Sandra Sussman, Buck ConsultantsMichael Voves, Dorsey & Whitney LLP

NASPP Twin Cities, February 7, 2013

Trends, Considerations and New Developments in Employee Stock Purchase Plans

Agenda

• Overview

• Plan Design Alternatives

• Trends/Best Practices

• New Developments

• Questions & Answers

Overview

What is an ESPP?

• ESPPs are broad-based stock purchase plans that allow employees to purchase company stock through after-tax payroll deductions

• Often, shares are purchased at a discount

• ESPPs may be tax-qualified (under IRC 423) ornon-qualified

• ESPPs may be “compensatory” (ASC 718 / FAS 123R) or non-compensatory

Why Offer an ESPP?

• Facilitates employee ownership

• Creates corporate identity/ownership culture

• Aligns employees’ interests with shareholders’

• Good bang for the buck

Qualified ESPP (Code Section 423)

• Basic statutory requirements:– Employees only– Exclude 5% owners– Stockholder approval– Equal rights and privileges– $25,000 limit and share limit– Purchase rights non-transferable

Qualified ESPP (Code Section 423)

• Additional requirements allow for design alternatives:– Eligibility– Purchase price – no less than 85% of the lesser of

grant date and purchase date fair market values – Length of offering (3 to 27 months)– Look-back feature

• Purchase discount, offering length, look-back feature all affect the ASC 718 compensation expense

Qualified ESPP (Code Section 423)

• Tax Treatment– No tax at purchase; no FICA or withholding (in the US)– Tax triggered by sale of shares– Favorable tax treatment if stock held two years from

offering date and one year from purchase• Qualifying Disposition (QD): Most of (if any) gain over

purchase price taxed at capital gains rate; always small amount of ordinary income

• Disqualifying Disposition (DD): Ordinary income on spread at purchase; company gets tax deduction for same amount

– Ordinary income reported on W-2– Form 3922 reports prior year’s purchases

Nonqualified ESPP

• No rules or limits

• More flexibility around eligibility/exclusions

• Company match permitted

• Spread on purchase taxed like NQSO– Withholding (including FICA) at purchase– W-2 reporting– Company tax deduction– No Section 6039 reporting

ESPP Accounting

• No earnings charge if non-compensatory– Discount does not exceed 5% of purchase date FMV– Minimal or no “option-like” features (e.g., look back)

• Subject to ASC Topic 718 if compensatory

• Expense (fair value) comprises 3 components:– Value of any discount– Value of call option (if look-back feature)– Value of put option (if no limit on shares purchased if price

declines)

• Certain features trigger modification accounting

Plan Design

Design Decisions

• Qualified or nonqualified?

• Eligibility

• Offering period/purchase period(s)

• Withdrawals, contribution increases/decreases

• Discount

• Match

• Look back

• Holding requirement

• Refund or rollover residual cash

Design Considerations

• Plan objectives

• Workforce demographics– Sophistication level and needs– Pay level (ability to accumulate enough during a purchase period

to purchase a meaningful number of shares)

• The greater the benefit to the employee, the greater the accounting expense and/or administrative cost– Discount– Look-back feature– Length of offering period– Contribution rate changes (increases)

Administrative Considerations

• Shorter offering periods – Creates ownership faster– More purchases to administer

• Avoid scheduling purchase dates during blackouts or at quarter or year end– Schedule during mid-pay cycle to allow time to reconcile

contribution data

• Limit frequency of contribution-rate changes

• Reporting back to enrollees– Beyond Section 6039

Trends/Best Practices

ESPP or no ESPP?

The NASPP’s 2011 Domestic Stock Plan Administration Survey tells us that, among the 583 companies participating in the survey

• 52% have an ESPP– 60% in 2007– 64% in 2004

• Of those that do not have an ESPP, 71% never did

Qualified or Non-Qualified?

• Qualified Pros– Opportunity for favorable tax treatment to the

employee at purchase

• Qualified Cons– Must be non-discriminatory– Complicated tracking and reporting requirements– Complicated accounting– Shareholder approval required– No tax deduction (unless disqualified disposition)

Qualified or Non-Qualified?

• Non-Qualified Pros– More flexibility in design– Less complicated reporting and accounting

• Non-Qualified Cons– No favorable tax treatment at purchase– Withholding on purchase– Shareholder approval may still be required under

applicable exchange rules

Qualified or Non-Qualified?

• NASPP survey results:– 82% of companies with ESPPs have qualified

Section 423 plans• 77% in 2007• 84% in 2004

– 24% have nonqualified plans• 26% in 2007• 16% in 2004

Key Plan Features

• Six-month offering period is most common (53%)– Three months is next (19%), then 12 months (11%)– In 2004, order was six months (29%), 12 months (24%), then

24 months (19%)– Purchase periods = offering period at 67% of companies

• 15% is most common purchase discount (71%, vs 79% in 2007, 87% in 2004); 5% is next, at 17% of companies

• Look back (lower of beginning/end) still is most common(62% vs 66% in 2007, 82% in 2004)

• Contribution-rate changes not typical—fewer than 25% in any scenario

• Automatic resets not typical—85% of companies do not use

Key Plan Features

• Trend has been to eliminate look back and shorten offering periods, in order to reduce compensation expense– Assuming 50% volatility, shortening a 15% look back from 24 to

12 months cuts expense by 20%; shortening to three months cuts expense by 40%

– Lowering discount to 5% from 15% with 24-month look back reduces the expense by 22%

• Studies have shown that elimination of look-back feature does not significantly affect participation levels, in contrast to changes to purchase discount

• Contribution rate increases, automatic resets trigger modification accounting

Other Features

• 20% of companies mandate holding periods to prevent same-day sale for quick gain– Six months most common (38%) followed by 12 (34%)– May also ease burden of tracking dispositions

• Per person limits (in addition to IRS limits)– Contribution max– Share max

• Match if nonqualified plan

New Developments

Cost Basis Reporting

• ESPP purchases for cash are covered

• Brokers have choice to report complete basis or just purchase price

Questions & Answers

Legal Notice and Treasury Circular 230 Notice

This presentation is intended for general information purposes only and should not be construed as legal advice or legal opinions on any specific facts or circumstances.  An attorney-client relationship is not created through this presentation.

To comply with certain Internal Revenue Service (“IRS”) rules, please note that any U.S. federal tax advice contained in this presentation, including handouts, is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed by the IRS. We understand that you do not intend to use or refer to anything contained in this presentation to promote, market, or recommend any particular entity, investment plan, or arrangement.