How to Audit Your Upcoming ESPP Purchase

There are a lot of moving parts to an ESPP that all come together in just a few days. That’s a lot of things that can go wrong and not a whole lot of time to dot all the Is and cross all the Ts. In this blog, I provide a list of audits to perform that can help you feel more confident that your records are error-free before you finalize the purchase results and send the share issuance instructions to your transfer agent.

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Plan Parameters

Before processing your purchase, confirm that the plan parameters are set correctly in your stock plan administration platform. This is especially important if your plan parameters have changed—for example, if a plan limit has been modified. Even if nothing in your plan has changed, it’s possible that a system update has added or modified settings that must be reviewed and validated before the purchase is processed.

One of the most important parameters to verify is that the purchase price is being calculated correctly. A great way to confirm that the plan settings are correct is to run a practice or “mock” purchase in advance to confirm the purchase price and key parameters for contribution amounts and limits. Perform all the same audits and reviews that you will do for the final purchase.

Residual Contribution Amounts

If your plan limits purchases to whole shares, there will be excess contributions for each participant after each purchase. These amounts are less than the price of one share and can be refunded to participants or can be carried forward and applied to participants’ subsequent purchases.

When participants’ purchases are limited, e.g., due to the $25,000 limit or a plan limit, they will have large sums of unused contributions left after the purchase. Most companies refund these larger sums, although they also can be carried forward and applied to subsequent purchases.

Trap for the Unwary: In Section 423 qualified plans, any unused contributions exceeding a participant’s final per-share purchase price in an offering should be refunded at the end of the offering. Carrying these larger sums forward to a subsequent offering could violate the equal rights and privileges requirement of Section 423, disqualifying the offering from preferential tax treatment.

Regardless of whether you refund or carry forward unused contributions after a purchase, you’ll need to verify that they have been handled correctly before processing the next purchase:

• Refunds: If you refund this excess amount back to the participant, confirm that the refund has been recorded appropriately in your recordkeeping systems (both payroll and stock plan administration).
• Carry-Forwards: If you carry the excess forward and apply it to the next purchase, verify that the residual contribution amount associated with each participant is equal to the excess contribution amount recorded after the previous purchase. Additionally, verify that any remaining unused contributions have been refunded to any participants who terminated or withdrew from the plan after the previous purchase and that this refund is reflected in your recordkeeping systems.

This audit ensures that participants purchase the correct amount of stock and prevents inadvertent purchases for individuals who are no longer participating in the plan.

Contributions

As you receive reports of the contributions recorded by each of your payroll groups, you will be confirming that the amounts are correct. One reconciling item you may have overlooked is verifying the total contribution amounts recorded by payroll against the contribution amounts deposited into the clearing account where contributions are held.

This verification will help ensure that the contributions used to calculate purchased shares are correct. If there is a discrepancy between the payroll record and the clearing account, it may indicate an error that you’ll want to address prior to the purchase.

If you offer your ESPP in countries that require contributions to be held in a separate account, you may need to reconcile against more than one account.

Eligibility

Section 423 qualified ESPPs must be operated in a manner that allows all eligible employees who desire to participate in the plan to do so and prevents ineligible employees from participating. Even if your plan isn’t qualified under Section 423, you still need to operate it in a manner that complies with its eligibility requirements.

One common violation of eligibility requirements is when an employee enrolls in the plan but is prevented from participating in the purchase due to an administrative error. This could be because the enrollment record did not get communicated correctly to payroll, contributions were not withheld, contributions were not communicated to the stock plan management team, the participant was inadvertently withdrawn, or any number of other administrative issues.

In a Section 423 plan, this error can cause the entire offering to no longer qualify for preferential tax treatment. In a nonqualified plan, it will, at a minimum, result in a disappointed employee. In both cases, employees might be able to bring legal claims against the company that they were denied a benefit they were entitled to.

One way to proactively minimize the likelihood of excluding an eligible participant from your purchase is to send a communication to all eligible employees confirming whether each is currently enrolled (and their contribution level). Including employees who are not enrolled in this communication gives them an opportunity to notify you if they should be (and it may help promote the ESPP—sort of like how confirming you don’t want insurance when you rent a car might make you think twice about declining it).

It is also important to check your enrollment records against your payroll contribution records prior to the purchase to confirm that each individual who enrolled in the purchase period also has contributions. Give special attention to employees who experienced status changes during the purchase period (e.g., employees who were on leave, transferred to a new location or corporate entity, changed to part-time status)—these types of changes can sometimes cause payroll to inadvertently cease withholding contributions for affected employees.

Uncovering any participants that may have been incorrectly excluded prior to the purchase will give you the opportunity to take corrective action before it becomes a bigger problem.

Terminations and Withdrawals

Another common eligibility violation is allowing someone to participate in the plan who is ineligible. Although this isn’t as dire a situation as preventing eligible employees from participating, it can still be a challenge to unwind after the purchase (especially if the employee sells the shares acquired under the plan before you take action to correct the error).

As part of your final purchase audit, take a close look at participants who enrolled at the beginning of the period, but who have withdrawn from the plan either voluntarily or because of a termination. Here again, give extra scrutiny to employment status changes and transfers between locations and corporate entities.

Here are some of the issues you are looking for in this audit:

• Match a termination or withdrawal record to any employee who has an enrollment record but is not on the final contribution list that you receive from payroll.
• Verify that the final contribution list does not include contributions for any terminated or withdrawn employees.
• Validate that all enrollees who experienced a status change are either still contributing or have been withdrawn, as is required under the terms of the plan. Be sure that you understand how transfers from one location or corporate entity to another are reflected in your HRIS database and how these status changes are treated under your ESPP, so that you can confirm all transfers have been handled appropriately.
• If you allow employees to reduce their contribution amount to zero without withdrawing, add this to the possible scenarios to validate as you confirm the termination and withdrawal records for your purchase.

Exchange Rates

Whether you receive contribution amounts from your international payroll teams already converted to US dollars or you manage the conversion yourself, verify that the correct exchange rate is used. Don’t forget to check for silly, but costly, mistakes like an inaccurate decimal point or a formula that is pointing to the wrong field in your spreadsheet.

Purchase and Contribution Limits

Review all contributions and amounts that employees are purchasing to ensure that none exceed the limits established under your plan. If your plan is qualified under Section 423, don’t forget to make sure purchases comply with the $25,000 limit.

Available Shares

Verify that the aggregate number of shares employees will purchase do not exceed the shares available for purchase under your plan.

Fair Market Values

Talk about catastrophic failures: a mistake in a fair market value can be a true disaster! Check and double-check all relevant values, including the FMV on the purchase date and each enrollment date. Consider validating the values through multiple sources. If using online sources, save screen captures of the values from each source you use.

Get Proactive

Tired of doing everything at the last minute? The article Preparing for a Purchase in Your ESPP explains how moving some audits to earlier in the purchase period can make for a less stressful purchase date.

Need a checklist? Use our sample purchase checklist as a starting point to create your own.