Section 423 (Employee Stock Purchase) - max contrib rules

[Guest Tom Moses]

I'm looking for guidance on the maximum contribution rules applied to ESPPs. As I understand it, there's a $25,000 annual cap placed on the "value" of stock that can be purchased under this type of plan. Further, if the plan has multiple pricing periods, the cap is proportionately applied. The value is normally related to the Fair Market Value of the stock at the beginning of the period. My question is: if the FMV of the stock is lower at the end of the period than it is at the beginning, is there any hope of using the end-of-period FMV to determine "value" for the $25,000 rule?

[Guest MJD]

Tom, I have seen this done many ways, but the most effective version I've seen is this (ESPP w/ monthly allocations, price = 85% of either the average of the high/low price on 1st of the month or the average of the high/low on the last business day of the month, whichever is lower): On 1/1(or first business day), divide $25k by the FMV to determine the max # of shares that can be purchased. At the end of the month, divide the EE contrib by the determined purchase price to get the possible # of shares that can be allocated. If the possible # is > the max #, allocate the possible and subtract their value (FMV * possible #) from the $25k to get the remaining value (RV). On 2/1, divide the RV by the new FMV to get the new max # of shares. Repeat for each month until the possible # exceeds the max #. When that happens, allocate the max # and refund the difference ((max #- possible #)* purchase price(not FMV)) to the participant. This is very complicated for such a simple concept, but it is very conservative. If the price is lower at the end of the period, a partic. will max out quicker.

[Guest Beth N]

MJD - Your reply includes an assumption for which I'm trying to track down the source. Do you know WHERE it is written that the max # of shares cannot exceed that which is determined at the beginning of the purchase period?

[Kirk Maldonado]

Tom Moses. Read IRC Section 423.

Beth N. Read Rev. Rul. 73-223, 1973-1 C.B. 206

[This message has been edited by Kirk Maldonado (edited 06-13-2000).]

[Guest Beth N]

Kirk - I have read 73-223 and it's as clear as mud. I have also found other PLRs (e.g. PLR 9414042) which find valid ESPPs under section 423 where the grant is found to be on the last day of the purchase period. Hence my confusion.

It seems the distinction is whether the purchase price is fixed as of the last day of the purchase period versus allowing it to fluctuate throughout the purchase period giving the participants the benefit of the lowest price. In the former, it's OK for the grant to be on the last day of the purchase period. In the latter (as in RR 73-223)the grant must be on the first day (i.e. the amt of shares must be fixed and determinable on that day).

What I'm hoping for is some additional gloss on RR 73-223 (either from IRS or commentators) affirming my suspicion. Thanks.

[pjkoehler]

Reg. Sec. 1.421-7©(1) provides that the grant date for purposes of Code Sections 421-425 means the date when the corporation completes the corporate action constituting an offer of stock for sale to an individual in the form of a statutory option. As a technical matter, the grant date is, therefore, not necessarily the first day of the purchase period. The plan at issue in Rev. Rul. 77-223 excludes employees who have not completed two years of service (the maximum statutory period) as of the beginning of the purchase period, but determines the exercise price based on FMV on the last day of the period. If the grant date is the last day of the period, the plan would not satisfy the minimum coverage requirements under 423(B)(4). What saved this plan was that the plan had a provision that made it impossible for the employee to purchase more than 100 shares, regardless of the decline in value of the stock during the purchase period. Thus, the Service concluded that the grant date was the first day of the purchase period because the optionee is treated as having been granted an option to purchase the maximum number of 100 shares on that date.

While as a technical matter ESPPs can determine exercise price based on FMV on a date other than the first day of the period, such a provision creates a plan design contraint for purposes of meeting the minimum coverage requirements of 423(B)(4), unless the plan imposes a maximum limit on the number shares that can be purchased on any purchase date. As a practical matter, ESPPs that want to avoid imposing such inside limits and the problems of refunding after-tax payroll deductions (which may well be the vast majority), while imposing the maximum 2-year statutory waiting period to participate, will have to use an exercise price based on FMV determined on the first day of the purchase period to avoid violating 423(B)(4).