The Advisors' Blog

– Ed Burmeister, Baker & McKenzie LLP

In Proposed Regulations issued July 29, 2008, the IRS has made a restrictive, and, in my view, unjustified interpretation of the $25,000 limit for ESPPs set forth in Code Section 423(b)(8). This view, if sustained, will require many companies with purchase periods overlapping calendar years to revise their approach to the $25,000 limit, as reasonably interpreted under the statute and existing regulations. It will likely also require reprogramming by service providers who track the $25,000 limit.

What does Section 423(b)(8) provide? There are three concepts in the statute as follows:

1. The $25,000 limit is an annual limit that applies per calendar year (or any part of a calendar year) in which the option is outstanding (no mention of exercisability).
2. The rate (not amount) of accrual of a right to purchase shares is regulated per calendar year the option is outstanding.
3. The right to purchase stock is deemed to “accrue” when it first becomes exercisable.

The first concept is easily understood. If an ESPP “option” is granted December 1, 2008 (i.e., that is the start of an offering period) and expires 24 months later on November 30, 2010, then (leaving aside for a moment the rate and accrual concepts) it is possible for the employee to be given the right to purchase up to $75,000 in fair market value of shares (determined based on the grant date fair market value of the shares), because the option is outstanding in three different calendar years – 2008, 2009 and 2010. No problem so far.

However, Section 423(b)(8) puts a cap on the rate of accrual of the option by calendar year – namely, the rate of accrual may not exceed $25,000 per calendar year the option is outstanding. Here, it is clear that if the ESPP in question had a purchase date on May 31, 2009, it could not permit the employee to purchase $75,000 in shares, because that would reflect an accrual of $37,500 per calendar year the option was outstanding. Again, no problem so far.

Here is the problem. The IRS takes the third concept of 423(b)(8), that an option accrues when it first becomes exercisable, and then concludes that this must mean that no amount of the option can “accrue” (i.e., no purchase date can permit a purchase) in excess of $25,000 in any calendar year – regardless of how long the option has been outstanding.

Hence, in the above example, on the May 21, 2009 purchase date, only $25,000, not $50,000 of shares could be purchased, since the first “exercisability” of the 12/1/08-granted option accrued in 2009.

The IRS by its own admission – see preamble to Proposed Regulations – was trying to interpret 423(b)(8) in a manner consistent with the ISO $100,000 limit. This is, to put it bluntly, absurd, because the statutory language is entirely different. The ISO limit regulates simply the value of shares that can first become exercisable in any calendar year. The ISO language makes no reference either to the period the option was outstanding or to the rate of the option becoming exercisable.

The IRS, to reach its conclusion under 423(b)(8), had to read into the statutory language the phrase “and exercisable” after the phrase “for each calendar year in which such option is outstanding at any time” and read out of the statute the word “rate” of accrual. An option which is granted in 2008 but first becomes exercisable in 2009, and which permits $50,000 in shares to be purchased in 2009, simply does not reflect a rate of accrual in excess of $25,000 per calendar year the option is outstanding, even though there is an actual accrual of $50,000 in 2009.

This seems so obvious to me it makes me doubt my Stanford Law School and public high school English class education.

I am commenting on the Proposed Regulations to the IRS. If you share my view, please feel free to send your own comments to:

CC:PA:LPD:PR (REG-106251-08)
Room 5203
Internal Revenue Service
PO Box 7604
Ben Franklin Station
Washington DC 20044