Open questions on the ECE site need some FAS 123R, Valuation and Legal answers
I just sent this blast:
Hi everyone,
I hope that everyone is well during these turbulent times. I have noticed that a few recent qeustions on the ECE site have gone unaswered and I know the ECE membership has the expertise to provide information. Please take a look at the following three questions and provide answers if you have them.
You can post your answer on the site, send a private message to the questioner or send me your response and I will post it for you (let me know if you want to be credited).
THANKS,
Dan
Question 1 - Forfeiture Rates
I am trying to calculate the forfeiture rate for the last grant. I have ten years of actual forfeiture data. What I noticed right away was that for every grant there was some forfeiture but the actual forfeiture goes from 3 to 28%. My group size is only twenty five people and the variance in the number shares granted to the group members is very high. In order for the grants to vest the employee has to still be an employee at the end of the three year vesting period. We have already exceeded the estimated forfeiture for the two non vested grants. The actuals for those two grants are in the range of 10%.
How do others calculate the estimated forfeiture rate when it really seems like a really random estimate, at least to me. I am guessing that I may need to do some type of modeling.
Thanks,
Mike
Question 2 - W2 / 1099 Reporting for former employee
A former employee who is now a consultant has exercised some options and received taxable compensation. This employee will be receiving a W-2 for his severance this year but receives a 1099 for all other services rendered. As part of his consulting agreement, options which would have cancelled upon his termination as an employee, continued to vest and remain exercisable during his consulting term. Will the taxable compensation recognized as a result of the exercise be included in the W-2 or on a 1099? This employee would also like to have tax withheld on an ISO exercise? Can we withhold tax and record it on the W-2? Please advise.
Kristi
Question 3 - Restricted Shares/Units in Belgium
I posted this situation on the WorldatWork bulletin board -- two individuals suggested I check in with this group to gain better information...so here goes!
I need advice...to ensure we are appropriately administering the plan and are in compliance with all legal and tax requirements (US and local). I became aware of this plan only a few weeks ago.
My company issued RSU Awards last year...the first traunch (12%) vest in April, 2009. Two award recipients are located in Belgium....and from what I understand, the company should have reported the grants at that time (the awards are minimal -- 5,000 units for each employee), the fmv was $3/share at grant.
The award documents state that the units are to be settled in shares at each vesting date. However, our legal counsel states that the intent is to issue "Unit Certificates" (not referenced in original agreement) that read as follows:
"This Unit Certificate represents XXX shares of Common Stock (the "Shares") of COMPANY NAME (the "Company") issued to _____ (the "Employee"), effective ______. This Unit Certificate shall entitle the Empoyee the right to receive a cash payment based upon the fair market value of the Shares upon the sale of the Company or upon redemption of this Unit Certificate by the Company upon a termination of employment. This Unit Certificate is issued pursuant to the Company's Restricted Stock unit Agreement dated as of ____."
=========
My take is that the Unit Certificate actually defers compensation for the employee -- almost indefinitely; however, we would have to amend the original agreement to allow for deferral?
Then we would need to explain this to Belgian authorities when we finally report the grants.
My Finance group says, "issue in shares," but is also cognizant that the value is minimal.
Any other considerations (pitfalls) I should be aware of? I need to plead my case with Legal.
Thank you, very much!
Shawn
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Question Number 2 -
Hi Kristie - Regarding the consultant's wishes to have tax taken out on an ISO exercise. Was this exercise within the 90 period after termination? If it was after the 90 day period his stock options now become NSO's. Only employees or terminated employees within the 90 day window are eligible for ISO tax treatment. You can only withhold this tax and report it on a W2 if he exercised within the window described above.
Additionally, does this former employee (now a consultant) truly pass the test to be considered a 1099 independent contractor?
I hope this helps.
Regarding question number 1: The forfeiture rate is determined by historical experience and can be adjusted for anticipated changes in the rate, for example if a restructuring occured, or layoffs, etc... To determine the rate you should examine the each traunch and determine the forfeiture rate of each traunch, with a large population you can weight each traunch forfeiture rate in the calculation of the historical forfeiture rate. If you know that your current forfeitures already exceed the historical rate you can adjust your estimate and recognize it as a true-up in the compensation costs in the period you made the change. It is always an estimate until everything has been cancelled, forfeited, or exercised, but you can hone in on the forfeiture rate through time. With a smaller population like yours is, the issue is that if a top award recipient leaves it can really affect your overall rate.
Regarding question number 2. The IRS wants its tax dollars and so for a terminated employee, the option exercise income must be W-2 income. I used to recall we had a "once a W-2 reported employee, always a W-2 reported employee" rule, but I have been away from this for a while. I will do a little research on this rule. Also, Haley is correct above on the ISO needed to be exercised in 90 days or there needs to either plan rules, apreement language or Comp Committee or Board approval on a modification of the grant to convert it to an NQSO.
Regarding question number 3. OK, From what I read in your question, the RSU's were granted to individuals, but upon vesting there is still a restriction that prevents the individuals from receivin cash for their units until such time as the company is sold or the employee terminates. The key issue here is the VESTING of the RSU. Once they are vested even if they cannot touch the units, it is considered income to the individual. In the US they would be required to pay Federal, State and FICA taxes on the units at that time. Then later, when the employee terminates or the company is sold they will owe income taxes on the difference, but they will not owe FICA tax. You are correct that it works like a non-qualified deferred compensation plan, but the individual does not have an election because the document specifies when they settle in cash. Now in the US the individual would be entitled to an 83(b) election at grant on the RSU's if they desired. I am not sure what the Belgian rules indicate for the employees, but are they Belgian nationals, or are they expats? At grant were they in Belgium or the US? At vest are they in Belgium or the US?
I agree with the answer that the ISO would be treated as an NQ after 90 days, but if he did a same day sale on the ISO within the 90 days and wanted you to withhold, we have been doing that because it is disqualified and will be treated as ordinary income to the emloyee. But he'd not be too smart to pay tax on the ISO if it still qualifies for ISO treatment and doesn't sell them and holds them for the required time period. As to the income being on his W2 or 1099, when did he exercise, as an employee or a consultant? But again, does he meet all the requirements of a consultant? I'd check with HR on that question. You also have the issue with the consulting agreement that let him keep his options at their current vesting -- to me that almost makes it W2 income since he "earned" them as an employee. I've had retired individuals who were allowed to keep their options and fully vest at retirement come in as a consultant and then exercise and you do re-create a W2 for them and take taxes if it's a NQ or an ISO held more than 90 days after retirement, even though they may now have a contract as a consultant and will receive a 1099. I know, I just confused you more. I hope not. Email me with any questions. barbara.buisman@toro.com
Barbara Buisman, CEP
Question 2 - IF he exercised the ISO after 3 months of his termination, it should have been taxed as an NQ - if it was within the 3 month grace period - then it is an ISO and must be on the w-2 for the dd. Taxes could have been withheld if it was within the grace period. After the grace period all payroll taxes are required to be withheld and reported on the w-2.
It is my understanding that if the shares were earned when he was an employee - then they should be treated as an employee exercise and taxes withheld when required and reported on the w-2.
Grants after the termination should be treated as consultant shares subject to FAS123 for expensing and reported on a 1099.
I would suggest you check this with your external auditors, as they may have a different definition
Karen
I'd be currious to see the plan language that allows a separate contract (the consulting one) to override the termination clause in the plan document or the grant agreement. The easiest thing may be to give him/her the cash equal to what the FMV of the shares would have been on the day of the vest if he had been still an employee. Don't know if that is an option (forgive the wording) or not. Otherwise, did you change the accounting for the award at all or is it still in the employee pool?
Karen's response noting that the character of the compensation (whether from employment or consulting) determines whether to withhold is a good one. What's the practical answer then? I'd go with first in, first out. The number of unexercised shares that had vested by the time of employment termination would be the number of shares subject to withholding and W-2 reporting. Once that number has been exercised, the rest are from service as an independent contractor and go under 1099 reporting
Brandon has noted an important distinction, the plan document and the option agreement generally control the terms on which shares of the corporation are to be sold and cannot be modified by a consulting agreement as the corporate power to set the terms on which shares of the company are to be sold is placed with the board or a duly authorzed committee of the board. Plans typically provide for continued vesting and exercisability if there is a seamless transition between employee/consultant and vice versa. I imagine that's the case here, otherwise, potential problem (though there may be other facts to allay concern).
Q3 - Complicated issue and I suspect not all the facts necessary for resolution are known at this time. The Unit Certificate says shares were issued so it doesn't appear to be a bar to issuance (Belgian/EU securities laws may be depending on the plan terms and/or that law) unless there is some later amendment to the RSU agreement. Some nations tax equity awards on grant, if Belgium is one, then there may be no deferral of taxable income if the award was taxed at grant. If the recipient is subject to US tax, then I will note that when the right to income vests, but the income is to be brought within the taxpayer's dominion and control in a later tax year, then IF the deferral has been undertaken in compliance with Sec. 409A of the US tax code, only employment taxes are due at vesting and income taxes apply at distribution. The foregoing are general observations of possible concerns in relation to what's been described and not advice on the subject. My advice is to have the company's legal counsel consult with outside counsel (in the case of concerns of law outside the US, Baker & McKenzie has a global equity practice as do the major accounting firms).
A clarification of my earlier point when I indicated "agreement language" - I was refering to the option agreement not the consulting agreement. Typically one woud say priority is as follows:
1) Applicable Federal and State Laws and regulations
2) Plan document
3) Award Agreement
The award agreement should never provide anything which the plan document does not allow for. The plan document cannot provide anything which is a violation of state or federal laws.
I would respectfully disagree with the vesting cutoff suggested by Tahir - UNLESS the Award Agreement or the Plan Document called for Continued vesting for services provided after employment. Based on what I read, the vesting would have continued regardless of whether the individual had a consulting agreement or not. If the Plan document or Award Agreement indicated that the options would not continue to vest UNLESS the individual agreed to a consulting arrangement after termination I would be very surprised, Unless the Board or Compensation Committee if granted the authority could have approved an amendment of the Agreement to provide for continued vesting under the condition of the consulting arrangement provided the plan document allowed them to make such an agreement.
Regarding #3 Tahir makes an excellent point if the award complied with 409(A) regulations. Then taxation would only be for FICA and MEDICARE in the US, again not sure about Belgium.
Generally what we do to avoid the employee to contractor issues with options is to separate what they had as an employee to what they will receive as a contractor. We create a new NSO grant for the consultant that may or may not accomodate what they are "leaving on the table" during a transition in roles. It is certainly a much cleaner approach. (We are a private company - not public.)
Two Step Software conducted a webinar last year regarding stock plan administration and financial reporting audits. It included information from experts about forfeiture rates. Below is a short summary of the webinar. Feel free to sign up for the recording or to download the materials. There is no charge.
http://www.twostep.com/signupforms/webinar_signup_fas123r_best_practices.asp
Summary:
In this 53-minute presentation, find out what you must be able to provide to your auditors to support your equity compensation expensing under FAS 123R, satisfy the internal controls requirements under SOX or the new SAS 104-111, and get out from under the magnifying glass of options backdating and IRS Sec. 409A.
Whether your organization is venture-backed or a small public company, find out what you need to deliver -- and identify what you are missing -- before your auditors arrive.