If an employee stock bonus plan (Code sec 423) inadvertently grants op

[Guest Ray Goetz]

I have a question on the requirements in Section 423 of the Internal Revenue Code, regarding Employee Stock Purchase Plans ("ESPPs").

An ESPP that meets the requirements in Section 423 receives the tax treatment provided under Section 421 -- in particular, the treatment that no income results for the employee/participants at the time of the transfer of shares of stock to that person, pursuant to that person's exercise of the underlying stock options.

One of the 423 requirements is that the options under the ESPP can be granted only to employees of the employer corporation, or of its parent or subsidiary corporations. This rule does not allow options to be granted to employees of a subsidiary joint venture, because that would be a partnership and not a corporation. PLR 8826053.

Here is the question. If a ESPP inadvertantly grants some options to employees of a subsidiary partnership (which is not allowed), is the result just that those particular employees lose the ability to no have income when they exercise their options? Or does the entire ESPP lose the ability to not create income for ALL persons who participate in the program?

Is there any specific authority on this point?

Also, has anyone had any experience with regard to the best way to "fix" a situation like this?

[Kirk Maldonado]

I can't respond as to whether all of the options issed under the plan are bad or not in your situation. You might want to post that question on the bulletin board of the National Association of Stock Plan Professionals ("NASPP").

However, there is no mechanism to correct operational errors in ESPPs, unlike the programs for tax-qualified retirement plan. On the other hand, I've never heard of a client undergoing a full-scope audit of an ESPP. The only audit activitity that I'm aware of relates to withholding obligations.

[pjkoehler]

Restricting participation to employees (that satisfy the employment relationship test set forth in Reg. 1.421-7)is a form and operational requirement of an ESPP. Reg. 1.423-2(B). Employees of an unincorporated related employer do not satisfy this test. One approach to consider treats the options granted to the employees of the joint venture as NQSOs, rather than stock purchased under the ESPP. The Service ruled in PLR 9822012 that stock options of a corporate parent granted to employees of a partnership formed by the parent and an S Corp. receive NQSO treatment. Granting NQSOs to these employees may require board approval. You'll want to review the corporate bylaws to make sure the proper ratification of the grants is obtained. Going forward, of course, you may wish to adopt a formal omnibus stock option plan, so that management has the discretion to make such grants within specified limits without obtaining approval.

[Kirk Maldonado]

I agree with PJK that those options do not qualify under Section 423.

But that does not resolve the question as to whether noncompliance with respect to those options invalidates all the options granted to others under the plan.

My guess is that it would. See Treas. Reg. § 1.423-2(i)(1)(iii) (holding that if the $25,000 amount is exceeded for an individual, that "disqualifies" all of the options granted under the plan).

[pjkoehler]

I assume that the ESPP in question has the required language restricting participation to those with the necessary employment relationship. So there is no question of compliance in form. While the plan-wide affect on all participants of an employer who violates this restriction in operation is an intriguing one, and worthy of research, as a practical matter, we probably don't have to go there. Most ESPPs contain a provision that gives the board or a committee full power to adopt, amend and rescind any rules desirable or appropriate for the plan's administration, construe and interpret the plan and make all other necessary determinations. One exercise of this authority would be to bifurcate the plan into a Section 423 plan (or spinoff a new one) and a mirror non-Section 423 plan for the purchase of shares by employees of the joint venture. This would safeguard the original plan's compliance with Section 423 and there is authority for the position that the exercise and disposition of options granted under the mirror plan should receive NQSO treatment.

This is analogous to employee stock purchase plans that cover international employees. Certain attributes of the Section 423 nondiscrimination requirements are difficult to meet if, for example, the employer wants international employees to participate. The typical approach is to offer such employees a "mirror" plan that operates much like the ESPP, i.e. eligible employees are granted options to purchase shares over the selected offering period at the applicable option price. The plan can provide that the options are exercisable by cash payments as well as by payroll withholding. The employees who exercise such options are taxable under Code Section 83, rather than 421.

[This message has been edited by PJK (edited 05-30-2000).]

[Guest Ray Goetz]

The above comments were all very helpful. Thank you.