New Rules Govern Employee Stock Purchase Plans and Incentive Stock Options

The new ESPP rules include some important clarifications that might necessitate plan amendments or changes in administrative practices. In addition, for ESPP and ISO share transactions that occurred in 2009, employees should have received information reports that met updated requirements by Jan. 31, 2010.

Final ESPP Regulations

An ESPP is a written plan that permits an employer to sell its stock to employees at a small discount on a tax-advantaged basis. An employee’s participation in an ESPP is treated for tax purposes as a grant to the employee of an option to purchase employer stock. The period over which the option is in effect is referred to as an “offering.”

The principal tax advantage of an ESPP is that neither the purchase discount (which might be up to 15 percent from the stock’s fair market value on the date of grant or the date of exercise, whichever is less) nor the option spread over the discount is taxed until the shares are sold. Furthermore, the option spread over the discount is eligible to be taxed at more favorable capital gains rates, provided the employee meets certain holding period requirements. A purchase discount generally cannot be offered under an ISO or a nonqualified stock option without triggering adverse tax consequences for the recipient.

Some of the most important aspects of the regulations are as follows.

Multiple Offerings Allowed

One of the requirements for an ESPP is that all employees who are eligible to participate in a particular offering participate on the same terms and conditions (or, in ESPP parlance, have “equal rights and privileges”) as all other eligible employees. The proposed regulations had implied that there could be only one offering under an ESPP at any time. However, the final regulations clarify that ESPPs may have multiple offerings. Such offerings can be consecutive or overlapping, and the terms of each separate offering need not be identical, as long as the ESPP and each offering together complies with the ESPP requirements.

This clarification will allow employers to structure their plans more strategically. A plan covering multiple related companies could have one offering for the employees of one subsidiary and another offering for employees of the parent company and its other subsidiaries. Such an approach might be attractive in situations in which related companies operate in disparate industries or have differing pay practices.

Employee Exclusions

As a general matter, all employees of a corporation that is a participating employer in an ESPP must be allowed to participate in the plan. However, ESPPs are permitted to exclude employees who have been employed less than two years, employees who customarily work 20 hours or less per week, employees who customarily work not more than five months in a calendar year, and certain highly compensated employees. The final regulations clarify that employee exclusions may differ from offering to offering, as long as the exclusions are otherwise permissible.

A number of commentators had requested that the final regulations permit employers to exclude nonresident aliens who have no U.S.-source income and employees below a specified minimum age. The Treasury Department and the IRS rejected these requests on the basis that the Internal Revenue Code does not allow for such exclusions.

However, the regulations do permit individual ESPP offerings to provide more restrictive terms for citizens or residents of foreign jurisdictions to the extent necessary to comply with the laws of that foreign jurisdiction. In addition, the ability to have different terms for different multiple, overlapping offerings might as a practical matter allow employers to structure offerings to address differing legal requirements for employees outside the U.S.

Maximum Shares Available for Purchase

A key requirement under an ESPP is identifying the “date of grant” of an option awarded under the ESPP. The date of grant is important for many purposes, including applying the $25,000 limit (discussed below), applying the purchase price discount (for plans with look-back periods) and measuring the start of the holding periods that must be met in order for acquired shares to have favorable tax treatment upon sale.

Under the new rules, the date of grant will be the first day of an offering period if the terms of the ESPP or the offering designate a maximum number of shares that may be purchased by each employee during the offering. However, the rules do not require that an ESPP or offering designate a maximum number of shares purchasable during an offering (or incorporate a formula to establish such a maximum).

If no limit is designated, the date of exercise (i.e., purchase) will be the date of grant. Importantly, the regulations clarify that merely specifying the $25,000 annual limit (or the total number of shares reserved for issuance under the plan) is not sufficient to establish a maximum share limit. As a result, employers might wish to amend the terms of their plan or modify the terms of their offering periods to designate a maximum number of shares that can be acquired during an offering period. This is particularly important for employers with ESPPs that offer a look-back period.

Annual $25,000 Limit

An ESPP must provide that all of an employee’s ESPP options (under all ESPP plans sponsored by the employer and its related companies) may not vest and become exercisable with respect to more than $25,000 worth of employer stock (measured of the option date of grant) per year. In the proposed regulations, the limit did not begin to apply with respect to a particular option until the year in which the option was outstanding and exercisable.

The final regulations adopt a more generous approach that permits the limit to begin to apply in the year in which the option is granted even if it does not vest and become exercisable until a later year. To the extent the limit is not “used” during the year of grant (because the option does not vest until a later year), it may be added to the limit for the subsequent year.

Updated Information Reporting Requirements

Employers generally are required to provide a statement to an employee after the employee exercises an ISO or transfers shares purchased under an ESPP. Such statements must be provided by Jan. 31 of the year following the year in which occurs the exercise or transfer, as applicable.

In addition, a 2006 change in the tax laws required employers to file an information return with the IRS for such stock transfers. This requirement was originally scheduled to go into effect in 2007 but the Treasury Department and IRS waived it for exercises and transfers occurring in 2007 and 2008. Regulations finalized in late 2009 make this requirement effective for exercises and transfers that occur in 2010 (thereby waiving the information return requirement for 2009). The IRS will make forms available for 2010 (Form 3921 for ISO exercises and Form 3922 for stock transfers under an ESPP).

Employers must continue to provide employees with information statements for exercises and transfers that occurred in 2009. Information statements for 2009 exercises and transfers must be sent to employees no later than Jan. 31, 2010. The required information is intended to allow the employees to calculate axes they might owe with respect to the transfer of ESPP shares or exercise of ISOs.

In addition, the final regulations clarify certain aspects of reporting share transfers under ESPPs. First, if the shares acquired under the ESPP are issued directly to the employee or registered in the employer’s records in book-entry form, no transfer of legal title is considered to have occurred and thus no information return is required. However, if the employer transfers ESPP-acquired shares to a brokerage account on behalf of the employee, or if the employee sells the shares issued to the employee or transfers those shares at the employee's initiative to a brokerage account, a transfer of legal title is considered to have occurred and an information report and a return (beginning for transfers in 2010) must be filed.

Transfers to Nonresident Aliens

In response to comments, the final regulations include an exception to the reporting and return requirements for certain nonresident aliens. Neither an information report nor a return is required for employees for whom the employer is not required to file a Form W-2 for certain specified periods.