423b Subject to Disqualification: What Does it Mean in Non-qualified ESPPs

Casey Fenton

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January 8, 2024

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Suppose you're the owner of a burgeoning tech startup. Your team has been working tirelessly, and you're on the brink of your next funding round. To reward your dedicated employees and further incentivize them, you decide to introduce an Employee Stock Purchase Plan (ESPP). You initially consider a qualified ESPP, drawn by its tax advantages. But then you realize the IRS's stringent guidelines won't allow you to offer this benefit to contractors who've been pivotal in your success. What do you do?

Enter the non-qualified ESPPs, specifically what is termed as "423b Subject to Disqualification." Despite its intriguing name, this type of plan could offer the flexibility and inclusivity you've been searching for.

Here, we’ll explore the ins and outs of 423b Subject to Disqualification in non-qualified ESPPs, breaking down the unique advantages that make it a viable, if not preferable, alternative to qualified plans.

What is a Non-Qualified ESPP?

You may already be familiar with qualified ESPPs, governed by IRS Section 423, which comes with specific tax advantages but also strict compliance requirements. But what about non-qualified ESPPs? 

A non-qualified ESPP is an equity-based compensation plan that allows your employees to purchase company stock, usually at a discounted price, without having to adhere to IRS Section 423 regulations. Unlike its qualified counterpart, a non-qualified ESPP offers a unique blend of features:

1. Strategic Alignment

A non-qualified ESPP can be designed to meet specific strategic objectives. Whether you're looking to incentivize long-term employment, attract new talent, or reward specific categories of employees like high-performing teams or contractors, you have the liberty to set your own parameters.

2. Targeted Offering

Do you have different classes of stock? A non-qualified ESPP allows you to target specific stock offerings to distinct employee groups. This approach can be instrumental if you have multiple stock types with varying voting rights or dividend policies.

3. Lower Barriers to Entry

Since non-qualified ESPPs are not bound by IRS rules, they often come with lower barriers to entry. For example, you can choose to have shorter service requirements for participation or even offer the plan to part-time employees or contractors, providing a broader base of stakeholders who can contribute to and benefit from your company’s growth.

4. Immediate Implementation

Non-qualified ESPPs can usually be rolled out more quickly because they are not subject to the regulatory requirements of qualified plans, such as IRS approval or mandatory shareholder votes. This speed to market allows you to implement, test, and adjust your plan with relative ease, adapting to real-time feedback and changing business needs.

Understanding 423b Subject to Disqualification

Plans designated as "423b Subject to Disqualification" typically start with the intention of complying with IRS Section 423 guidelines. These guidelines offer certain tax benefits but come with strict requirements on plan structure, eligibility criteria, and purchase price. However, for various reasons, some plans either cannot maintain compliance or choose to deviate from these standards, putting them in the realm of "423b Subject to Disqualification.

Triggers for Disqualification

What might cause a plan to be subject to disqualification? It could range from failure to meet Section 423 regulations due to administrative oversights, to intentionally structuring the plan to include employees otherwise excluded by Section 423—like foreign employees or contractors. Understanding the triggers can help you make conscious decisions about your ESPP structure.

Potential Advantages

Having a 423b Subject to Disqualification does not mean your plan is inherently flawed; instead, it opens up a different set of possibilities. For example, you can extend the plan's benefits to broader categories of employees, set different purchase price mechanisms, or even experiment with innovative offering periods. You're essentially turning the plan into a customized instrument, tailored to meet your unique business objectives.

A Transitional Phase

Some companies use 423b Subject to Disqualification as a transitional stage, especially startups or businesses experiencing rapid growth. As you scale, you might find that what worked for a 20-person company doesn't fit a 200-person organization. A plan that is 423b Subject to Disqualification allows you the flexibility to adapt your ESPP as your company evolves, without the need for significant overhauls or shareholder re-approval.

Risk Management

It's crucial to consult with legal and financial experts when dealing with plans that could be subject to disqualification. Understanding the tax implications and compliance requirements can help you manage risks effectively while taking advantage of the plan’s inherent flexibility.

Advantages of 423b Subject to Disqualification

The term "disqualification" often carries negative connotations, leading you to think that being 423b Subject to Disqualification means something has gone awry with your ESPP. However, this couldn't be further from the truth. While it might deviate from the more conventional route of qualified ESPPs, a plan subject to disqualification offers its own set of unique advantages that could be ideal for your company. Here's why:

1. More Inclusive Employee Eligibility

A qualified ESPP typically limits participation to employees who meet stringent IRS criteria, excluding certain types of employees, such as part-time workers, contractors, or even foreign nationals. A plan that is 423b Subject to Disqualification allows you to include these categories, fostering a more inclusive corporate culture and extending the plan's benefits to a broader set of contributors.

2. Flexibility in Offering Periods

Qualified ESPPs have set offering periods, often dictated by tax and regulatory considerations. If your business doesn't align neatly with these predefined timelines, a non-qualified plan, including those subject to disqualification, provides the flexibility to set offering periods that make sense for your operational cycles.

3. Customized Pricing Options

The ability to determine your pricing options can be a massive advantage in attracting and retaining talent. While qualified ESPPs often have rigid rules for setting the purchase price of the stock, a 423b Subject to Disqualification plan allows you to get creative. You can set different price mechanisms for different groups or strategically time the purchase price to align with business milestones.

4. Operational Ease

When operating under Section 423, a minor administrative error could disqualify the plan or incur penalties. A plan that is 423b Subject to Disqualification is more forgiving of such errors, allowing for corrections and adjustments without causing a crisis. This adaptability can be particularly useful for smaller companies or startups where administrative resources are limited.

5. Strategic Tax Planning

While it's true that qualified ESPPs offer specific tax advantages, they also come with limitations, such as the inability of the company to deduct the discount as a business expense. Plans subject to disqualification offer a different tax landscape, allowing for strategic tax planning from both the employee and employer perspectives.

When Should You Opt for a 423b Subject to Disqualification Plan?

Making the decision to go for a plan that falls under "423b Subject to Disqualification" isn't to be taken lightly. It's a calculated, strategic choice that can yield significant benefits when aligned with your company’s specific needs and objectives. So when should you consider opting for such a plan?

✔ When Flexibility is Paramount

Are you a dynamic company experiencing rapid change, perhaps due to growth, mergers, or shifts in the business model? In such cases, the flexibility inherent in a plan subject to disqualification can be invaluable. Unlike qualified plans, you can easily adapt the terms, extend benefits to various categories of employees, or make operational changes without jumping through numerous regulatory hoops.

✔ To Accommodate Diverse Employee Types

If your workforce is a mix of full-time employees, part-time staff, contractors, and even foreign employees, then a "423b Subject to Disqualification" plan could be ideal. This structure allows you to extend benefits to a wide range of contributors, improving morale and incentivizing diverse talent pools.

✔ For Quick Implementation

Time is of the essence in business. If you need to roll out your ESPP quickly—perhaps to align with other corporate milestones or before a funding round—a plan subject to disqualification can be implemented more swiftly than its qualified counterpart. The lack of regulatory delays can be a significant advantage in fast-paced business environments.

✔ When Testing the Waters

If you're new to ESPPs or unsure about how well such a plan will be received by your employees, starting with a 423b Subject to Disqualification plan can be a prudent choice. It allows you to test different features, offering periods, and pricing options to see what resonates most with your team.

✔ To Customize Financial and Tax Strategies

While the tax benefits of a qualified ESPP are standard, a non-qualified plan, especially one subject to disqualification, offers room for creative financial planning. Consult your financial and legal advisors to explore how the tax implications could be optimized for both employees and the company.

✔ When Navigating Complex International Laws

If your company has a global footprint, navigating the tax and legal landscapes of multiple countries can be daunting. A "423b Subject to Disqualification" plan provides the flexibility to adapt to different jurisdictions, making it easier to extend your ESPP benefits globally.

Comparative Analysis: Qualified vs. Non-Qualified ESPPs

When it comes to choosing the type of ESPP that best suits your company, understanding the differences between qualified and non-qualified plans is crucial. Let's break down the distinctions based on several key factors.

1. IRS Criteria

Qualified ESPPs must meet specific guidelines under IRS Section 423 to receive tax benefits. This includes rules regarding eligibility, offering periods, and purchase price.

Meanwhile, non-qualified ESPP (Including 423b Subject to Disqualification) does not have to conform to Section 423 guidelines, giving you more leeway to customize your plan.

2. Discount Range

Qualified ESPPs are usually capped at a maximum discount of 15% off the fair market value of the stock. Some companies offer a "lookback" feature, which allows employees to buy stock at the lower of two prices: the price at the start or the end of the offering period.

In non-qualified ESPPs, you have the freedom to set the discount as you see fit, making the plan potentially more attractive to employees.

3. Shareholder Approval

Qualified ESPP requires shareholder approval for initiation and any significant changes to the plan, which can make the process more cumbersome.

On the other hand, in non-qualified ESPPs, shareholder approval is generally not mandated, although some companies choose to seek it for good corporate governance.

4. Tax Benefits

Qualified ESPP offers tax advantages for employees, as the discount is generally not taxed until the stock is sold. However, companies don't receive a tax deduction for the discount provided.

For non-qualified ESPPs, the discount is generally considered taxable income for employees at the time of purchase. On the flip side, companies can often deduct this amount.

5. Plan Design Flexibility

Qualified ESPPs are more restrictive due to IRS guidelines, limiting how much you can tailor the plan to your needs.

Meanwhile, non-qualified ESPPs offer more room for customization, from eligibility criteria to the offering period, allowing you to align the plan more closely with your company goals.

Which One is Best for Your Company and Workers?

Choosing an Employee Stock Purchase Plan is a strategic decision that should align with your company's unique needs and objectives. Qualified ESPPs offer tax benefits but come with stringent regulations. On the flip side, a 423b Subject to Disqualification plan provides flexibility and customization at the expense of certain tax advantages.

Both options have their merits and drawbacks. Your task is to evaluate these within the context of your business goals and workforce. Consult your financial and legal advisors, consider your employees' needs, and weigh how each plan aligns with your long-term objectives.

Alternatively, in case you’re still looking around for the ideal equity compensation model, we recommend you check out Upstock’s RSU equity platform. Its innovative restricted stock units (RSUs) are a game-changer not just in the tech industry but also in up-and-coming and scaling companies. Book a demo today to see how it works.

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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