What do IRS examiners look for when auditing filings with equity-based compensation plans? The IRS recently released its Equity (Stock)-Based Compensation Audit Techniques Guide, which offers an opportunity to see how the IRS views equity-based compensation arrangements. The guide is intended to assist IRS examiners as well as to provide insight to corporate and individual taxpayers.
As we’ve discussed before, scrutiny of 409A-related valuations has been increasing. Although case history remains limited, the new IRS guide helps to solidify expectations and highlights potential areas that the IRS might review. The guide is organized around the following areas:
- Summary of the various types of equity-based compensation
- Suggestions for examiners on where to find information on equity-based compensation plans, including SEC filings (annual filings, proxy statements, registration statements) and internal documents (employment contracts, meeting minutes, shareholder communications)
- Discussion of specific characteristics of stock transfers and the potential tax consequences associated with each type
- Potential issues involving statutory and non-statutory stock options
- Potential issues involving other types of equity-based compensation, including phantom stock plans, stock appreciation rights, restricted stock units, and stock warrants
Types of Equity-Based Compensation
The IRS guide discusses several types of equity-based compensation and comments on potential tax issues associated with each.
- Statutory and Non-Statutory Options. Statutory stock options, which include Incentive Stock Options (“ISOs”) and options granted under an Employee Stock Purchase Plan, generally have stricter requirements than their non-statutory kin. For statutory options, exercise does not result in income or income tax obligations for the employee and the employer cannot take a corresponding deduction. Subject to certain conditions, when the stock is sold, the employee recognizes capital gains/losses on the stock equal to the lesser of (a) the excess of the fair market value (“FMV”) of the stock on the date of disposition over the amount paid for the share and, (b) the excess of the share value on the option grant date over the exercise price. Non-statutory options result in ordinary income on the date of exercise. Non-statutory options with an exercise price less than the FMV on the date of grant (a “discounted option”) may be subject to IRC §409A. Both types of options have their own reporting requirements.
- Phantom Stock Plans. Phantom stock is an arrangement under which deferred amounts are determined by a reference to hypothetical “phantom” shares of the employer’s stock without ever issuing the actual shares to the employee. The employee generally only receives the growth in the value of the share between the grant and exercise dates. Alternatively, the employee may be entitled to receive the entire value of the stock as well as any dividends paid from the time the employer grants the phantom shares. The employee may be paid in either stock or cash. The IRS notes that phantom stock plans are classified as Non-Qualified Deferred Compensation arrangements, not stock arrangements.
- Stock Appreciation Rights. A Stock Appreciation Right is an arrangement in which the employee is entitled only to the appreciation of the underlying stock between the issue and exercise dates. Because the employee only receives the appreciation, taxes are not due until the rights are exercised. When the right is exercised, the employee recognizes income and the employer recognizes an expense.
- Restricted Stock Units. Restricted stock units are agreements to pay either cash or stock at a specified date. One restricted stock unit typically represents one share of actual stock. Restricted stock units are not considered property for purposes of IRC §83 since no actual property has been transferred, and therefore an IRC §83(b) election cannot be made with respect to the grant of a restricted stock unit. Restricted stock units can be settled in either cash or stock.
- Stock Warrants. Stock warrants are similar to stock options and allow the holder to purchase a specified number of shares at a specified price and at a specified time. Stock warrants are often granted to non-employees and typically have longer terms than regular stock options. Unlike many other types of stock compensation, stock warrants may be transferred to other parties. Warrants may be taxable under IRC §83(b) subject to certain conditions.
Stock Transfer Considerations
With respect to stock transfers and potential tax consequences, the IRS guide notes six areas of focus for examiners, which we have briefly summarized below.
- Whether the stock was actually transferred or not. The IRS only considers stock to be transferred if the recipient has the risks and benefits of being an owner. Restrictions on sale of the stock, lack of voting, inability to participate in liquidating distributions, and the lack of rights to gains or losses on the stock could affect the status of the transfer.
- Stock option transfers to a related person. Transfer of compensatory stock options to a related person is a “listed transaction” as defined by the IRS and may require additional documentation and review procedures.
- Whether there has been a reduction in the purchase price of a note used to acquire employer stock. Promissory notes are sometimes issued in order to facilitate the purchase of stock. If the market price of the stock declines and the employer reduces the balance of the note in satisfaction of the exercise price of an option, various additional taxes may be triggered.
- Whether a “substantial risk” of forfeiture exists. Because risk of forfeiture typically only exists if transferred property rights are conditional upon future performance, the IRS does not consider property to be transferred if there is a substantial risk of forfeiture. In such cases, the compensation can only be recognized when the substantial risk of forfeiture has passed.
- Whether dividends from restricted stock are received. The receipt of dividends from substantially non-vested restricted stock is treated as additional compensation to the individual. Once the restricted stock award is vested, all dividends are treated as dividend income. However, with an §83(b) election, the income may be treated as dividend income rather than compensation.
- Whether a Section 83(b) election has occurred. An election pursuant to IRC §83(b) allows a recipient of restricted property to be taxed when the property is transferred instead of when the property actually vests (at a later date when the value may be higher). The IRS Guide outlines some of the restrictions relating to Section 83(b) elections and under what conditions the elections may be used. As we have discussed previously, sometimes Section 83(b) elections can have unintended consequences.
Obviously, every equity compensation plan is different and the particular tax treatment of a given security depends on the facts and circumstances of the arrangement. That said, the IRS guide provides a useful framework for understanding the general types of equity-based compensation and illustrates how an IRS examiner might approach an audit or review where equity-based compensation is a significant factor. Mercer Capital has deep experience helping clients determine the value of stock-based compensation for both financial reporting and tax-related purposes. Contact a Mercer Capital professional to discuss your situation in confidence.
- Look Before You Leap: Evaluating a Section 83(b) Election
- 8 Things You Need to Know About Section 409A
- New Rules Aim to Claw Back Incentive-Based Pay
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