How Does the 1% Excise Tax on Buybacks Apply to Equity Awards?
February 22, 2023
The Inflation Reduction Act of 2022 imposes a 1% excise tax on corporations that repurchase their own stock after December 31, 2022. Late last year, the IRS issued Notice 2023-2 to provide interim guidance on the tax until regulations can be issued.
Companies that use equity to compensate employees often regularly buy back their own stock to offset the dilution created by the plan. In addition, the value of repurchases subject to the excise tax is reduced by the value of any stock issued during the tax year. For many public companies, the majority of their stock issuances occur under their equity compensation plans, making it important for stock plan professionals to understand the excise tax.
Summary of the 1% Excise Tax on Repurchases
Here is a summary of how the tax works:
- Covered Corporations: The excise tax generally applies to public companies in the United States.
- Covered Repurchases: The excise tax applies to any stock repurchased by the corporation in a transaction that is considered a redemption under Section 317(b) of the Internal Revenue Code or any economically similar transaction, as defined by Treasury.
- Amount Taxed: The excise tax applies to the fair market value of the shares a corporation repurchases during the tax year. E.g., if a corporation repurchases $50 million worth of stock, the excise tax is $500,000 ($50 million multiplied by 1%).
- The Netting Rule: Only the repurchase value in excess of the value of shares issued during the year is subject to the tax. Thus, any shares issued under a company’s stock plans will reduce the excise tax the company owes. If the company in my prior example issued $10 million of stock during the same tax year, the company’s excise tax is reduced to only $400,000 ($50 million repurchased, less $10 million issued, multiplied by 1%).
What the Heck Are Redemptions Under Section 317(b)?
Good question! Section 317(b) defines a redemption as any stock acquired by a corporation “from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.” This can include stock repurchased from the public markets and in private transactions. Notice 2023-2 includes a list of transactions that are economically equivalent to a redemption (and thus treated as a repurchase) and a list of redemptions on Section 317(b) that are not considered repurchases for purposes of the excise tax.
Are There Any Exceptions?
What’s a tax law without some exceptions? The legislation specifically exempts the repurchases described below from the tax.
Retirement Plans Exception
Most notably, the legislation includes an exception for repurchased shares that are contributed to an employer-sponsored retirement plan, ESOP, or similar plan. Notice 2023-2 limits this exception to plans that are qualified under Section 401(a) of the revenue code.
Equity compensation plans are not typically qualified under this section of the revenue code. Prior to publication of Notice 2023-2, some practitioners had hoped that this exception might be broad enough to cover shares contributed to stock compensation plans. Based on the guidance in the notice, this does not appear to be the case.
De Minimis Exception
If a corporation’s total repurchases for a tax year do not exceed $1 million, the corporation is exempted from the excise tax. Notice 2023-2 clarifies that eligibility for this exemption is determined without considering any other exemptions or the value of shares issued during the year.
There are a few other exceptions for certain types of repurchase transactions, such as repurchases treated as a dividend or in connection with a reorganization.
The Netting Rule
The “netting rule” is a key provision when it comes to equity plans. Under this rule, the aggregate value of repurchases subject to the excise tax is reduced by the aggregate value of any issuances of stock during the tax year. This includes issuances of stock pursuant to stock options or other forms of equity compensation. Thus, a company’s equity plans could play an important role in reducing the granting corporation’s excise tax liability.
Notice 2023-2 clarifies how various equity plan transactions are treated for purposes of the netting rule, including which shares are treated as issued and how to determine the issuance date. Significantly, the notice distinguishes between shares that are withheld vs. shares that are sold to cover the cost of a transaction and any required tax withholding. Shares that are sold are treated as issued; shares that are withheld are not.
Stock Options and SARs
The issuance date for shares transferred to an option or SAR holder is the date of exercise. For cash, same-day sale, and sell-to-cover exercises, the aggregate shares exercised are treated as issued. For stock-settled SAR and net exercises, only the net shares transferred to the option/SAR holder are treated as issued (no shares are treated as issued for cash-settled SARs). The treatment of swap/stock-for-stock exercises is not addressed in the notice—your guess is as good as mine.
Restricted Stock Units
The issuance date for shares transferred to an RSU holder is the date the company initiates the payment of the stock, as described in GLAM 2020-004. If shares are withheld to cover the taxes due upon release, only the net shares transferred to the award holder are treated as issued. If shares are sold to cover the taxes due upon release or the taxes are paid in cash, the aggregate shares released are treated as issued.
Even though the shares underlying restricted stock awards are issued at grant, for purposes of the netting rule, they are treated as “issued” only upon vest, unless the award holder files a Section 83(b) election, in which case the issuance date is the transfer date.
Similar to RSUs, if shares are withheld to cover the taxes due upon vest (i.e., if a Section 83(b) election is not filed), only the net shares released to the award holder are treated as issued. If shares are sold to cover the taxes due at vest or the taxes are paid in cash, the aggregate shares released are treated as issued.
The notice does not address the treatment of ESPPs but because the code views ESPPs as a form of stock option, it is reasonable to assume that they would be treated in the same manner for purposes of the netting rule. If so, the purchase date would be the issuance date and the number of shares issued would be the aggregate shares purchased. If shares are withheld to cover taxes (e.g., for non-US employees), those shares would not be treated as issued.
How to Determine the Amount Subject to the Excise Tax
The notice stipulates a three-step process to determine the value subject to the excise tax:
- Calculate the aggregate fair market value of the stock repurchased during the year.
- Subtract the aggregate fair market value of any repurchased stock that is exempt from the excise tax.
- Subtract the aggregate fair market value of any stock issued during the year (i.e., the netting rule).
No Carry Forward
If reductions under steps 2 and 3 above exceed the aggregate fair market value of the stock repurchased during the year (step 1), the excess reductions cannot be applied against repurchases in a future or prior year.
Fair Market Value
Under Notice 2023-2, the fair market value of the repurchased stock is the market price of the stock on the date of the repurchase, which is the date ownership of the stock transfers from the shareholder to the company.
For publicly traded stock, the notice allows companies to use the following methods to determine the FMV of the repurchased stock:
- The daily volume-weighted average price on the repurchase date
- Closing price on the repurchase date
- Average of the high and low prices on the repurchase date
- Trading price at the time the stock is repurchased
Companies must select one of the above methods and apply it consistently to all repurchases and, for purposes of the netting rule, all issuances that occur during the tax year. If the repurchase date is not a trading date, the FMV should be based on the market price on the immediately preceding trading day.
Companies should apply the valuation principles prescribed under Section 409A to determine the FMV of stock that is not publicly traded (e.g., if the company has classes of common or preferred stock that are not traded).
FMV of Stock Issued to Employees
To determine the FMV of stock issued to employees for purposes of the netting rule, companies should use the FMV of the stock on the issuance date as determined under Section 83. This would generally be the same FMV that is used to determine the employee's taxable gain on the transaction in which the stock is issued. Companies will also presumably be allowed to use any method of determining the FMV that is acceptable under Section 83, even if it is not one of the methods specified in Notice 2023-2.
Repurchases to Offset Plan Dilution
As noted above, it is common for companies that offer stock compensation to employees to periodically repurchase their own stock to offset the dilution created by the equity program. Once the excise tax goes into effect, the timing of these repurchases could be important so that the value of the repurchased shares closely aligns with the value of the issued shares. When the stock is higher in value on the repurchase date than it was on the issuance date, the issuance will not fully offset the repurchase, causing the company to be subject to the excise tax.
Where a company repurchases shares on the open market to offset dilution from its ESPP, it may be desirable to time those repurchases to occur as near as possible to the purchases under the plan, to minimize any differences in values.
More to Come—Stay Tuned!
Notice 2023-2 merely provides interim guidance until the IRS can issue regulations. We will cover the regulations here in the NASPP Blog once they are issued.
The IRS is soliciting comments on the rules described in the notice. You can submit comments through March 20, 2023 at www.regulations.gov.
Update: On March 8, 2023, I updated this blog to clarify how the FMV of stock issued to employees is determined. Originally, I stated that the FMV for shares issued to employees would have to be determined in the same manner as other issuances; this is not correct.