must provide under the terms that the options cannot be exercised beyond 27 months after the grant date. Second, if the terms of the plan or offering have an option price term of no less than 85% of the fair market value of the stock at exercise, then the terms of the plan or offering must provide that the option must be exercised within five years after the grant date. In determining whether the option period may be up to five years, whether or not the fair market value of the stock at exercise is more or less than the fair market value as of the grant date is irrelevant. What is relevant, however, is whether the plan terms provide that the option price will be not less than 85% of the fair market value of the stock at exercise. $25,000 Annual Limit The final regulations provides guidance on the $25,000 annual accrual limit. 9 The rule is that the terms of a plan or offering must provide that no employee may be permitted to accrue the right to purchase stock at a rate which exceeds $25,000 in fair market value of the stock as of the grant date for each calendar year in which an option granted to an employee is outstanding. In general, in applying a plan term, the right to purchase stock begins to accrue when the option is first granted. In other words, the right to purchase stock begins to accrue as of the grant date in an amount equal to $25,000 in fair market value of the stock as of the grant date. As applied in the final regulations, this means that during each calendar year beginning in the year of the grant, an individual accrues the right to purchase shares of stock up to the amount of shares not in excess of $25,000 of fair market value as of the grant date. The amount of shares totaling $25,000 add up. This means that after two calendar years after the options are outstanding, the individual has accrued the right to purchase stock not in excess of $50,000 of the fair market value of the stock as of the grant date. Shareholder Approval In addition to complying with certain formal requirements, an ESPP must be approved by the shareholders. 10 The plan must be approved by the shareholders either 12 months before or 12 months after the plan is adopted. The adoption date of the plan is the date the board of directors of the granting corporation approved the plan. New approval is required if there is a change in the shares offered under the plan or there is a change in the granting corporation.

6 Footnotes 1 Treas. Reg (b). 2 Treas. Reg (c)(3). 3 Treas. Reg (f). 4 Treas. Reg (e). 5 Applied without regard to whether they are also citizens of the United States or resident aliens (within the meaning of section 7701(b)(1)(A)). 6 Treas. Reg. Section (h)(2)-(3). 7 Treas. Reg. Section (g). 8 Treas. Reg. Section (h) 9 Treas. Reg. Section (i). 10 Treas. Reg. Section (c).