Fixing Operational Errors in Section 423 Plans

Mistakes can happen when administering equity plans. In this blog entry, I look at common errors in ESPPs and how to fix them.

Excluding an Eligible Employee

One error with the gravest consequences is the inadvertent exclusion of an employee that should be eligible to participate in the plan. Under §1.423-2(a)(4), if an eligible employee isn't permitted to participate in an offering, the entire offering is disqualified under Section 423. This means that none of the purchases under the offering would qualify for preferential treatment under Section 423.

This is an error that I see happen with some regularity, especially when employees transfer between corporate entities. If you've experienced problems in the past with eligible employees being inadvertently excluded from the ESPP, now would be a good time to implement some controls to prevent this from happening in the future.

Inclusion of Ineligible Individuals

The flip side of excluding an eligible employee is allowing someone that isn't eligible under the plan to participate in an offering. Here the consequence are much less dire; that individual's purchase won't receive preferential tax treatment, but the overall status of the offering isn't impacted.

Purchases in Excess of Plan Limits

Another common error is allowing employees to purchase shares in excess of either the $25,000 limitation or a plan limit. The regs make it clear that where a purchase doesn't comply with the terms of the plan or offering, that purchase is no longer under the umbrella of the ESPP, even if it would otherwise qualify under Section 423 (for example, where a purchase exceeds a plan limit but not the $25,000 limitation). Purchases that aren't under a qualified ESPP can't receive preferential treatment under Section 423.

The regs also clarify that where the terms of the option under which the purchase is made originally complied with both the terms of the plan/offering and Section 423 and the purchase ends up violating the original terms of the option, only the purchase is disqualified; it doesn't impact the status of the entire offering. (By contrast, granting an option with terms that violate the plan/offering or Section 423 does likely disqualify the entire offering because the eligible employee that received the offending option now hasn't been allowed to participate in the qualified offering.)

A situation where an employee is allowed to purchase in excess of a plan limit or the $25,000 limit would likely fall under this treatment. The purchase itself--the entire purchase, not just the shares in excess of the limit--is disqualified but the status of the rest of the offering is unharmed.

Impact of Disqualification

When a purchase fails to meet the requirements of Section 423, it is treated as the exercise of a nonqualified stock option. The spread on the purchase is treated as compensation income, subject to tax withholding (and company matching payments) and reportable on Form W-2. Where an entire offering is disqualified from Section 423, this treatment applies to all purchases made under the offering (by US employees, that is; non-US employees are still subject to whatever tax treatment applies under the laws of their own tax jurisdiction).

The penalties for failing to collect the withholding taxes can be up to 100% of the amounts that should have been withheld, plus interest. The penalties for failing to report the income on Form W-2 can exceed $600 per form--over $300 for the return filed with the IRS and the same amount for the statement issued to the employee (up to an annual maximums of nearly  $4 million for the returns filed with the IRS and another $4 million for the employee statements). 

Designating Separate Offerings to Protect Against Disqualification

The final regs view each offering under the plan as independent of any other offerings. Consequently, operational errors may disqualify a single offering but are unlikely to ever disqualify an entire plan. For example, if a company prohibits an eligible employee from participating in an offering, that would disqualify that offering, but it wouldn't disqualify prior offerings under the plan (provided the employee either wasn't eligible to participate in those offerings or was allowed to participate in them), nor would it impact the status of future offerings under the plan (assuming that the error is addressed for those offerings).

I see a fair amount of operational errors with respect to the participation of non-US employees. To protect US participants from the possible ramifications of these errors, separate offerings can be established for non-US participants, where those participants are employed by a separate corporate entity (non-US employees of the US parent have to be allowed to participate in the same offering as US employees). I don't think it matters much whether you have one separate offering for all non-US employees or separate offerings for each distinct corporate entity, just so long as the employees of non-US entities aren't participating in the same offerings as US employees.

It may make sense to designate separate offerings for each distinct corporate entity within the United States, as well. One situation where I commonly see eligible employees excluded from participating in the ESPP is when they transfer between corporate entities. HR/payroll processes the transfer as a termination, causing the transferred employee to be withdrawn from the plan. If separate offerings are established for each corporate entity, then this error is a problem only for the offering for the corporate entity that the individual is now employed by; it doesn't jeopardize the tax treatment for all US employees.