Two questions about ESPP compensation reporting

TP participates in company A's ESPP. Under A's plan, TP may purchase shares of A at 85% of the lesser of FMV on the grant date and FMV on the exercise date. An offering period begins on 4/1/2007 (the grant date), at which time the FMV of A is $100. On 10/31/07, TP purchases 10 shares under A's ESPP. FMV on 10/31/07 is $90. TPs option price is $76.50, being the lesser of 85% of $100 and 85% of $90. Assume A's plan qualifies under section 423, and TP's sales are all qualifying sales.

1) TP sells all 10 shares in 2010 for $120/share, what compensation should be reported?

2) Suppose A spins off B in 2009. What compensation should be reported in 2010 when A shares are sold? If the spunoff shares are sold in

2011, what compensation should be reported then?

(more details below)

Here's my thought process; sorry to be so wordy:

QUESTION ONE: In 2010, TP sells all 10 shares for $120/share. Per section 423(c), the compensation element (per share) of TP's sale is the lesser of:

(1) the excess of the fair market value of the share at the time of such disposition over the amount paid for the share under the option, or

(2) the excess of the fair market value of the share at the time the option was granted over the option price.

FMV at disposition = $120/share. FMV on grant date = $100/share. Amount paid for the share = $76.50 Option price = ???

I've found an example in the IRS regs, and a description at fairmark.com, both of which indicate that the meaning of "option price" in (2) is "the option price determined as of the grant date".

Section 423(c) explains that throughout that subsection, if the option price isn't determinable on the grant date (as is the case here), you should compute it as though the option were exercised on the grant date. Assuming that this meaning of "option price" is correct, the "option price" in (2) would be computed as though the option were exercised on the grant date, so it would be 85% of the grant date FMV, or $85. That makes the compensation computation:

the lesser of (1) $120 - $76.50 = $43.50 or (2) $100 - $85 = $15

So TP would report $15/share (so $150 total) as compensation, and add it to his $76.50 basis. His basis would then be $91.50/share, and he would report $28.50/share as capital gain ($120 - $91.50).

If one believes that "option price" in (2) means the "price paid under the option", then (2) would be $100 - $76.50 = $23.50. I don't believe this is the correct meaning, but it's easy to see why such an obvious reading of the text would be convincing. One reason for the uncertainty about the meaning is that, before 2008, Pub 525 paraphrased the two choices in 423(c) this way:

o The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time the option was granted, or

o The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time of the disposition or death.

In other words, the older versions of Pub 525 interpreted "option price" in (2) as meaning "the price paid under the option". Current versions of Pub

525 don't paraphrase the code at all, they quote it verbatim without any clarification. However, the Regs seem to give an unambiguous example

- here's the relevant sentence (**'s are mine, of course):

----------------------------------- Compensation in the amount of $5 is includible in P's gross income for the year 2013, the year of the disposition of the share. This is determined in the following manner: The excess of the fair market value of the stock at the time of the disposition ($150) over the price paid for the share ($95) is $55; and the excess of the fair market value of the stock at the time the option was granted ($100) over **the option price, computed as if the option had been exercised at such time** ($95), is $5.

-----------------------------------

As it turns out, in their example, the "price paid for the share" turns out to be the same number as "the option price, computed as if the option had been exercised at such time", because the price was lower on the grant date than the exercise date. But the **text** is clear as to how the number is to be computed.

My question is whether the tax preparer community generally understands "option price" in (2) to mean "the option price, computed as if the option had been exercised on the grant date", or "the price paid under the option". I'm not sure which is more authoritative, an Example from the regs with no explanatory text, or an old version of Pub 525.

QUESTION TWO (I am assuming here that "option price" in (2) means as of the grant date.)

Assume the same facts as above, except that in 2009 A spins off subsidiary B, distributing one share of B for each share of A to the holders of A shares (to keep the math simple). Just after the spinoff, the FMV of a share of A is $88 and B is $22. That is, the value of the old shares of A has been divided so that 80% is in the A shares and 20% is in the newly distributed B shares. TP adjusts his $76.50 basis in the 10 shares of A down to $61.20 (80%), and the B shares have a basis of $15.30. As before, in 2010 TP sells all 10 shares of A for $120/share. In 2011, he sells all

10 shares of B for $30/share.

What is the compensation income to be reported for each sale? It seems that the spinoff should have no impact on the total compensation that TP is ultimately required to report... it should still be $150 total. One approach that works is to apply the 80% adjustment to all the relevant values in the compensation computation. In other words:

For first sale, of 10 A shares FMV at disposition = $120 FMV on option grant date = 80% * $100 = $80 Price paid for the (new) A shares = 80% * $76.50 = $61.20 "Option price" = 80% * $85 = $68

Compensation is lesser of (1) $120 - $61.20 = $58.80, or (2) $80 - $68 = $12

So, report $12/share (or $120 total) compensation for the A shares

For the sale of B shares FMV at disposition = $30 FMV on option grant date = 20% * $100 = $20 Price paid the B shares = 20% * 76.50 = $15.30 "Option price" = 20% * $85 = $17

Compensation is lesser of (1) $30 - $15.30 = $14.70 (2) $20 - $17 = $3

So, report $3/share (or $30 total) compensation for the B shares

That "works" - the reported compensation for the two sales combined adds up to $150, which seems correct. However, I find no support (other than "common sense") for the idea that, for purposes of computing the compensation element for a sale of ESPP shares after a spinoff, the FMV and option price should be adjusted in the same was as the basis, or any mention of the messy side-effect of doing that, namely, that part of the compensation element is carried into the shares of the spun-off company, creating a record keeping nightmare. If HP spins off Agilent which spins off Verigy, etc...

Since (1) is intended to compute your "profit" on the sale, it would seem that the numbers must be adjusted to match what it is you're actually selling, namely post-spinoff shares of A. Also, since one of the numbers (FMV at disposition) is a post-spinoff value, it seems that the other number (price paid for a share under the option) must also be adjust so that it is a post-spinoff value. If those two numbers are post-spinoff, then it seems the numbers in (2) should also be.

So - am I correct that the price paid under the option, and the FMV and option price on the grant date, should all be adjusted by 80% for the spinoff?

Whit Matteson

Reply to
Whit
Loading thread data ...

On 2010/10/17 14:57, Whit wrote: [...]

I glanced at your post but found it difficult to read due to hard line breaks and overall length, so I didn't.

-Mark Bole

Reply to
Mark Bole

TP participates in company A's ESPP. Under A's plan, TP may purchase shares of A at 85% of the lesser of FMV on the grant date and FMV on the exercise date. An offering period begins on 4/1/2007 (the grant date), at which time the FMV of A is $100. On 10/31/07, TP purchases 10 shares under A's ESPP. FMV on 10/31/07 is $90. TPs option price is $76.50, being the lesser of 85% of $100 and 85% of $90. Assume A's plan qualifies under section 423, and TP's sales are all qualifying sales.

1) TP sells all 10 shares in 2010 for $120/share, what compensation should be reported?

2) Suppose A spins off B in 2009. What compensation should be reported in

2010 when A shares are sold? If the spunoff shares are sold in 2011, what compensation should be reported then?

(more details below)

Here's my thought process; sorry to be so wordy:

QUESTION ONE: In 2010, TP sells all 10 shares for $120/share. Per section 423(c), the compensation element (per share) of TP's sale is the lesser of:

(1) the excess of the fair market value of the share at the time of such disposition over the amount paid for the share under the option, or

(2) the excess of the fair market value of the share at the time the option was granted over the option price.

FMV at disposition = $120/share. FMV on grant date = $100/share. Amount paid for the share = $76.50 Option price = ???

I've found an example in the IRS regs, and a description at fairmark.com, both of which indicate that the meaning of "option price" in (2) is "the option price determined as of the grant date".

Section 423(c) explains that throughout that subsection, if the option price isn't determinable on the grant date (as is the case here), you should compute it as though the option were exercised on the grant date. Assuming that this meaning of "option price" is correct, the "option price" in (2) would be computed as though the option were exercised on the grant date, so it would be 85% of the grant date FMV, or $85. That makes the compensation computation:

the lesser of (1) $120 - $76.50 = $43.50 or (2) $100 - $85 = $15

So TP would report $15/share (so $150 total) as compensation, and add it to his $76.50 basis. His basis would then be $91.50/share, and he would report $28.50/share as capital gain ($120 - $91.50).

If one believes that "option price" in (2) means the "price paid under the option", then (2) would be $100 - $76.50 = $23.50. I don't believe this is the correct meaning, but it's easy to see why such an obvious reading of the text would be convincing. One reason for the uncertainty about the meaning is that, before 2008, Pub 525 paraphrased the two choices in 423(c) this way:

o The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time the option was granted, or

o The amount, if any, by which the price paid under the option was exceeded by the fair market value of the share at the time of the disposition or death.

In other words, the older versions of Pub 525 interpreted "option price" in (2) as meaning "the price paid under the option". Current versions of Pub

525 don't paraphrase the code at all, they quote it verbatim without any clarification. However, the Regs seem to give an unambiguous example - here's the relevant sentence (**'s are mine, of course):

----------------------------------- Compensation in the amount of $5 is includible in P's gross income for the year 2013, the year of the disposition of the share. This is determined in the following manner: The excess of the fair market value of the stock at the time of the disposition ($150) over the price paid for the share ($95) is $55; and the excess of the fair market value of the stock at the time the option was granted ($100) over **the option price, computed as if the option had been exercised at such time** ($95), is $5.

-----------------------------------

As it turns out, in their example, the "price paid for the share" turns out to be the same number as "the option price, computed as if the option had been exercised at such time", because the price was lower on the grant date than the exercise date. But the **text** is clear as to how the number is to be computed.

My question is whether the tax preparer community generally understands "option price" in (2) to mean "the option price, computed as if the option had been exercised on the grant date", or "the price paid under the option". I'm not sure which is more authoritative, an Example from the regs with no explanatory text, or an old version of Pub 525.

QUESTION TWO (I am assuming here that "option price" in (2) means as of the grant date.)

Assume the same facts as above, except that in 2009 A spins off subsidiary B, distributing one share of B for each share of A to the holders of A shares (to keep the math simple). Just after the spinoff, the FMV of a share of A is $88 and B is $22. That is, the value of the old shares of A has been divided so that 80% is in the A shares and 20% is in the newly distributed B shares. TP adjusts his $76.50 basis in the 10 shares of A down to $61.20 (80%), and the B shares have a basis of $15.30. As before, in 2010 TP sells all 10 shares of A for $120/share. In 2011, he sells all

10 shares of B for $30/share.

What is the compensation income to be reported for each sale? It seems that the spinoff should have no impact on the total compensation that TP is ultimately required to report... it should still be $150 total. One approach that works is to apply the 80% adjustment to all the relevant values in the compensation computation. In other words:

For first sale, of 10 A shares FMV at disposition = $120 FMV on option grant date = 80% * $100 = $80 Price paid for the (new) A shares = 80% * $76.50 = $61.20 "Option price" = 80% * $85 = $68

Compensation is lesser of (1) $120 - $61.20 = $58.80, or (2) $80 - $68 = $12

So, report $12/share (or $120 total) compensation for the A shares

For the sale of B shares FMV at disposition = $30 FMV on option grant date = 20% * $100 = $20 Price paid the B shares = 20% * 76.50 = $15.30 "Option price" = 20% * $85 = $17

Compensation is lesser of (1) $30 - $15.30 = $14.70 (2) $20 - $17 = $3

So, report $3/share (or $30 total) compensation for the B shares

That "works" - the reported compensation for the two sales combined adds up to $150, which seems correct. However, I find no support (other than "common sense") for the idea that, for purposes of computing the compensation element for a sale of ESPP shares after a spinoff, the FMV and option price should be adjusted in the same was as the basis, or any mention of the messy side-effect of doing that, namely, that part of the compensation element is carried into the shares of the spun-off company, creating a record keeping nightmare. If HP spins off Agilent which spins off Verigy, etc...

Since (1) is intended to compute your "profit" on the sale, it would seem that the numbers must be adjusted to match what it is you're actually selling, namely post-spinoff shares of A. Also, since one of the numbers (FMV at disposition) is a post-spinoff value, it seems that the other number (price paid for a share under the option) must also be adjust so that it is a post-spinoff value. If those two numbers are post-spinoff, then it seems the numbers in (2) should also be.

So - am I correct that the price paid under the option, and the FMV and option price on the grant date, should all be adjusted by 80% for the spinoff?

Whit Matteson

Reply to
Whit Matteson

Mark -

Thanks for at least glancing! I can blame the line breaks on a series of problems with Outlook Express vs. Google, and trying to find a new news server that allows posting, after my ISP stopped supporting it. I've reposted it, hopefully without as many breaks. We'll see.

The length is my fault; it's two questions in one post, and I probably included more detail than I needed to. I'll look again to see if I can be more concise, but so often, the posts omit information that's necessary to give a good answer, or omit the part the poster has already figured out, and lots of subsequent posts are wasted getting to the crux of the matter.

Whit

Reply to
Whit Matteson

I had a lot of trouble figuring out my ESPP also, since I got some as a pre-spin-off, then some ESPP in the spin-off in $ not %, then more post-spin-off, then the spin-off went private. I just took a common sense approach (I know, I know, the tax code is NOT common sense) and they haven't arrested me yet. All those numbers, percentage, and particulars just made my head ache. I figure if they ever come after me on it, I will plead stupid and unable to follow their own jumbled, contradictory, and confusing instructions.

Chip

Reply to
Chip Wood

Sorry, forgot this piece of advice. I used nntp.aioe.org as an absolutely, no hidden agenda, free news server for the past 6 years. Very dependable and has 1000's of groups. Allows you to post and only balks at cross-posting which I hate anyway. I use Thunderbird as a news reader and it works a treat. Much better than Outlook Express.

Chip.

Reply to
Chip Wood

Q1: On a qualifying disposition, your ordinary income is the lesser of your profit or the discount offered to you on the date of grant. In your case, the profit is $43.50 per share and the discount on 4/1/07 was $15. Therefore you report on a per share basis: $15 of ordinary income; add the $15 to your purchase price of $76.50 to arrive at your adjusted basis of $91.50 and a LTCG of $28.50. If you add $28.50 to $15.00 you get $43.50 (your total profit).

Q2: There are series of revenue rulings on this issue that I don't have on hand. However, I believe that no adjustment is made to the grant date data. Given your assumption that the FMV just before the spinoff was $110 and the drop in FMV is directly related to the spinoff: You allocate 80% of your cost basis of $76.50 to A and 20% to B. That puts A at $61.20 and B at $15.30 per share. Your profit on the A sale is $58.80. $15 is compensation (same as Q1) and $43.80 is LTCG. Your profit on the B sale is $30 - $15.30 = $14.70. All of it is LTCG.

Reply to
Alan

Chip -

Thanks, I'll check it out!

Whit

Reply to
Whit Matteson

Alan -

Thanks for wading through that, and for the confirmation that I was on track in the first scenario.

I like the approach you describe for the second situation (leave the grant date data unadjusted and take all the compensation income with the disposition of the A shares) because it's simpler and cleaner. Would you take the same position if the two lots had been created from a stock split instead of a spinoff? It seems like a very similar situation (similar basis adjustment, etc.) but if I take the same approach of not adjusting the grant date data, I think I would have a bunch of A shares with the same basis and acquisition date, but 10 would carry the compensation income attribute and the rest wouldn't. That doesn't seem right somehow.

I'll try to track down the revenue rulings; if you come across them, please point me in the right direction!

Thanks, Whit

Reply to
Whit Matteson
[snip]
[snip] No. I know that for sure as it happens all the time. A former employer even provided the adjusted numbers for the date of grant pricing.
Reply to
Alan

replying to Whit Matteson, lakshmi wrote: Hi Whit Wondering if you were able to access the IRS rulings on the topic of ESPP spin-offs. I am in a similar situation as yours. And the company has attributed all the compensation to the ESPP stock of A. Not pro-rating the compensation element is akin to 1) pre-payment of tax if you sell stock A but not B at the same time 2) A higher proportion of tax get attributed to simple income as compared to it being capital gains. Should the employee carry the extra burden of the spin off of the company ?

Reply to
lakshmi

Try reading this article about equity compensation in spin-offs. Companies have a lot of flexibility on how they handle this.

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Reply to
Alan

replying to Alan, omkar nayak wrote: Thanks Alan. My company took the Shareholder approach. So if I relate the "Stock Options" calculations in your PDF to my ESPP situation, I should be adjusting the compensation element based on the % FMV of the RemainCo & SpinCo shares. Did I under your PDF correctly ? And apologies for the late response. I was expecting a notification from Beansmart and did not receive it.

Reply to
omkar nayak

I do not have all of the facts, but.... If the shareholder approach was used and they kept the employee stock purchase element with the original company then: The basis in the stock purchased under ESPP is split between the two companies based on FMV on the closing date. Using the example in the document you read ($20 FMV was split $15 to original co. and $5 to spin-off) then 25% of the basis moves to the new company. 75% of the basis (what you paid) stays with the old co. This basis gets divided by .85 (I assume the discount was 85%) and multiplied by .15 to arrive at the bargain element. If the stock had risen after the grant, the bargain element would represent the 15% discount off the derived option price. If the stock had fallen in price, the bargain element would represent the 15% discount off the market price on the date of purchase. Either way, you would now have the amount needed to determine how much of any profit on the sale is ordinary income and how much is capital gain when it is sold. This obviously depends upon whether you have a qualifying or disqualifying disposition of the ESPP stock. The gain or loss on the sale of the spin-off company is cut and dry as it is all capital in nature.

Reply to
Alan

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