Annual Information Statements and Returns for Incentive Stock Options and Employee Stock Purchase Plans and Other Reporting Requirements

The Internal Revenue Code imposes a US$50 penalty for each statement not furnished or for each statement furnished with incomplete or incorrect information, up to a maximum penalty of US$100,000 per year. Greater penalties will apply if a company intentionally fails to provide a statement.

In addition to furnishing the annual information statements referenced above, the Internal Revenue Code requires companies to submit information returns to the Internal Revenue Service (IRS) for any (1) exercise of an ISO or (2) transfer of a share of stock purchased pursuant to an ESPP. Although this new obligation applies to stock transfers occurring on or after January 1, 2007, the IRS waived the obligation to make information returns to the IRS for stock transfers that occurred in 2007, 2008 and 2009. This waiver has no effect on the requirement to furnish the annual information statement to persons as discussed above.

On July 17, 2008, the IRS set forth proposed regulations which retained the information required to be reported for ISOs, slightly modified the information to be reported for ESPPs, and stated that the information return to be provided to the IRS and the information statement to be provided to participants must be provided on Forms 3921 and 3922 (the IRS has not published these forms as of the date of this alert). On November 17,
2009, the IRS issued final regulations regarding the ISO and ESPP reporting requirements. Under the final regulations, companies will have to submit their first information return to the IRS by January 31, 2011 for transactions that occurred in 2010. Further, the final regulations were generally consistent with the proposed regulations but simplified certain reporting requirements and clarified certain requirements, including those described below.

• Employers are required to report the first transfer of legal title of stock purchased under an ESPP plan. When an employee’s shares are put into a brokerage account on behalf of such employee, the transaction is considered a transfer of legal title and, if it is the first transfer of legal title of the shares, it must be reported to the IRS and to the employee. If instead an employee’s shares are issued directly to such employee or registered in the employee's name on the company's records, the transaction need not be reported to the IRS or to the employee because such transaction is not considered a transfer of legal title.
• Companies must report the price per share of ESPP stock transfers. If the exercise price is indeterminable on the date of grant, companies may report the exercise price as if the option was exercised on the grant date.
• The transfer of shares acquired under an ESPP must be reported whether or not the transfer is a qualifying or disqualifying disposition of the stock.
• Companies are not required to report the exercise of an ISO by a nonresident alien who the company is not required to issue a W-2 for any calendar year during the period beginning with the calendar year in which the grant was approved and ending with the calendar year in which the ISO was exercised.
• Companies are not required to report the transfer of shares purchased under an ESPP by a nonresident alien who the company is not required to issue a W-2 for any calendar year during the period beginning with the calendar year in which the grant was approved and ending with the calendar year in which the shares were first transferred.

A company must report any ordinary income that an optionee recognizes in connection with a disqualifying disposition of ISO shares during the 2009 calendar year in box 1 of the optionee's 2009 Form W-2. Failure to report this income will prevent a company from taking a deduction for the ordinary income that results from the disqualifying disposition and may subject the company to certain reporting penalties.

A sale of ISO shares before the later of the date which is two years after the date of grant and the date that is one year after the date of exercise is treated as a disqualifying disposition. The ordinary income recognized on a disqualifying disposition is equal to the difference between the ISO exercise price and the lesser of the fair market value of the shares on the date of exercise or the sale price of the shares.

If any person transferred ESPP stock for the first time during the 2009 calendar year, a company must report in box 1 of the person's 2009 Form W-2 the amount of the purchase price discount (described below), if any, on ESPP stock and, if the ESPP stock was transferred in a disqualifying disposition, any ordinary income that the person recognized when the shares were transferred. The "purchase price discount" is the difference between the fair market value of the shares on the first day of the offering period and the purchase price that would result if the shares were actually purchased on the first day of the offering period. For example, if the purchase price of the ESPP stock is equal to the lesser of 85% of the fair market value on the first day of the offering period and 85% of the fair market value on the last day of the offering period (the purchase date), the purchase price discount is 15% of the fair market value on the first day of the offering period. Failure to report this income will prevent a company from taking a deduction for the ordinary income and may subject the company to certain reporting penalties.

A transfer of ESPP stock before the later of the date which is two years after the first day of the offering period or the date which is one year after the purchase date is treated as a disqualifying disposition. The ordinary income recognized on a disqualifying disposition is equal to the difference between the purchase price and the fair market value of the shares on the purchase date.

If you would like additional information on the topic discussed in this Compensation and Benefits Alert, please contact any member of Orrick’s Compensation and Benefits Group.