Chapter 3 – The Equity Headline, or the Unintended Effects of Regulation

The IRS has just notified you that you did not submit payroll taxes for restricted stock paid to employees earlier in the year.  In addition to the taxes due, the IRS has charged the company a significant amount of interest and taxes as a penalty for not paying your taxes on time.

Regulators tend to create laws to protect people, not to employ them – at least not officially. Their intentions are unassailable. Who does not agree that an employee should be paid promptly for work he or she performed? Who does not want to protect investors from unscrupulous businessmen? And who really believes that an unregulated workplace is a safe workplace?

It happens that some regulations actually do what they were intended to do. For example, Congress passed Glass-Steagall in 1933, in the wake of the 1929 stock market crash that led to the Great Depression. The law kept commercial banks (where customers deposit money and take out loans) separate from investment firms (which hold securities and make investments). The rule was simple, easy to enforce and easy to comply with.

Alas, regulations often do not work as intended. Payroll taxes are an illustration of good intentions morphing into byzantine requirements that guarantee both a high cost to comply and a high probability that a company will run afoul of at least a few of the ever changing rules. Let’s examine one example:  prior to an IPO, a company has to deal with the rules regulating restricted stock units and stock options, whether employees can privately trade stock prior to an IPO, taxes on 83(b) plans, and how to value their stock for tax and accounting purposes.

This is the reason that, unlike other internal processes, equity compensation needs to be automated as soon as the company receives financing. You cannot complete a cost effective audit of equity compensation without a system that values stock awards in accordance with regulatory guidelines. All good equity tools make it easier to create a capitalization table that the board will want for each meeting. It will help track and value grants with unusual terms or grants to non-employees. And it will help you reconcile stock records to your HR and legal records, something a company should do every quarter.

The real challenge starts once your company completes its IPO. The whole company is abuzz as employees can now trade stock. For the first time in the company’s history, everyone’s attention is now focused on their stock plan.

This is the point when most back office teams and individuals fail. They fail because they do not anticipate the effort and coordination needed to administer, account for, disclose and pay tax on stock compensation. The adverse impact of making a mistake is exacerbated by the unreasonable amount of time in which tax payments must be submitted to the US government. Payments must be disbursed to the government within twenty four hours of the trades being executed. It is a deadline many companies fail to meet.

The period of time in which your company can make a tax payment to the government can be brutal. The first consequence of this lack of time is that, for payroll tax payments, you overpay the government. You overpay because it is impossible – even with a good automated tool – to calculate tax payments for every employee without advance preparations. For every current employee, and former employees who trade options or stock they received from the Company, the company must pay taxes at the federal, state and local levels. These tax rates do not change often, but some rates will change every quarter. Also, the Payroll and Stock teams do not know the price at which the stock will be traded until it is sold. Then you must add further complications for employees with 83(b) plans or employees who routinely have inside information of the company’s performance or merger activity. The SEC allows these individuals to set up a trading plan in advance to sell a predetermined number of shares at a predetermined time.

You overpay because the interest and penalties associated with not paying on time are significant, and you have no say in the matter. But this is nothing compared to paying taxes in countries where your company may have disrupted business for local companies, especially if they are owned or supported by the government. If your tax payment in one of these countries is even one day late, you could be liable for prosecution, fines, and negative publicity. “What publicity,” you say? Try an exposé about either the company, or an executive of the company being charged with tax fraud. And get ready for a “dawn raid” by regulators to further investigate the matter, an event which could damage your company’s international brand.

If you want to avoid these regulatory punishments, it is essential to plan ahead. To compute compensation and distribute stock and cash to all of your employees as well as the government will require a monumental amount of coordination. This is one of the primary reasons why there must be cross-functional extended meeting to discuss the end-to-end compensation process. This meeting must have a sponsor, a facilitator, as well as members from the stock, legal, finance, accounting and HR teams who can share information about how the process works. When members of these groups have opened their operations to review, a constructive dialog can begin.

The key to a constructive dialogue is a visible rendering of the end-to-end process. The rendering does not need to be complex or a thing of beauty; in fact, the best rendering happens on white boards. It is amazing what can be accomplished with a good facilitator and a big white board. The rendering enables teams who own the data to work together to analyze process flaws or constraints from the bottom up. You will discover that working together in this manner helps teams understand and empathize with other teams’ problems. Responsibility and formal accountability can be created for the good of the process, not just the good of one group.

• See what happened to Uber
  (How Uber’s Tax Calculation May Have Cost Drivers Hundreds of Millions)
• Because You’re Smart –
  • Did you submit payroll taxes for restricted stock paid to employees who left the company earlier in the year and have then exercised their stock? Was this information included in their W-2 forms submitted to the Government?
  • Do any employees have 83-(b) stock plans? Are they aware of the tax ramifications if the value of your company, and their stock, decreases?
  • Are you aware of the local payroll tax filing deadlines and rates in every location where your company does business?
• Have you encountered a similar problem with regulations? How did you deal with it? Share your story.