The Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”), in an April 2024 follow-up to IRS Notice 2023-2, issued proposed regulations dealing with the one-percent excise tax under Internal Revenue Code (“Code”) Section 4501 on the fair market value of stock repurchased by covered corporations during a year. This provision was added to the Code by the Inflation Reduction Act in 2022. The IRS had already issued final regulations, which were effective June 28, 2024, providing guidance on the reporting and payment of the excise tax for repurchases made after December 31, 2022. However, those final regulations on the reporting and payment of the Code Section 4501 excise tax did not finalize the proposed regulations on the computation of the excise tax which are discussed below. These proposed regulations will be finalized in a separate Treasury decision.

A covered corporation is a domestic corporation the stock of which is traded on an established securities market. (The proposed regulations would also apply in several instances to specified affiliates (generally with an affiliation level of 50 percent or more) of a covered corporation; for ease of reading, references to a covered corporation herein will include reference to such affiliates except where otherwise specified.) The amount of repurchased stock subject to the excise tax is reduced by the issuance of stock during the covered corporation’s taxable year. This reduction includes the fair market value of stock issued to employees or non-employees of a covered corporation. It also includes the fair market value of stock provided to employees of a specified affiliate but does not include the fair market value of stock provided to non-employees of a specified affiliate.

The excise tax does not apply when stock, or an amount of stock equal to the value of the stock repurchased, is contributed to an employee stock ownership plan (“ESOP”) described in Code Section 4975(e)(7), or any other plan that is tax-qualified under Code Section 401(a). The amount of the reduction cannot exceed the aggregate fair market value of the stock repurchased. The proposed regulations provide that a covered corporation that had a taxable year beginning before January 1, 2023, and ending after December 31, 2022, could include the fair market value of all contributions of stock to an employer-sponsored retirement plan during the entire taxable year. Treasury and the IRS have also sought comments on whether this statutory exclusion should also apply to broad-based foreign retirement plans.

Under the proposed regulations, stock held in a leveraged ESOP that is released from a suspense account as a result of cash contributions by the plan sponsor and allocated to the accounts of ESOP participants would be treated as stock contributed to the plan for purposes of the stock-contribution exception described in the preceding paragraph. This treatment applies as of the date the stock attributable to repayment of the exempt loan is released from the suspense account and allocated to participant accounts. Because dividends on employer stock held in the ESOP that are used to repay an exempt loan are not actual employer contributions, stock released from the suspense account as a result of loan repayments made with dividends would not be treated as an employer contribution for purposes of the stock contribution exception.

Regarding the timing of the offset for stock contributions, Treasury and the IRS take the position that the rules for timing of deductions for tax-qualified plans under Code Section 404(a)(6) do not apply. As a result, a covered corporation would be able to claim the income-tax deduction under Code Section 404 in the taxable year in which the stock is contributed to the plan, but would claim the offset for excise tax purposes in the preceding taxable year if: (i) the stock is contributed to the plan by the filing date for the form on which the stock excise tax is reported (Forms 720 and 7208) due for the first full quarter after the close of the corporation’s taxable year, and (ii) the stock is treated in the same way as the plan would treat a contribution to the plan received on the last day of the preceding taxable year. However, the proposed regulations further provide that stock contributed to or purchased by a plan does not reduce the excise tax base under the netting rule. Under the netting rule, the stock repurchase excise tax base for a taxable year is reduced by the aggregate fair market value of stock of the covered corporation that is (i) issued or provided by the covered corporation and (ii) stock of the covered corporation that is provided by a specified affiliate to employees of the specified affiliate.

Several provisions of the proposed regulations address executive compensation arrangements. For example, if an employee makes a Code Section 83(b) election with respect to substantially nonvested stock and subsequently forfeits the stock, that forfeiture would be treated as a repurchase. Similarly, a clawback would be treated as a repurchase if on the date the stock was issued or provided, the stock was subject to a clawback agreement, and a clawback results from the occurrence of an event specified in the clawback agreement.

Any advance payments by a third party (for example, a broker) to facilitate the purchase of shares or payment of income tax and FICA withholding would be treated as the issuance of stock for these purposes. However, stock of a covered corporation withheld to satisfy the exercise price of a stock option issued in connection with the performance of services, or to pay any withholding obligation, including state, local or foreign taxes, would be disregarded for purposes of the Code Section 4501 netting rules.

Under the proposed regulations, stock of a covered corporation would be treated as transferred in connection with the performance of services by an employee only if the transfer is described in Code Section 83, including both nonqualified stock options and incentive stock options under Code Section 421 and employee stock purchase plans under Code Section 423. The proposed regulations further provide that stock is treated as issued or provided to an employee or other service provider when beneficial ownership is transferred for federal income tax purposes. Beneficial ownership ordinarily transfers when the service recipient initiates the transfer or when the stock vests. However, if the service provider makes a valid election under Code Section 83(b), as could be the case with respect to, for example, restricted stock, beneficial ownership transfers for these purposes on the date the property is transferred. Stock transferred to a grantor trust (such as a rabbi trust) would not be treated as issued or provided until beneficial ownership is considered to have transferred to the service provider for tax purposes. Stock transferred to an employee pursuant to a nonqualified stock option or an incentive stock option or a stock appreciation right would be considered to be issued as of the date the employee exercises the option or stock appreciation right.

The fair market value of issued or provided stock issued by a covered corporation would be considered to be the market price of the stock on the date on which the stock is issued or provided. If the stock of the covered corporation is traded on an established securities market, the proposed regulations list four acceptable methods for determining the market price: (i) the daily volume-weighted average price as determined on the date the stock is issued by the covered corporation; (ii) the closing price on the date the stock is issued by the covered corporation; (iii) the average of the high and low prices on the date the stock is issued by the covered corporation; and (iv) the trading price at the time the stock is issued by the covered corporation. For purposes of each of these four valuation methodologies, if the date on which the stock of a covered corporation is issued is not a trading date, then the date on which the market price is determined would be the preceding trading day. The methodology selected by the covered corporation would have to be applied consistently to all stock of the covered corporation issued throughout its taxable year. If the stock of a covered corporation is not traded on an established securities market, the market price of the stock would be determined as of the date the stock is issued under the valuation principles in the Code Section 409A regulations. Special rules would apply if the shares of the covered corporation are traded on multiple exchanges.

Code Section 4501 is a complex provision, and considerations surrounding employee benefits and executive compensation are not the only ones that a covered corporation should consider, particularly if the excise tax is increased from one percent to four percent, as has been recommended by the Biden administration in its fiscal year 2025 budget. It is also true that for covered corporations, the Code Section 4501 implications may not be high on their list of priorities for ESOPs or other tax-qualified plans holding employer common stock, or their equity-based compensation arrangements. However, covered corporations should be aware of these rules, even if they are currently only in proposed format, so that they can accurately determine their potential excise tax liability under Code Section 4501.