Donald Rumsfeld famously said of the Iraq war that "There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns, the ones we don't know we don't know." He got a lot of flack for that, but what he said makes a lot of sense. He should have added one more, however: the unknown knowns, the things we think we know that we really don't.
The equity compensation industry is highly regulated, with many pitfalls for the unwary. This book contains some humorous and painful examples of what happens when otherwise competent and responsible professionals don't know what they don't know and fail to get advice before taking actions that result in consequences that range from the merely awkward to the downright serious.
This book is not a comprehensive compendium of all the things you shouldn't do. That list could go on and on. But it does try to cover the most common kinds of problems that occur, presented in the form of brief case histories, each followed by lessons on what should have been done.
Table of Contents
Introduction: Not Knowing...and Not Knowing You Don't Know
Chapter 1: Plan Design and Modifications
Chapter 2: Administration, Process, and Policy
Chapter 3: Culture and Cultivation
Chapter 4: Communication and Education
Chapter 5: Technology
Chapter 6: Tax and Law
Chapter 7: Accounting and Valuation
Chapter 8: Corporate Transactions
From Chapter 6, "Tax and Law"
It's one thing to fail to turn in something to your payroll department on its timeline. It's another thing to forget to pay the IRS on its timeline.
In September 2008, Joe Camello, CEO at GH Inc., received a restricted stock unit grant that would vest in full 12 months from the grant date. GH Inc. had a very good year in 2008. So good that CEO Camello's annual bonus was $900,000. Joe received his bonus in January 2009, just in time to buy tickets to Super Bowl XLIII. Joe was a big Arizona Cardinals fan. Alas, the game was a bust.
On September 1, the stock administrator was reviewing the upcoming month's award vesting report and noticed that Joe's RSU payout of $500,000 was scheduled for the next day. She checked the equity administration database and confirmed that Joe's annual salary was $400,000, and his average annual bonus was $300,000, so the RSU payout wouldn't put him over the $1 million limit for supplemental income tax withholding payment, then notified payroll about the payout and reminded payroll that taxes should be withheld at the supplemental tax rate of 35%.
The junior payroll clerk called Joe. He explained that they could either order a hand cut check for the $325,000 after-tax payout or run the payout through the September 15 payroll along with the withholding. Joe, feeling better than he'd felt since the Cardinals' loss in February, asked for a hand-cut check instead of waiting.
The payroll clerk reported the RSU payout to the payroll service in the next regular payroll run on September 10. Imagine the payroll department supervisor's expression when the payroll service provider called about the deposit of the $175,000 supplemental income withholding taxes for Joe's payout. Because of his unusually large January bonus, Joe's RSU payout had pushed him over the $1 million supplemental income limit, and the taxes on the RSU payout should have been deposited with the IRS the day after the payout date. She asked if they wanted to deposit the already overdue $175,000 supplemental income withholding taxes immediately or wait until the regular payroll deposit on September 15. The service provider recommended waiting until September 15 because the payment had already missed the first penalty tier (2% for one to five days late) and five more days wouldn't make it any worse, but the 5% penalty ($8,750) should be deposited at the same time.
Lessons Much like the CEO, the IRS wants its money at the first opportunity. We have three failures in this example:
- Failure to coordinate. Once again, we have a plan administrator who has failed to plan ahead to take the payroll schedule into consideration. Remember, even though you provide financial reports at month end, it is a good idea to review cash-based award payouts in coordination with the payroll schedule. In this example, the September 2 payout would still have been made between payroll submission dates, but if the payout date had been on September 1 the administrator could have planned ahead to have it pay out and have the withholding deposited on the regular September 1 pay date.
- Failure of communication. Some equity administration programs now have interfaces to integrate with payroll systems, but it has not yet become industry-wide practice. When these systems are not integrated, it is important to get regular downloads from the payroll system if the equity administration database will be involved in calculating the taxes on equity compensation transactions, especially if there is a chance that any executives will have substantial bonus income. As in this example, even if the equity administration database was not used for calculating withholding taxes, if the administrator had received payroll downloads she would have noticed the supplemental income and been able to alert the payroll clerk instead of relying on a simple note in the system about average bonus amounts to this participant.
- Failure of knowledge. When dealing with equity compensation, some of which is reportable as supplemental income, the stakeholders in all departments must have enough experience to at least know what questions to ask. In this example, the junior payroll clerk did not have a clear understanding of payroll withholding in the context of supplemental income. The equity administrator assumed that the payroll clerk would know to check the exact amount of the participant's supplemental income, and the clerk did not know enough about supplemental income to do so.