Fixing Mistakes: Operational Errors in Section 423 Plans

In this blog entry, I continue my series on fixing mistakes in the operation of equity plans with a look at common errors in ESPPs and how to fix them. Other installments in the series address omitted grants and late-reported terminations.

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. Unfortunately, the best fix for this error is to prevent it from occurring.  The second best fix is to catch it early, before the excluded employee has fallen so far behind on plan contributions that it is hard for them to catch up and before they’ve missed any purchases. Here are a few controls to implement to identify this error early:

• Conduct an audit after the first payroll period in each offering/purchase period to ensure that contributions are being recorded for all enrolled employees.
• Conduct a mid-purchase period dry-run to verify contribution rates for all enrollees.
• Instruct participants to verify their ESPP contributions on their pay stub and notify you right away if the amounts are wrong or if deductions are not being taken.
• Before processing a purchase, audit the contribution records for employees who experienced a status change (e.g., employees returning from leave) or transferred between corporate entities.

When an excluded employee is discovered, the following principles should govern the company’s approach to remedying the error:

• The excluded employee should be allowed to participate in the offering on an equal basis with all other participants.
• All similarly affected employees should be treated equally.

If the error is discovered before the purchase occurs, the excluded individual can be enrolled in the offering and allowed to make up the missed contributions. Some companies might allow excluded employees to choose whether to make up the missed contributions or simply contribute from that point forward.

The path to correct an exclusion that isn’t discovered until after the purchase has occurred is less clear. If the error is discovered quickly (e.g., within a few days) after the purchase, one solution might be to allow the employee to make up the purchase. The more time that passes before the omission is discovered, the murkier the remedy is. Because the IRS does not have a formal corrections program for ESPP operational errors, I recommend consulting your tax advisors regarding the appropriate course of action.

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 consequences are much less dire; that individual's purchase won't receive preferential tax treatment in the United States, but the overall status of the offering isn't affected.

If the error is discovered prior to the purchase, the ineligible individual should be withdrawn from the plan and his/her contributions refunded. Even though the individual’s purchase won’t affect the tax status of the plan or offering, there can be securities law and contractual considerations to allowing participation that violates the terms of the plan.

If the error is discovered after the purchase has occurred and the individual is allowed to keep the purchased shares, the purchase should be taxed as the exercise of a nonqualified stock option (assuming the participant is subject to tax in the United States—see “Impact of Disqualification” below). In this situation, however, many companies might first try to rescind the purchase. i.e., require the ineligible participant to return the purchased shares and refund the purchase price. Under US tax regs, rescissions generally need to be effected within the same calendar year as the transaction (this is another reason to avoid scheduling ESPP purchases for December 31).

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 ESPP regs make it clear that when 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, when 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 in question is disqualified; it doesn't affect the status of the entire 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.

If the participant is allowed to keep the purchased shares, the purchase should be taxed as the exercise of a nonqualified stock option (assuming the participant is subject to tax in the United States—see “Impact of Disqualification” below). But because there can be securities law and contractual matters to consider when the purchases do not comply with the terms of the plan, many companies might first try to require the participant to return the excess shares and refund the purchase price for those shares.

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 be close to $800 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 maximum of exceeding $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 ESPP 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.