IRS Issues Final ESPP Regulation and Reporting Requirements for ISOs and ESPPs

The IRS recently issued a final regulation (the “ESPP Final Regulation”) relating to options granted under an employee stock purchase plan (an “ESPP”) as defined in Section 423 of the Internal Revenue Code, as amended (the “Code”), and a final regulation (the “Reporting Regulation”) regarding the reporting requirements for incentive stock options granted under Section 422 of the Code (“ISOs”) and ESPPs.  Some of the key provisions and changes contained in the ESPP Final Regulation and the Reporting Regulation are:

• Determination of the ESPP option grant date is contingent on whether the plan or offering designates a maximum number of shares that may be purchased by each employee during the offering
• Clarification of the $25,000 limit for ESPPs
• Creation of a new concept of separate offerings for ESPPs
• Beginning with transfers of stock in 2010 relating to ISO exercises and ESPP purchases, employers will be required to file an information return with the IRS, in addition to providing employees with an information statement

ESPP Final Regulation

The ESPP Final Regulation applies to offering periods beginning on or after January 1, 2010.  Companies with ESPPs should review their plans immediately and determine whether any amendments to their plans may be necessary as a result of the ESPP Final Regulation.  The following is a brief summary of the three major provisions of the ESPP Final Regulation:

Option Grant Date

The ESPP Final Regulation provides that the date of grant will be the first day of an offering period only if the ESPP or the terms of the offering state a maximum number of shares that may be purchased by each employee during the offering.  Establishing the start of the offering period as the date of grant is required if the plan bases the purchase price on the lesser of the fair market value of the stock at the beginning or end of the offering period.  It is also advantageous for several reasons, including determining the annual $25,000 limitation (as discussed below) and eligibility for capital gains tax treatment.  By having the date of grant be the first day of an offering period, it starts the one-year and two-year holding periods that are required for an employee to obtain long-term capital gains tax treatment.  The date of grant will default to the date of exercise if the ESPP or the terms of the offering do not contain a maximum per employee limit.  Therefore, it is important to amend any ESPPs before the first offering starting in 2010 if it is desirable to set the date of grant as the first day of an offering period.

Annual $25,000 Limitation

With respect to the annual $25,000 limitation, the ESPP Final Regulation clarifies that such annual limit on the fair market value of the stock that may be purchased by an employee increases by $25,000 for each calendar year that an option is outstanding.  This annual limit is determined without regard to exercisability of such option.  The fair market value of the stock is determined on the date of grant, which, as described above, will be considered to be the first day of an offering period only if the plan imposes a maximum limit per employee.

Separate Offerings

The ESPP Final Regulation provides that there may be one or more offerings under an ESPP and that such offerings may contain different terms, provided that each offering separately complies with the rules.  This is significant for those companies that would like to establish separate offerings with different terms for foreign employees.

Reporting Requirements for ISOs and ESPPs

In 2008, the IRS issued a proposed regulation regarding information reporting requirements for incentive stock options and ESPPs under Section 6039 of the Code.  Goodwin Procter’s January 13, 2009 Client Alert, “Information Statements and Tax Reporting for ISO and ESPP Transactions,” discusses these information reporting requirements in detail.  The IRS recently finalized the Reporting Regulation regarding such requirements.  Although the Reporting Regulation applies as of January 1, 2007, the IRS waives the information reporting requirements to the IRS for stock transfers that occurred prior to 2010.  Therefore, the first information filings with the IRS will be required in early 2011 with respect to ISO exercises and ESPP transfers occurring in 2010.  This is in addition to the information statements already required to be provided to employees and former employees.  For 2009 ISO exercises and ESPP transfers, employers should continue to provide information statements to employees and former employees as they did last year.

With respect to reporting of ISO exercises, the information required in the return and information statement is the same as in the proposed regulation.  However, the Reporting Regulation clarifies the timing requirement for filing a return with respect to a stock transfer pursuant to the exercise of an ESPP option.  Since the timing of the filing hinges on when the first transfer of such stock is made, there was some ambiguity in the proposed regulation as to when such transfer of legal title occurs when the employer, upon the exercise of an ESPP option, immediately deposits such shares into a brokerage account established on the behalf of the employee.  The Reporting Regulation provides that transfer of legal title to a recognized broker or financial institution immediately following the ESPP option exercise is considered the first transfer of legal title and therefore the filing requirement is triggered with such transfer.  The IRS indicated that it expects to release the IRS forms required with respect to the reporting requirements in the near future.