IRS Issues Proposed Regulations for Employee Stock Purchase Plans

The Internal Revenue Service has proposed new regulations for employee stock purchase plans qualified under section 423 of the Internal Revenue Code. Generally more common among public companies than private, these plans give employees an opportunity to purchase shares of their employer at a discount on a periodic basis. Apart from the possibility of acquiring employer stock at a discount, the chief benefit to employees of a section 423-qualified plan is the ability to receive favorable income tax treatment for the shares acquired under the plan.

A section 423-qualified plan generally operates as follows: A participating employee is issued an "option" under the plan to purchase shares of the employer. The participating employee elects to have a certain amount or percentage of his or her after-tax wages deducted from payroll to be used to acquire shares under the plan. At the end of the regular purchase period, the option is exercised, and the employee's deducted wages are applied to purchase shares for the employee at the option price, which is typically at a discount to the fair market value of the shares.

As long as certain conditions are met, the employee will not recognize income at the time he or she acquires the shares (and correspondingly, the employer will not receive a deduction for the discounted price on the transfer of the shares). These conditions are that (1) the employee is employed for the period starting on date of the option grant and up to three months before the option is exercised, and (2) the employee holds the transferred shares for the later of two years from the date of grant of the option or one year from the date of transfer of the shares. This tax treatment is provided under section 421 of the Code, which applies to statutory stock options—incentive stock options (ISOs) as well as options under employee stock purchase plans.

As stated in the notice that sets forth the new rule, which was published in the Federal Register on July 29, the IRS's objective in issuing the proposed regulations was to provide a comprehensive set of rules governing section 423 options. Toward that end, the proposed regulations amend the existing section 423 regulations in three main respects. They update the regulations for statutory changes and conform them, where appropriate, to the section 422 regulations governing ISOs. They also clarify the requirements for employee stock purchase plans, and they remove obsolete rules.

Employers will find few, if any, of the changes introduced by the proposed regulations to be of earth-shaking consequence. That said, the proposed regulations do touch on almost all of the principal features of a section 423-qualified employee stock purchase plan. Highlighted below are a few of the areas addressed by the proposed regulations:

Shareholder approval. A section 423-qualified plan must be approved by shareholders within 12 months before or after the board action approving the plan. However, it has not always been clear as to when an amendment to a plan would be tantamount to creating a new plan, and thus trigger the need for new shareholder approval. The proposed regulations reaffirm that an increase in the aggregate number of shares that may be issued under a plan or a change in the designation of corporations whose employees may participate in the plan will be deemed the adoption of a new plan, and provide that the same is true for a change in the granting corporation or the stock available for purchase under the plan. As to the latter changes, the proposed regulations provide additional guidance regarding stockholder approval requirements where a plan is assumed in connection with business combinations or divestitures.

The proposed regulations also clarify that, when board approval is made subject to the occurrence of a specific event, the board approval is considered to have been obtained on the date on which the event occurs, unless the board's resolution otherwise fixes the date to be the date of the board action.

Maximum aggregate number of shares. Existing section 423 regulations already require that a plan designate the maximum number of shares that may be issued under the plan, which can be expressed as a percentage of the company's issued, outstanding or authorized shares on the date of the plan's adoption. The new regulations make clear that, as with incentive stock option plans, the plan can specify that the maximum number will increase annually by a specified percentage of the company's issued, outstanding or authorized shares on the date of the plan's adoption. The proposed regulations also allow for the maximum number of shares that may be issued under options to change based on any other specific circumstance—for instance, annually on the anniversary of the plan's adoption, by a percentage of the then-outstanding shares—but only if the shareholders approve an immediately determinable number of shares that may be issued under the plan in any event.

Employees covered by the plan. As a general matter, a section 423-qualified plan must be broadly based, but the exclusion of certain employee categories—part-time employees, seasonal employees, employees who have been employed for less than two years, and highly compensated employees—is permitted. The proposed regulations make clear that an employer may exclude certain highly compensated employees—those who are officers, subject to section 16(a) of the Securities Exchange Act or whose compensation is above a certain level—and not all highly compensated employees. Or an employer may adopt a lesser restriction than that permitted under the rule—e.g., employees employed less than one year, rather than two years. These exclusions are permitted, however, only if they apply in an identical manner to all similarly situated employees.

Equal rights and privileges. Section 423 generally requires that all employees granted options under a plan have the same rights and privileges. The new regulations provide certain exceptions and clarifications to that general rule. For example, the proposed regulations make an exception for options granted to foreign employees on less, but not more, favorable terms than those granted to other employee participants, but only if those less favorable terms are intended to comply with the law of a foreign jurisdiction.

The proposed regulations also clarify the terms on which employees may carry forward amounts that were withheld, but not used, toward the purchase of shares under a current plan or offering to a subsequent plan or offering, without violating the equal rights and privileges requirement of section 423.

Option price. The proposed regulations provide that the option price may be determined in any reasonable manner, including valuation methods permitted under section 20.2031-2 (estate tax regulations). This change achieves consistency in the treatment of employee stock purchase plan options with ISOs.

Date of grant. The proposed regulations clarify when an option is considered to have been granted under an employee stock purchase plan. This date is critically important, as it will determine, among other things, whether the employee has satisfied the relevant service and holding period requirements, the employees eligible to participate in the offering, and in some cases, the option price.

The proposed regulations provide two new clarifications. The first is that the minimum option price does not need to be fixed or determinable in order for a date of grant to be established. This is helpful for companies that allow a "look back" to determine the option exercise price: that is, the option price will be the lower of the price (or discounted price) of the shares on the first or last day of an offering period. Where this "look back" feature is offered, the option price will not be determined until the date of exercise at the end of the offering period, but most companies would desire that the first day of the offering period be the date of grant. The proposed regulations confirm that the first day of the offering period can be the date of grant, even though the minimum option price is not fixed or determinable on that date.

The second clarification is with respect to the maximum number of shares that may be purchased upon exercise of the option. Generally, an option will not be deemed granted until the number of shares that may be purchased upon exercise of the option has been fixed. The proposed regulations make clear that if the terms of the plan or the offering designate a maximum number of shares that an employee may purchase during an offering period, or establish a formula by which such a maximum number of shares may be determined on the first day of an offering period, then the grant date of the option will be the first day of the offering period. As an example of such a formula, the proposed regulations point to a plan that establishes a maximum number of shares equal to 10% of an employee's annual salary divided by the fair market value of a share of the stock on the first day of the offering period.

The proposed regulations also make the point that the designation of a maximum number of shares that may be purchased during an offering period is not accomplished merely by reserving a fixed number of shares issuable under the plan, and including the $25,000 annual limitation (described below) in the plan terms. However, the proposed regulations also make clear that the plan or the offering is not required to designate a maximum number or formula. If the plan or offering does not fix the maximum number of shares that may be purchased during an offering period, or if the maximum number is not determinable until the date the option is exercised, then the date of exercise of the option, and not the first day of the offering period, will be the grant date.

Annual $25,000 limitation. Under section 423, employees are not permitted to acquire shares at a rate that would exceed $25,000 in fair market value of the stock for each calendar year in which an option granted to an employee is outstanding and exercisable. The proposed regulations provide that the $25,000 limit will be calculated in a manner consistent with the $100,000 limitation for ISOs, based on when the option first becomes exercisable and the fair market value of the stock at the date of the option grant.

Finally, the proposed regulations clarify the consequences of certain plan or offering failures. In certain instances, the failure will cause the entire offering not to qualify under section 423. For instance, the issuance of an option with terms inconsistent with the terms of the plan or offering will disqualify all options issued under the same offering. This problem might arise if, for instance, an option were issued with an exercise price of 85% of the fair market value of the stock, when the plan terms permit only a 90% discount. By contrast, if an option is granted to an employee who is not entitled to the grant, then the option granted to that employee will not be treated as a qualified option, but the grant will not disqualify all of the other options granted under the offering.

The proposing release states that, once final, the proposed regulations will apply beginning on January 1, 2010. Comments on the proposed regulations must be received by October 27, 2008.