Final ESPP Regulations Become Effective January 1, 2010

The Internal Revenue Service (IRS) and Treasury Department have issued final regulations for employee stock purchase plans (ESPPs) designed to qualify for favorable tax treatment under Section 423 of the Internal Revenue Code of 1986, as amended.  The final regulations provide guidance to assist taxpayers in complying with Section 423 and also clarify certain existing rules.  The final regulations apply with respect to any option grants that are intended to qualify for favorable tax treatment under Section 423 on or after January 1, 2010.  Taxpayers may rely on the final regulations for the treatment of any statutory options granted prior to January 1, 2010.  

Consequences of Inconsistent Terms

The final regulations provide that, in order to receive favorable tax treatment, an option must be consistent with the terms of the ESPP or an offering made under the ESPP.  If an option with terms that are inconsistent with the terms of the ESPP or the offering is granted to an eligible employee, and the employee is not granted an option under the offering that is consistent with the terms of the ESPP or offering, then none of the options granted under the offering will be eligible for the favorable tax treatment.

Stockholder Approval

The final regulations retain the requirement that an ESPP be approved by the stockholders of the granting corporation within 12 months before or after the date the ESPP is adopted and provide additional guidance concerning the circumstances under which stockholder approval is required.  In particular, 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, for example, in the case of certain corporate transactions.

Employees Covered

Section 423 generally provides that an ESPP or offering must, by its terms, provide that options are to be granted to all employees of any corporation whose employees are granted options.  However, Section 423 permits an employer to exclude certain categories of employees from participation in an ESPP, including employees who have been employed less than two years; employees who customarily work 20 hours or less per week; certain seasonal employees; and highly compensated employees.  The final regulations clarify that an ESPP or an offering will not fail to satisfy Section 423’s coverage requirements if the employer excludes a subset of any such groups (e.g., employees who have been employed less than one year or those who customarily work 10 hours or less per week).  In the case of highly compensated employees, the final regulations provide that the terms of an ESPP or offering may exclude highly compensated employees (i) with compensation above a certain level or (ii) who are officers subject to Section 16(a) of the Securities Exchange Act’s disclosure requirements.  The terms of each offering under an ESPP may be different, even where multiple offerings overlap, so long as the exclusions with respect to a particular offering are applied in an identical manner to all employees. 

Foreign Employees

Section 423 generally requires that all employees granted options under the ESPP have the same rights and privileges.  However, the IRS and the Treasury Department agree that, under certain circumstances, it may be appropriate for terms to be less favorable with respect to foreign employees.  Accordingly, the final regulations provide that an ESPP or an offering will not fail to satisfy Section 423’s requirements if, in order to comply with the laws of a foreign jurisdiction, the terms of an option or offering to citizens or residents of foreign jurisdictions are less favorable than the terms of options granted under the ESPP or offering to U.S. employees. 

Purchase Price

The final regulations provide that the purchase price of options under an ESPP may be determined in any reasonable manner, so long as the price is not less than the lesser of (i) 85 percent of the fair market value of the stock on the grant date and (ii) 85 percent of the fair market value of the stock on the purchase date.

Annual $25,000 Limitation

The final regulations provide that no employee may purchase stock under all ESPPs of an employer corporation and its related corporations at a rate that increases by more than $25,000 of stock (based on the fair market value of the stock on the grant date) for each calendar year that an option is outstanding.

Date of Grant

Setting the grant date of an option under an ESPP is essential, as it is the relevant date for compliance purposes, including ensuring that the participation requirements are satisfied and applying the annual $25,000 limitation. The final regulations generally provide that the grant date of an option means the date when the maximum number of shares that can be purchased under the option is fixed or determinable, even if the minimum option price is not fixed or determinable.  Thus, the final regulations provide that the date of grant will be 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, or if the terms of the ESPP or offering provide a formula on the first day of the offering to determine the maximum number of shares that may be purchased.