IRS Finalizes New Rules on Employee Stock Plans—New Reporting Requirements for ESPPs and ISOs to Begin in 2010

Last week the IRS issued two related sets of final regulations: regulations governing the substantive terms of employee stock purchase plans (ESPPs) qualified under §423 of the Internal Revenue Code, and regulations imposing new tax reporting requirements for both ESPPs and incentive stock options (ISOs) under §422 of this Code. The new reporting requirements will not take effect until January of 2011, but the ESPP regulations may require some companies to amend their plans before the beginning of 2010 in order to preserve favorable tax treatment for their employees.

ESPP Regulations

ESPPs allow the employees of a company to purchase its stock at a favorable purchase price through payroll withholding. Employees are allowed to have a portion of each paycheck withheld during a specified offering period, and at the end of the offering period the accumulated withholding is used to purchase the stock. The purchase price may be as low as 85% of the fair market value of the stock, which may also be set at the beginning or end of the offering period, or may be the lower of the two values.

Although ESPPs have been around a long time, in 2008 the IRS proposed comprehensive new regulations to govern their operation. Among the key provisions of the proposed regulations was a definition of when the employees’ right to purchase the stock, which is technically a form of stock option, is “granted” for purposes of §423. In order to obtain the full tax advantage of §423, an employee must hold the stock for the longer of two years after the option is granted or one year after it is exercised. An earlier sale is a “disqualifying disposition” and results in the employee’s recognition of additional taxable ordinary income.

The proposed regulations provided that if the number of shares that may be purchased is not “fixed or determinable” at the beginning of the offering period, the option is not considered “granted” until the end of the offering period when the stock is purchased, which means that an employee must hold the stock until two years after the stock is purchased to avoid a disqualifying disposition.

The final regulations retain this rule, and confirm that an ESPP that sets the purchase price as a percentage of the stock value at the end of the offering period (or at the lower of the price at the beginning or end of the period) will not be considered to set a fixed or determinable number of shares at the beginning of each offering period unless the plan also imposes a limit on the number of shares that can be purchased by each employee during the offering period. Furthermore, the regulations provide that the $25,000 dollar limit imposed by §423 on the maximum value of stock on which options can be granted in any one year is not sufficient to establish such a share limit.

Accordingly, any ESPP that sets the purchase price on the last day of the offering period should be reviewed prior to the beginning of 2010 to ensure that the plan properly limits the total number of shares that can be purchased in any offering period to insure that employees will get the maximum tax benefit from §423. Although it is now too late in the year for many companies to have a formal plan amendment approved by their board of directors, it may be possible for the limit to be added as an administrative matter by the compensation or other governing committee.

In other respects, the final §423 regulations are helpful. In particular, the new regulations permit an ESPP to make different offerings to employees in different countries, which will make it easier for multinational companies to deal with offerings to employees in countries that have different laws governing stock ownership by employees. The new regulations also clarify the permitted carryover of unused portions of the $25,000 annual limit to subsequent offerings.

New ESPP and ISO Reporting Rules

In 2006, §6039 of the Code was amended to require companies that sold stock to an employee on a tax-favored basis pursuant to either an ISO, or an ESPP that sets the purchase price of stock at a discount from fair market value, to file a return with the IRS. Previously, §6039 had only required the employer to give such a report to employees who purchased the stock to enable them to properly calculate their taxable income.

The IRS has also finalized the §6039 new reporting rules. However, the IRS waived the reporting rules for all years through 2009. Accordingly, the first returns will not need to be filed with the IRS until January of 2011, for stock sold during 2010. Employers are still required to furnish the statements to employees in January of 2010, but can use either the new regulations or the prior regulations under the pre-2006 version of §6039. The IRS is developing new Forms 3921 and 3922 to be used to satisfy the new reporting requirements, but the forms have not yet been released.

The new reporting rules apply to an ESPP only if the purchase price is set at a discount from the fair market value of the stock. In addition, the reporting requirement does not apply to the year in which the stock is transferred from the company to the employee, but when the stock is transferred from the employee to a third party. In recognition of the fact that most companies no longer issue certificates to employees who purchase stock through an ESPP, the final regulations provide that the stock will be considered to have been transferred by the employee when the stock is deposited into a brokerage account for the employee’s benefit. However, if the company does still issue certificates—either automatically or upon the employee’s request—the company will need to have its transfer agent monitor when the employee transfers the stock.

It should be noted that the new §6039 reporting rules do not replace the existing rules requiring an employer to report, and sometimes withhold on, any taxable income recognized by an employee on the exercise of an option.

If you have any questions about the application of the new regulations to your company’s ESPP or ISO plan, please contact the Seyfarth attorney with whom you work, or any Employee Benefits attorney on our website (www.seyfarth.com/employeebenefits).