The IRS has issued final regulations relating to stock options granted under an employee stock purchase plan (ESPP) designed to meet the requirements under Section 423 of the Internal Revenue Code (Code). The final regulations apply as of January 1, 2010, and will apply to any statutory option granted on or after that date. Employers may rely on these final regulations for the treatment of ESPP options granted before this date.
In general, Code Section 83 governs the income tax treatment of an option grant in connection with an employee’s performance of services and the transfer of stock pursuant to the exercise of such option. However, Code Section 421 provides special income tax treatment regarding the transfer of shares on the exercise of an option granted if the requirements of Code Section 423 are met. The special tax treatment under Code Section 421 provides that there is generally no income tax to the individual who receives shares pursuant to the exercise of an option under an ESPP and that the employer is not entitled to a compensation deduction under Code Section 162 with respect to the transfer. This tax treatment only applies if (i) there is no disposition of the stock within two years from the date of the option grant or one year from the date of transfer of the share and (ii) at all times during the period beginning on the date of grant and ending on the day three months before the exercise of the option, the individual is an employee of either the corporation granting the option or a parent or subsidiary of such corporation, or a corporation (or a parent or subsidiary of such corporation) issuing or assuming an option in a transaction to which Code Section 424(a) applies (corporate reorganizations, liquidations, etc.). If the option price is less than 100% but not less than 85% of the fair market value on the grant date, the employee will recognize income when the employee disposes of the stock or on the employee’s death. The income recognized will equal the lesser of (a) the fair market value of the stock on the date when the option was granted minus the option price and (b) its fair market value at disposition or death minus the option price. The IRS’s revisions to and clarifications on the July 2008 proposed regulations are summarized below.
Reading Provisions in Offering and Plan Together
The final regulations permit an option to qualify for the special tax treatment under Section 421 even if the terms of the ESPP are inconsistent with certain requirements of the final regulations, as long as the option is granted under an offering with terms that comply with the requirements of the final regulations.
Offerings under the ESPP
The final regulations provide additional guidance for an ESPP under which more than one offering is made. The final regulations clarify that one or more offerings may be made under a plan and offerings may be consecutive or overlapping. The terms of the offerings do not need to be identical as long as the terms of the ESPP and the offerings together satisfy the requirements of the final regulations. Additionally, when a parent corporation adopts an ESPP, it may establish separate offerings with different terms under the ESPP and designate which subsidiary corporations of the parent corporation may participate in a particular offering, provided such terms, together with the ESPP, satisfy the final regulations.
Employees Covered by the ESPP and Offerings
The final regulations revise the proposed regulations to permit the ESPP and terms of the offering to satisfy the requirements of the final regulations on an offering-by-offering basis. This permits each offering to provide different exclusions of employees, as permitted in the regulations, as long as the ESPP and the offering comply with the requirements set forth in the regulations. The exclusions established with respect to a particular offering must be applied in an identical manner to all employees of every corporation whose employees are granted options under that particular offering. The final regulations also permit some additional flexibility in excluding highly compensated employees by providing that the terms of each offering made under an ESPP need not be identical with respect to the exclusion of highly compensated employees, provided that the exclusion is applied in an identical manner to all highly compensated employees of every corporation whose employees are granted options under the ESPP or offering.
Equal Rights and Privileges under the ESPP and Offerings
The final regulations permit employers to make multiple offerings with different rights and privileges applicable to the participants of each offering under the plan, with the determination of whether such terms satisfy the requirements of the regulations made on an offering-by-offering basis. However, the rights and privileges established with respect to a particular offering must be applied in an identical manner to all employees of every corporation whose employees are granted options under that particular offering.
Maximum Number of Shares That May Be Purchased by an Employee under the ESPP
The final regulations provide that the grant date of an option under an ESPP is the first day of an offering period if the terms of an ESPP or offering designate a maximum number of shares that may be purchased by each employee during the offering. Similarly, the option’s grant date will be the first date of the offering if the terms of the ESPP or offering require the application of a formula to establish, on the first day of the offering, the maximum number of shares that may be purchased by each employee during that offering. However, the final regulations do not require that an ESPP or offering designate a maximum number of shares that may be purchased by each employee during the offering or incorporate a formula to establish a maximum number of shares that may be purchased by each employee during the offering. If the maximum number of shares that can be purchased under an option is not fixed or determinable until the date the option is exercised, then the date of exercise will be the date of grant of the option. The IRS reiterated that the $25,000 limit under Section 423(b)(8) and the limit on the aggregate number of shares that may be issued under an ESPP are not sufficient to establish the maximum number of shares that can be purchased by an employee under an option so that the date of grant will be the first day of the offering.
Annual $25,000 Limitation
Section 423(b)(8) provides that an ESPP must, by its terms, provide that no employee be permitted to accrue the right to purchase stock under all the ESPPs of his or her employer corporation and its related corporations at a rate that exceeds $25,000 in fair market value of the stock (determined on the grant date) for each calendar year in which an option granted to the employee is outstanding. Code Section 423(b)(8)(A) provides that the right to purchase stock under an option accrues when the option first becomes exercisable. Due to confusion on how to apply the $25,000 limitation, the IRS clarified that the limit increases by $25,000 for each calendar year during which the option is outstanding.
Stockholder Approval Requirements
To qualify as an ESPP, Section 423(b)(2) requires that the ESPP be approved by the stockholders of the granting corporation within 12 months before or after the date the ESPP is adopted. The final regulations clarify that new stockholder approval is required if there is a change in the shares with respect to which options are issued or a change in the granting corporation. In particular, the final regulations clarify that the stockholders of a subsidiary corporation include the parent corporation and any other stockholders of the subsidiary.