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Changes to IRS Section 423 for ESPPs -- What to Watch for

There are undoubtedly many benefits to having an employee stock purchase plan (ESPP). Not only are they a vehicle for employees to acquire company stock, typically at a discount, but they also result in favorable tax treatment for U.S. companies.

However, in order to reap the benefits of these tax breaks, companies must comply with Section 423, which the IRS modified in November, 2009. Two of these clarifying regulations are particularly noteworthy:

First, for a tax-qualified plan using a "look-back" provision, the plan must specify -- as of the offering date -- the maximum number of shares an individual can purchase during the offering period. Plans that fail to do so will be required to use the purchase date as the grant date. This means that a plan providing a discounted price at the beginning of the purchase period, which would no longer be treated as the grant date, would lose its tax-qualified status, subjecting the employees (and the employer for FICA taxes) to taxation at the time of share purchase.

Second, an ESPP without a separately stated plan share authorization will not meet the requirements of Section 423, again potentially subjecting purchases under that plan to lose their tax-qualified status.

ESPP Expensing - Not What it Seems

U.S. FASB Accounting Standards Codification ASC 718-50-20, ASC 718-50-35 and ASC 718-10-35-3 provide for recognition of expense for compensatory ESPPs associated with increases in employee withholdings. These are regulations that dictate how an ESPP would be expensed if an employee changed the percentage of money they automatically contribute to their plan from each paycheck.

These regulations deal with three types of changes: the percentage of compensation an employee designates for withholding from each of their paychecks; a modification measured on the change of the date of election; and a salary increase that is not treated as a modification. In the final case, the incremental compensation cost is the product of the incremental shares to be purchased times the fair value, measured on the grant date. For example, an employee may elect to participate in the plan on the grant date by requesting that 5% of their annual salary be withheld for future purchases of stock. If the employee receives an increase in salary during the term of the award, the base salary on which the 5% withholding amount is applied will increase, thus increasing the total amount withheld for future share purchases. This is not considered a modification of the original award.

A modification of the terms or conditions of an equity award, including an ESPP modification, shall be treated as an exchange of the original award for a new award. In substance, the entity repurchases the original instrument by issuing a new instrument of equal or greater value, incurring additional compensation cost for any incremental value. Modification expense is the excess, if any, of the fair value of the modified award over the fair value of the original award immediately before its terms are modified. The estimate at the modification date of the portion of the award expected to vest shall be subsequently adjusted, if necessary.

As a practical matter, to avoid the requirement to recognize ESPP expense under the modification principle, many companies do not allow elective employee increases during an offering period. Similarly, companies that allow the contribution amount to increase as a result of company-wide increases in salary (e.g. as a result of an annual salary increase) will apply a company-wide factor to capture the higher expense due to the increased number of shares eligible for purchase by everyone enrolled in the plan.

Given the complexity of expensing, even as it relates to ESPPs, and the increased emphasis it has received of late, it's always a good idea to regularly review your plan to ensure it meets current ESPP expensing requirements.

Changes to Section 6039 - Is Your Company Ready?

In late 2009, the IRS issued final guidelines under Section 6039 for filing returns for incentive stock option (ISO) and employee stock purchase plan (ESPP) transactions.

These regulations require companies to provide a statement to employees upon exercise of an ISO and upon first transfer following purchase of ESPP shares. Final regulations clarify that, where shares purchased under an ESPP are immediately deposited into brokerage accounts, that is considered to be the first transfer of legal title.

The Tax Relief and Health Care Act of 2006 amended Section 6039 by requiring companies to file a return with the IRS in addition to providing the information statement to their employees. However, the act also waived the requirement to file returns with the IRS for transactions occurring before 2010. Consequently, your company has until early 2011 to start filing these returns, and they don't have to be filed for employees that do not require a Form W-2.

In May 2010 the IRS issued Draft Forms 3921 for reporting ISO exercises and 3922 for reporting ESPP transactions, as well as instructions for these forms, both of which may be subject to change. Final forms and instructions are expected to be issued in August. The Form 3921 requires six pieces of information related to the transaction and the Form 3922 requires eight pieces of information, excluding required information on the employee and employer. Both the 3921 and 3922 forms are due to the employee by January 31, 2011, and electronically to the IRS by March 31, 2011.

Solium Capital can assist you in ensuring that you're correctly capturing the accounting expense of your company's ESPP. For more information, please contact your Account Manager or email us at solutionsconsultants@solium.com

866.976.5486

Since the SEC announced in February that a confirmation on IFRS implementation in the U.S. would be put off yet again, many people have expressed concern over the amounts of time and money that would be involved with a switchover, as well as how investors would react.

Some of these concerns were addressed at a recent accounting conference sponsored by Pace University's Lubin School of Business. Perhaps most notably, Aaron Anderson, Director of IFRS Policy and Implementation at IBM, predicted that investors would be "underwhelmed," as the changes would mostly be to areas that are of no concern to them.

Anderson stated that IBM has already begun the process of preparing for a switchover, which has been a good opportunity for the company to revise some old processes, also mentioning that the cost "won't be very much."

HSBC's chief accountant John McGinnis also touched on pricing involved with a switchover, saying one of the major benefits of an IFRS adoption is that it allows companies to file under one set of standards, and therefore cut costs (HSBC adopted IFRS for its year-end in 2005). However, this cost saving is applicable only to multi-national corporations who may be subjected to varying local regulations.

In 2008, the SEC estimated that a switchover would cost companies between 0.125 percent and 0.13 percent of their revenue in the first year of filing but that costs would subside in subsequent years, by as much as 75% in the second year.

SEC dragging its feet?

In May, SEC chairman Mary Schapiro spoke out against accusations that the organization was dragging its feet on a final IFRS decision. She said the organization is committed to the global accounting standards but just needs to take the time to make sure that a transition is done properly and with the highest standards in mind. She also refuted accusations that the organization was protecting the country's "parochial interests," saying that the SEC is, as always, protecting the interests of investors in the market.

Schapiro also said the SEC needs to spend time working with the International IASB on several important areas the conversion would affect, and to analyze input they receive from companies, investor and stakeholders.

People are acquainting themselves with the regulations

However, the SEC's slow movement hasn't stopped the financial industry from getting to know the regulations. According to an AICPA survey released in May, the number of AICPA members who claim to have a basic knowledge of IFRS has increased since the last study in 2008.

Nearly 50% of respondents claimed to have a basic understanding of IFRS regulations in 2010 -- an increase of nearly 10% from October of 2008. Another 24% of CPAs think they will need "advanced" knowledge of IFRS in coming years, while roughly the same amount think they'll need a basic knowledge, and 8% think they'll need expert knowledge.

Principles-based regulations versus rules-based regulations:

There is speculation that moving away from the more rules-based U.S. GAAP system and more towards a principles-based IFRS system will open up room for risk of litigation issues and class-action lawsuits from shareholders second-guessing companies' accounting decisions.

A recent study addressed this issue by gathering evidence in an attempt to investigate whether violations of rules-based standards affect the occurrence of class-action securities lawsuits.

The study concluded that "violations of rules-based standards are associated with a lower threat of litigation." These results are of interest to the debate regarding the switch from a "more rules-based" U.S. GAAP to a "less rules-based" IFRS in the United States.

SEC is waiting on IASB's final modifications to the regulations

The IASB, which makes the IFRS rules, had originally announced a June 2011 deadline for converging with the U.S. FASB to come up with a single, acceptable set of global accounting rules for both organizations. However, FASB Chairman Robert Herz recently said this deadline would likely be pushed back about six months. The reason for the delay, he said, was that they don't want to compromise the standards of regulations by being rushed into meeting a deadline.

"The reason we go through our due process is you learn a lot from the constituent input and the letters and roundtables," Herz said in an interview with Reuters. "We'd all like to see the work done as expeditiously as possible, but we don't want to sacrifice proper due process." Herz went on to say they are hoping to have most of the process finished by the end of 2011.

Meanwhile, the status of the convergence is seen as a particularly important factor in the U.S. Securities and Exchange Commission's decision over whether or not to adopt and enforce the use of IFRS for U.S. companies.

SEC Chairman Mary Schapiro has said she is confident the organization will make a final decision in 2011.

Described by Obama as "the toughest financial reform since the ones we passed in the aftermath of the Great Depression," the House of Representatives recently approved the Dodd-Frank Wall Street Reform and Consumer Protection Act, now scheduled to hit the Senate floor in mid-July. The act reflects attempts to make public companies in the U.S. more accountable to the public and to shareholders within areas of executive compensation and corporate governance. But at what cost?

The bill will require 47 studies, 74 reports and over 350 regulatory rulemakings -- a massive undertaking, especially when compared to the 16 rulemakings and six studies required for the Sarbanes-Oxley Act.

If passed by the Senate, the bill will require all public companies to have a clawback policy in place for circumstances where there is a need to revoke previously awarded performance-based executive compensation due to a financial restatement.

Another big change would involve mandating "say on pay" regulations. The bill proposes that companies give their shareholders the right to vote on executive compensation amounts, as well as the right to choose how often they would vote on this - the options being every year, every two years or every three years. However, when large corporations such as AT&T, UnitedHealth and Johnson & Johnson were presented with the opportunity to have a "say on pay" earlier this year, the majority of shareholders declined.

Further changes would require companies to provide more disclosure about their executive compensation -- specifically, how their executive pay levels correlate to performance and how they compare to those of their global peers. The bill also proposes banning the practice of executive officers hedging against their company stock holdings (although most companies have already banned this internally).

Clarification is needed on these details and on how these rules would be enforced and carried out. For the clawback option specifically, questions have arisen as to how companies would determine amounts of money owed and how to deal with the taxation of funds, etc. There has been some speculation on the amount of extra work and costs enforcing these regulations would require. Based on initial estimates from the major financial institutions (BAC, JPM, MS, WFC, GS), they anticipate a negative impact on their earnings per share to be between 5-10%.

The bill still has to be passed by the Senate and the regulations would still be subject to further modifications from the SEC.

Click here to access a 10-page summary of the 2319-page reform.

Regular Sections

Leave the company, keep your options Former Fidelity CFO sues
for unvested stock options

Mark Sullivan, former EVP and division CFO for Fidelity Investments, is suing the company for unvested stocks after being let go in 2008.

Sullivan left behind 975 options that were set to vest a year after he was let go, and another 2,900 that will vest over the next 18 months.

Typically employee claims for unvested options have very little chance of success, unless there is proof that the employee in question was let go without just cause. Regardless of the reason for departure, the purpose of vesting shares is employee retention, so even in the case of layoffs, employees are usual only given 90 days to exercise any outstanding vested options once employment ceases.

However, Sullivan's basis for this lawsuit is that the company had administered the incentive plans in an "inconsistent, arbitrary and capricious manner," and his complaint claims that the stock option plan documents didn't legally specify that the plan participant must be a Fidelity employee at the time of vesting in order to claim their shares.

The complaint filed did not disclose a dollar amount for the reimbursement being sought, simply "damages, to be determined at trial." It is also not clear why Sullivan was let go from the company, although the layoff is not being contested. Sullivan and his lawyer have both refused to comment.

A Fidelity spokesperson has said that the company does not believe the claim has any merit.

The specific legalities of a company's incentive plan documents demand high levels of scrutiny and a comprehensive understanding of stock-based compensation. For assistance with your current plan documents or to draft a new plan, please contact Solium Capital:

solutionsconsultants@solium.com
866.976.5486

Taking the office home ... and abroad
No one can accuse CFOs of not being devoted to their jobs.

A recent study by Robert Half Management Resources indicated that CFOs are getting better about leaving work behind when they go on holidays, but still more than two thirds of them check in with work once or twice a week while on vacation.

This is slightly less than the 74% that reported doing the same five years ago.

The study, published in June, asked more than 1,400 CFOs of U.S. companies about how often they check into work while on vacation. Another 18% said they typically check in several times daily, while 15% said once or twice daily. Another 26% said not at all.

Risks CFOs Face

CFO.com recently pre-released results of a study done by finance professors that outlined the top goals of today's working finance professional. Not surprisingly, the No. 1 answer was to avoid a huge loss. This was followed by fulfilling shareholders' expectations, increasing the expected future cash flow and increasing the firm's value.

The same study also looked at the biggest risks that finance executives face in a professional capacity today. Credit risk was at the top of the list, followed immediately by foreign-exchange risk and interest-rate risk. Respondents also said these three concerns have all increased in recent years.

See the chart below for other threats that were believed to be on the rise.

On a related note, a recent study by Eisner LLP looked at primary concerns of board members in the wake of the recession. The study asked board-member respondents what areas of risk management were most important to them, beyond financial risk, and the No. 1 concern cited was regulatory compliance (63%), followed closely by reputation risk (54%). IT, product and fraud risk were all also listed, respectively.

Source: CFO.com

A Precedent for Prosecuting CEOs?

Should a CEO be held responsible for financial fraud that goes on at their company, even if they are not personally involved?

That is the central question in the case of Maynard Jenkins, former CEO of auto-parts retailer CSK Auto Inc. The SEC has accused him of security fraud -- seeking $4.1 million in damages for fraudulent stock option gains and bonuses that the company paid out in the last decade -- even though Jenkins was not personally involved with the scheme.

This is the first time the SEC has gone after a CEO who had security fraud occur on his watch, but was otherwise innocent. The SEC has argued that the fraudulent bookkeeping allowed the company to report a financial gain instead of a loss, allowing Jenkins to receive a larger bonus than he would have otherwise. Jenkins has sought to have the case dismissed, but his bid was rejected in June. A trial likely won't happen until next year, but the industry will be watching with great interest to see if this case will change the future of prosecuting CEOs in the U.S.

Gen Y Needs New Plan for Retirement

In the last KnowledgeWorks issue, we published an article about Gen Y's reluctance to make long-term investments through their stock plan incentives and the need for HR professionals to educate this generation on the benefits of long-term investments.

In a related discussion in this issue, we'll look at supporting evidence that many members of this generation are also not thinking about retirement savings. A recent study by Hewitt Associates showed that 60% of respondents between the ages of 20 and 29 had opted to cash out of their 401(k) plans when leaving a previous employer.

This isn't a new trend either -- the cash-out rates were roughly the same in a study done five years earlier, indicating that the recession is not the direct cause of the generation's recent retirement-saving patterns.

There has been much speculation and concern about what will happen to an entire generation that has not taken proper precautions to save enough money for retirement. As an HR professional, now might also be a good time to educate your employees not only on the benefits of long-term investments, but also on enrolling or increasing their contribution levels to their ESPPs, to put towards retirement.

Solium Capital can help you design effective communication plans for your employees of all ages. If you require assistance with developing informative communications specific to your plan please contact Solium's Communication Specialists.

In May the 2010 Culpepper Equity Compensation & Long-Term Incentives Practices Survey was released which revealed that an increasing number of companies are diversifying their equity compensation and long-term incentive (LTI) plans. 74% of companies now offer a portfolio mix of different LTIs.

LTI Plan Mix