The Securities and Exchange Commission (SEC) last year amended rules under the Securities Exchange Act of 1934 to shorten the securities transaction settlement cycle for most broker-dealer securities transactions, from “T+2” to “T+1,” meaning that securities transactions will need to be settled within one business day of the transaction date (“T”), effective as of May 28, 2024.
Impact on Equity Awards
The new SEC-required settlement timing will directly impact equity awards that are settled through an open-market transaction, such as same-day-sale stock option exercises and sell-to-cover RSU settlement transactions. It may also result in the acceleration of settlement of non-market transactions such as stock option cash or “net” exercises and “net-settled” RSUs. In either case, the shift to T+1 settlement will have a significant knock-on effect from a U.S. federal tax perspective because the IRS determines the timeliness of federal tax deposits due under the “next-day” deposit rule by reference to the SEC’s settlement timing rule. Therefore, the tax reporting, withholding and deposit calculations for equity awards will need to be expedited to be in line with the new settlement cycle.
IRS Tax Deposit Rules for Equity Awards
The “next-day” deposit rule requires the deposit of accumulated employment taxes (both income tax withholding and FICA contributions) of $100,000 or more by the next business day following the applicable “Liability Date.” Under the IRS’s most recent guidance, issued in 2020 in the form of a GLAM (General Legal Advice Memorandum 2020-004), the Liability Date for options and stock appreciation rights (“SARs”) is the date of exercise and for RSUs is the date the employer “initiates payment” by requesting the transfer agent to deliver shares. However, under the IRS’s internal revenue manual, which was amended shortly after the GLAM was released, the IRS allows for an administrative waiver of the next day deposit deadline for such equity award transactions. Under this waiver, employment tax deposits will be treated as timely as long as they are made within one business day of settlement, provided settlement occurs within two business days of an option/SAR exercise or RSU payment initiation. In other words, under the administrative waiver, the Liability Date would be the settlement date (provided settlement occurs within T+2).
The IRS has not indicated that it will amend the administrative waiver to accommodate the new settlement cycle, e.g., by treating tax deposits as timely if they are made within two business days of settlement (thereby retaining the current three business days for issuers to calculate and deposit taxes due on covered equity award transactions). As a result, the new settlement timing rule will effectively eliminate a day from the period that companies previously had to process equity award tax withholding calculations and deposits in order to meet the next day deposit rule. To meet this newly compressed timeline, many companies are finding that they need to calculate the tax withholdings on equity award transactions using an earlier day’s trading price. For instance, companies using the closing price on the date of RSU vesting (typically, the “payment initiation” date referenced in GLAM 2020-004) may instead wish to use the opening trading price on that date or even the closing or opening trading price on the preceding trading date to buy some additional time to calculate and process withholdings.
Valuation of Equity Award Shares for Tax Purposes
While the GLAM described above states that the payment initiation date for RSUs (and exercise date of an option) is the date that compensation should be includible in income, it does not prescribe the share valuation method to be used to calculate the income and tax withholding obligations. Based on existing informal guidance from the IRS, it should be possible to rely on any reasonable valuation method, such as the closing price or opening price of the shares on the date prior to vesting or payment initiation of RSUs (or exercise of options), so long as the valuation method is applied consistently by the company. However, before changing the trading price that is used to determine the withholding amount, companies will need to confirm that their stock plan does not prescribe a particular definition of “fair market value” to determine the tax withholding obligations. While many stock plans contain a definition of “Fair Market Value,” the tax withholding provisions in plans or award agreements typically do not require such defined Fair Market Value to be used to calculate the withholding amount. However, if your plan does hard-wire a trading price that is required to be used to calculate the tax withholding amount, it should be possible to amend the plan without shareholder approval under U.S. stock exchange listing rules.
In deciding the trading price that will be used to calculate the withholding amount, companies should consider how and whether the new share valuation method will apply to different award types and any systems or administrative limitations, including with the company’s stock plan broker, and the feasibility of doing so under IRS guidance.
Looking Ahead
For companies that have already modified their tax withholding and deposit practices in preparation for a change to T+1, it will serve as a good exercise if and when the settlement cycle is further shortened to T+0 – which the SEC is currently contemplating. Assuming T+0 was to move forward, we can only hope that the IRS would then be willing to amend its administrative waiver to avoid further shortening the time companies would have to calculate tax deposits due under the next-day rule.
