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Designing and Implementing a Section 423 ESPP

This outline summarizes the principal features of employee stock purchase plans that are designed to qualify under Section 423 of the Internal Revenue Code ("ESPPs") and highlights some of the practical considerations involved in putting an ESPP into place.


The purpose of an ESPP is to encourage broadbased employee ownership of employer stock. Through an ESPP that qualifies under Sections 421 and 423 of the Internal Revenue Code (the "Code"), an employee subject to U.S. tax law can purchase stock at a discount from fair market value and, if certain holding period requirements are met, receive preferred tax treatment upon sale of the ESPP shares. At the same time, the employer incurs no compensation expense for financial accounting purposes with respect to grants made under an ESPP.

Operation of an ESPP

The basic operational parameters of an ESPP are set by Section 423, which are discussed in greater detail below. In general, under a typical ESPP, employees are given an "option" to purchase employer stock at a favorable price at the end of an "offering period." While Section 423 does not require that the shares be purchased through accumulated payroll deductions, most employers find this approach administratively simpler than having all of the plan participants pay for the stock on the same day.

Prior to the beginning of each offering period, eligible employees must indicate if they are going to participate in the plan. If so, the employee typically completes a subscription agreement or enrollment form indicating the percentage or dollar amount of compensation to be deducted from his or her paycheck throughout the offering period. During the offering period, the company withholds amounts from participants' compensation and credits the amounts to participant recordkeeping accounts established for this purpose.

Under most ESPPs, the purchase price is set at a discount from fair market value. While some plans provide that the discount is to be applied to the value of the stock on the purchase date (e.g., 85% of the fair market value on that date), it is more common to provide that that discount is applied to the value of the stock on the first day of the offering period on the last day, whichever is lower.

Most plans permit participants to withdraw from the ESPP prior to the last day of the offering period (the "exercise date"). If a participant does not withdraw from the plan, amounts held for his or her account under the plan are applied automatically to the purchase of shares on the exercise date for the maximum number of shares at the applicable option price. ESPP purchases often take place through a transfer agent of the company or through a brokerage account established for that purpose.

The original subscription agreement setting forth the payroll deduction percentage can continue as long as the plan remains in effect, unless the participant withdraws from the plan, becomes ineligible to participate, or terminates employment. Many plans permit participants to increase or decrease their payroll deduction percentage at any time during the offering period.

Section 423 C Requirements. Section 423 of the Code sets forth certain requirements applicable to ESPPs. To qualify under Section 423 of the Code, an ESPP must meet the following requirements:

  • Employees Only . Only employees of the plan sponsor (or its parent or subsidiary corporations) may participate in the ESPP. Thus, for example, consultants and non-employee directors may not participate in an ESPP.
  • Shareholder Approval . An ESPP must be approved by the shareholders of the plan's sponsor within twelve (12) months before or after the ESPP is adopted by the board.
  • No 5% Shareholders . Any employee who owns five percent (5%) or more of the stock of the plan sponsor may not participate in the ESPP.
  • Eligibility . All eligible employees must be allowed to participate in the ESPP, although certain categories of employees may be excluded:

    - employees employed less than two years;

    - employees whose customary employment is twenty (20) hours or less per week;

    - employees whose customary employment is for less than five (5) months in a calendar year; and

    - "highly compensated" employees (as defined in Section 414(q) of the Code).

  • Equal Rights and Privileges . All ESPP participants must enjoy the same rights and privileges under the plan, except that the amount of stock that may be purchased may be based on compensation differences (e.g., a percentage of compensation).
  • Purchase Price . The purchase price may not be less than the lesser of 85% of the fair market value of the stock (i) at the beginning of the offering period, or (ii) on the purchase date.
  • Maximum Term . The maximum term of offering periods under an ESPP may not exceed twentyseven (27) months unless the purchase price is based solely on the fair market value at the time of purchase, in which case the offering period may be as long as five (5) years.
  • $25,000 Limit . Under all ESPPs of the employer company and its parent and subsidiary corporations, an employee may not purchase more than $25,000 worth of stock (determined based on the fair market value on the first day of the offering period) for each calendar year in which the offering period is in effect.
  • Nontransferability . An employee's right to purchase stock under the ESPP may not be transferred except by will of the laws of descent and distribution and may be exercisable during the employee's life only by the employee.

Designing an ESPP

Within the broad framework of Section 423 there is a good deal of flexibility with regard to plan design:

1. Number of Shares. There is no limit per se on the number of shares that can be issued under an ESPP. The number of shares reserved under an ESPP should take into account the number of shares available to employees under other stock-based programs, the value of the stock, the duration of the offering, limits on employee contributions, eligibility requirements, and so on. In our experience, it is common for employers to reserve as little as 1% and as much as 8.5% of their outstanding shares for their ESPPs, with an average of about 3.5%. Some employers include an "evergreen" or automatic stock replenishment provision in their ESPP. With such a provision, the number of shares available for issuance under the plan increases automatically, typically each year, based on a specified percentage of the employer's outstanding shares (e.g., 2.5% per year). An evergreen provision avoids having to continually seek shareholder approval of plan share increases. For this reason, however, evergreen provisions are not viewed favorably by shareholders, particularly institutional shareholders, and getting initial approval of such a provision may be problematic.

Some employers limit their ESPP share consumption by imposing a cap on the number of shares that can be issued in any one offering period. Such a feature allows employers to plan for future share increases and the associated shareholder approval.

2. Dilution. Other than the number of shares in the plan, the two factors primarily responsible for the dilutive effect of an ESPP are the purchase price of the stock and the duration of the offering period. As a rule, the longer the offering period, the more dilutive the plan, since employees become more likely to purchase their shares at a substantial discount. For example, assume that the fair market value of the employer's stock on the date of grant is $30, and with a 15% discount, the purchase price would be $25.50 (85% of $30). Assume further that at month 24 the fair market value of the stock is $48. By allowing employees to purchase the shares at 85% of the value on the date of grant (i.e., $25.50), the 15% discount would increase, in this example, to a discount of 47% of the value on the date of purchase. The dilutive effect is even more pronounced in plans which include a feature (discussed in greater detail below) under which participants automatically flip into a new offering period in the event of a decline in the value of the company's stock.

3. Offering Periods. ESPPs typically permit participants to purchase shares at the end of an "offering period," which typically run from three to 27 months. Most plans have offering periods of either six months or some multiple thereof (e.g., 12 months, 24 months).

Plans with offering periods of more than six months typically include interim "purchase periods." For example, if the offering period is 24 months, employees might be allowed to purchase shares at the end of each of the four six-month purchase periods within the 24month offering period. In this situation the purchase price in any one purchase period is usually based on the fair market value on the first day of the offering period or the last day of the particular purchase period, whichever is lower. Plans with offering periods longer than six months are more difficult to administer, both because of the interim purchase periods and the fact that in most plans of this kind there are overlapping offering periods (e.g., a new 24-month offering commences every six months).

Some ESPPs include an offering period "reset" provision. These plans typically include offering periods that are 12 or 24 months long and begin every six months. For example, a 24- month offering period plan might include 4 six-month purchase periods (i.e., purchases occur every 6 months during the offering period.) Under a reset provision, if the company's stock declines in value, at the end of a purchase period the employees are considered to have automatically withdrawn from that offering period and enrolled in the next 24month offering period. This feature gives the employee the lowest possible purchase price, since the purchase price is reset as of the first day of the new offering period.

Some plans offer 12- or 24-month offering periods without interim purchases or otherwise restrict the transferability of purchased shares. These plans preclude employees from selling their shares immediately after purchase, and are intended to foster greater employee stock ownership.

4. Contribution limits. The IRS limits purchases under an ESPP to $25,000 worth of stock in any one calendar year, valued as of the first day of the offering period. Under this rule, if a plan has a 12-month offering period beginning each January 1, and the value of the stock on a particular January 1 is $10.00, then no employee may purchase more than 2,500 shares ($25,000 divided by 10) in that offering period. Where the offering period extends over more than one calendar year, the limit is $25,000 worth of stock for each calendar year in which the offering period is in effect.

Other than this limit, there is no statutory limitation on employee contributions. However, most plans limit employee contributions to a fixed percentage of compensation, generally 10-15%. For most plan participants, this limit usually falls well below the statutory $25,000 limitation.

5. Compensation. Closely related to the percentage limitation is the plan definition of compensation. Generally, base pay is the simplest, but another definition can be used if base pay does not accurately reflect the make up of the employees' compensation.

6. Eligibility. All employees may participate in an ESPP. Section 423 of the Code permits a plan to exclude employees who have been employed for less than two years or who are employed for less than 20 hours per week or five months per year. Also, owners of 5% or more of the common stock of a company by statute are not permitted to participate. Most companies impose either no service requirements or require only a brief employment period to participate, such as three months. Any service requirement should be considered in light of employee turnover, competitive practices, and the eligibility requirements of other company plans.

Offering periods often commence every six months. As a result, new hires may have to wait up to six months to participate in an ESPP, in addition to any service requirement.

7. Participation by Non-U.S. Employees. Often, employers with employees working outside of the U.S. wish to extend ESPP participation to such employees. Before expanding an ESPP outside the United States, however, employers should become familiar with the applicable laws and regulations of each of the foreign countries where participation will be extended. A discussion of these laws and regulations is beyond the scope of this outline.

Employers will also need to consider the impact of such participation on qualification of their ESPP under Section 423. Among other things, Section 423 requires (i) that all otherwise eligible employees of any corporation whose employees participate be allowed to participate in the ESPP, and (ii) that such participants be allowed to participate on the same terms and conditions. These requirements can be problematic with respect to non-U.S. participants. Local laws sometimes impose requirements that are unique to employees in a particular country, which could violate the equal rights and privileges requirement under Section 423. Similarly, problems can arise where the non-U.S. employees work out of branch offices or divisions, since the non-U.S. employees will be considered employees of the U.S. employer for purposes of Section 423.

As an alternative to adding non-U.S. employees to the ESPP, many employers implement mirror ESPPs for their non-U.S. employees. These plans, which are not intended to qualify under Section 423, give employers more flexibility in designing the plan to meet the particular requirements of each country and with respect to each employee group. Moreover, it preserves the 423 plan for the benefit of U.S. employees who can benefit from the favorable tax treatment offered under tax-qualified plans.

8. Maximum Number of Shares. In addition to the $25,000 limit discussed above, most plans establish a limit on a number of shares that may be purchased by any one participant in an offering period. This satisfies a rather loose IRS requirement that applies where the number of shares that will be purchased is not known until the last day of the offering period. The IRS takes a position that a plan must establish a maximum cap as of the first day of the offering period. Most plans define the maximum cap with reference to a formula or based on a specific number of shares.

9. Interest. Money contributed by the plan by employees becomes part of the employer's general assets. In the event the employee terminates employment, this money is refunded, typically without interest. A few employers provide that money returned to employees is credited with interest at some nominal rate, such as 5%.

Federal Income Tax Considerations . Section 423 Plan

If a plan meets all the requirements discussed above, an employee who purchases stock under the ESPP will not recognize income for federal income tax purposes on the purchase, but will instead defer the tax consequences until the employee sells or otherwise disposes of the stock.

If stock that was purchased under an ESPP is held for more than one year after the date of purchase and more than two years after the beginning of the offering period, or if the employee dies while owning the shares, the employee realizes ordinary income on a sale (or a disposition by way of gift or upon death). The amount of ordinary income recognized equals the lesser of: (i) the actual gain (the amount by which the market value of the shares on the date of sale, gift or death exceeds the purchase price), or (ii) the purchase price discount (however, if the purchase price is based on the lower of the value of the stock on the first or last day of the offering period, the purchase price discount is computed as of the first day of the offering period). All additional gain upon the sale of stock is treated as long-term capital gain. If the shares are sold and the sale price is less than the purchase price, there is no ordinary income, and the employee has a long-term capital loss for the difference between the sale price and the purchase price.

If the stock is sold, or is otherwise disposed of including by way of gift, within either of the Section 423 holding periods (a "disqualifying disposition"), the employee recognizes ordinary income at the time of sale or other disposition taxable to the extent that the fair market value of the stock at the date of purchase was greater than the purchase price (i.e., the "spread" at purchase). This amount is considered ordinary compensation income in the year of sale or other disposition even if no gain is realized on the sale or disposition. This would be the case, for example, in the event of a gift. The difference, if any, between the proceeds of sale and the fair market value of the stock at the date of purchase is a capital gain or loss, which is long-term if the stock has been held more than one year. Ordinary income recognized by the employee upon a disqualifying disposition constitutes taxable income that must generally be reported on a Form W2. Although the IRS appears to take the position that employers must withhold taxes in this situation, few employers do in reliance on Rev. Rul. 7152.

Subject to the limitations of Section 162(m) (the $1,000,000 deduction limit), the employer receives a tax deduction only to the extent that a participant recognizes ordinary income on a disqualifying disposition. The employer does not receive a deduction if the participant meets the holding period requirements. Since the purchase price is typically expressed as a discount from fair market value, compensation recognized by a participant will not be considered "performance-based" within the meaning of Section 162(m), and will therefore apply against the $1,000,000 deduction limitation under that Section. To enable the employer to take full advantage of its tax deduction, participants should be required to notify the employer in writing of the date and terms of any disposition of stock purchased under an ESPP.

Section 6039 of the Code requires that the employer provide participants with an information statement by January 31 of the year following the year in which they transfer shares purchased under an ESPP. While penalties may be imposed on an employer who fails to furnish such statements, the IRS has informally indicated that it will not impose such penalties.

Federal Tax Consequences . Non-Section 423 ESPP

In some cases, an ESPP may not qualify under Section 423, either by design or as a result of plan operation. In such cases, stock purchased under the plan will be treated, for tax purposes, as though it had been acquired under a nonstatutory stock option. As a result, a plan participant will not recognize income by virtue of participating in the plan, but will recognize ordinary compensation income for federal income tax purposes at the time of purchase measured by the excess, if any, in the value of the shares at the time of purchase over the purchase price. If the participant is also an employee of the company, the compensation income recognized at the time of purchase will be treated as wages and will be subject to tax withholding by the company. Subject to the deduction limitation under Section 162(m), the company will be entitled to a tax deduction in the amount and at the time that the plan participant recognizes compensation income with respect to shares acquired under the plan, provided the company properly reports the income recognized by the participant (e.g., on Form W2). Upon a resale of shares by the participant, any difference between the sales price and the purchase price (plus any compensation income recognized with respect to such shares) will be capital gain or loss and will qualify for long-term capital gain or loss treatment if the shares have been held for more than one year. Currently, the tax rate on net capital gain (net long-term capital gain minus net short-term capital loss) is capped at 28%. Capital losses are allowed in full against capital gains and up to $3,000 of other income.

Additional Considerations

Shareholder Approval. Section 423 of the Code requires that an ESPP be approved by company shareholders within 12 months of its adoption by the board of directors. No further shareholder approval is required, unless the company amends the plan to increase the number of shares available for issuance or changes the designation of corporations whose employees may participate in the plan (unless the plan provides that such designations may be made from time to time).

Federal Securities Law. For public companies, shares issued under an ESPP are typically registered with the Securities and Exchange Commission ("SEC") on Form S-8. Registration of shares by means of Form S-8 is relatively straightforward. Form S-8 consists of two parts, a prospectus and an information statement. The prospectus is intended to be distributed to participants but is not filed with the SEC. The information statement, which must be filed with the SEC, largely consists of documents, such as annual financial reports, that have been prepared by the company for other purposes and are incorporated in the S-8 by reference.

As a result of the 1996 changes to Rule 16b-3 of the Securities and Exchange Act of 1934, ESPP transactions (other than sales of shares purchased under any ESPP) are exempt from Section 16(b) of the Exchange Act (i.e., the short-swing profit rules). Transactions under any ESPP are exempt from the reporting requirements of Section 16(a) as well.

Accounting Considerations. Under APB 25, Section 423 ESPPs are generally considered "non-compensatory plans" and do not result in any compensation cost for financial accounting purposes, even though the shares are typically sold at a discount from fair market value. However, the recently-released FAS 123 now requires footnote disclosure of projected costs of most ESPPs.

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