Employee Stock Purchase Plans – New Rules Effective in 2010

Toward the end of 2009, the IRS issued two sets of final regulations that affect employee stock purchase plans (ESPPs) that are qualified under Section 423 of the Internal Revenue Code ("Code").  An ESPP is a plan under which an employer sells its stock to employees at a discount.  The new regulations affect the operation of ESPPs, clarify the information reports that must be provided to employees on ESPP transactions, and add a new requirement to file an information return with the IRS.

Regulations on ESPP Operations

An ESPP is a plan, governed by Code Section 423, that permits an employer to sell its stock to employees at a small discount on a tax-advantaged basis. An employee's ESPP participation is treated, for tax purposes, as a grant to the employee of an option to purchase the employer stock.  The period over which the option is in effect is referred to as an "offering."  Most employers allow eligible employees to make after-tax payroll deductions that are accumulated for some period (for example, over a calendar quarter) and which are used at the end of the offering period to purchase shares of employer stock.

An ESPP is attractive because neither the purchase discount (which may be up to 15% from the fair market value of the stock on the date of grant or the date of exercise, whichever is less) nor the increased value of the stock over the discounted purchase price is taxed until the shares of stock are sold.  In addition, a portion of any gain realized upon the participant's subsequent "qualifying disposition" of such shares will be taxed at capital gains rates rather than ordinary income rates.  In order to be a qualifying disposition, the participant must (A) remain employed by the employer from the option grant date until three months prior to the date of purchase, and (B) retain the shares for one year after the date of purchase and two years after the first day of the offering period.  If these conditions are not satisfied, then the entire gain is taxed as ordinary income.

Offerings

The regulations require that all employees who are eligible to participate in a particular offering under the ESPP participate on the same terms and conditions, but the regulations also clarify that ESPPs may have multiple offerings.  Those offerings can be consecutive or overlapping, and the terms of each separate offering need not be identical, provided that each ESPP offering together complies with the ESPP requirements.  Thus, employers are able to choose the terms and conditions that apply to each of the ESPP offerings.  For example, an ESPP covering related companies could have one offering for the employees of the parent company, and a different offering for employees of each subsidiary company.  Note, however, that if the ESPP makes an offering to the employees of a subsidiary corporation, all employees of that subsidiary corporation must participate on the same terms and conditions.  

Grant Date

A feature common to many ESPPs is to provide an offering period during which participants contribute a portion of their after-tax compensation to purchase shares of employer stock at the end of the period.  In this situation, the grant date is the first day of the offering period, provided that, as of such date, the maximum number of shares a participant may purchase is either fixed or will be determined under an existing formula.  Otherwise, the grant date is the purchase date, which is usually the last day of the offering period (or, if earlier, the first date the maximum number of shares becomes fixed or a formula is established).  While the regulations do not require that an ESPP impose a maximum number of shares for purchase during an offering period, by doing so, the grant date rule can shorten a participant's holding periods by a significant amount.  Note that this per-offering period limit differs from the statutory limits on the number of shares an ESPP may issue to an individual each year and the $25,000 limitation on accruals (described below). Although the annual share limit and the $25,000 accrual limit must be described in the ESPP, those provisions will not result in the first day of an offering period being considered the grant date.

Exclusions of Employees

Generally, if a corporation is a participating employer in an ESPP, all employees of that participating employer must be allowed to participate in the ESPP.  However, ESPPs are permitted to exclude employees who have been employed for less than two years, employees who customarily work 20 hours or less per week, employees who customarily work five months or less in a calendar year, and highly compensated employees.  The regulations provide that these employee exclusions may differ from offering to offering.

Although the regulations do not permit the exclusion of nonresident aliens who have no U.S.-source income and employees younger than a specified minimum age, the regulations do permit an ESPP offering to provide more restrictive terms for citizens or residents of foreign jurisdictions if necessary to comply with the laws of that foreign jurisdiction.  The ability to impose different terms for different offerings also may provide employers with the flexibility to structure offerings to impose differing legal requirements for employees in foreign jurisdictions.

$25,000 Annual Accrual Limitation

Current law limits the amount of shares a participant may purchase under an ESPP to $25,000 of the fair market value of the stock (determined as of the grant date) for each calendar year that the option remains outstanding.  Because the stock value for this purpose is determined on the grant date, the identification of the grant date (as described above) is important. 

Regulations on Information Reporting Requirements

Code Section 6039 requires that employers granting shares under an ESPP furnish information statements to participants and file information returns with the IRS when the legal title of shares issued under the ESPP is initially transferred by the participant.  Both of these requirements are satisfied by IRS Form 3922.  The statement and filing must be made by January 31 following the year in which the transfer occurs.  Note that Code Section 6039 imposes similar reporting obligations in connection with grants of incentive stock options.

If the employer arranges for shares purchased under the ESPP to be transferred to a brokerage account established for the participants, the transfer of the legal title of the shares directly to a broker or financial institution is treated as a transfer that triggers the reporting obligations.  However, if the employer issues stock certificates to participants upon the exercise of ESPP options, or if shares are registered in the participants' name and the employer holds those shares for participants in book entry form, then the initial transfer of shares does not occur until the participant's subsequent legal transfer of title.

Please note that the reporting to the IRS of ESPP transfers first is effective for transfers occurring in 2010.  However, employers must provide employees with information statements for transfers that occurred in 2009 and subsequent years. 

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If you have any questions about this Client Advisory, please contact any member of our Employee Benefits Team.

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©2010 Sherman & Howard                                                          February 10, 2010