I Seen a Girl on a One-Way Corridor, Stealing Down a Wrong-Way Street – Tax Opportunities with ISOs in M&A

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by John Ludlum

Incentive Stock Options (“ISOs”) have a somewhat legendary status as equity incentives for technology and other early-stage companies. It is true that ISOs are one of two types of equity awards that can achieve capital gains treatment on the entire appreciation value of the awards—profits and interests are the other type. It is possible that an ISO share may be taxed at the long-term capital gains rate for the entire difference between the exercise price and the disposition price.

To achieve this advantaged tax treatment, an option must meet the requirements of Code § 421-424 and the associated regulations, which include, but are not limited to:

  • Required terms for the plan issuing the ISOs (shareholder approval among other terms)
  • Eligibility requirements (must be an employee at the time of grant, and loses ISO status three months after ceasing to be an employee)
  • Limitations on the number of ISOs a recipient can receive (no more than $100,000 can first become exercisable in a calendar year measured by the exercise price)
  • Other additional requirements

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I’ve Been Trying to Get Down to the Heart of the Matter – the Board Action

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by John Ludlum

If you ever want to see a benefits lawyer get nervous, start talking about corporate intent.  Yes, the company intended to grant options at an earlier and lower exercise price, and yes it may have made promises to the individuals who would receive the awards; everybody seems to be in agreement. But there may be inadequate documentation, or worse, none at all, and the tax implications have to be considered. The foundation for any equity grant will be corporate action, and the experienced perspective is that if there is doubt about the corporate action, it will be hard to defend.

The Incentive Stock Option (“ISO”) regulations and the Code Section 409A regulations (“Section 409A”) both provide guidance on when an equity grant is actually made for the purposes of those Code Sections. For ISOs, the “date or time when the granting corporation completes the corporate action” constituting an offer under the terms of a statutory option which is not considered complete until the maximum number of shares and the minimum price are fixed or determinable. For Section 409A, the date when the “granting corporation completes the corporate action” necessary to create a legally binding right to the option which is not complete until the date on which the maximum number of shares and the minimum exercise price are fixed or determinable, and the class of underlying stock and the identity of the service provider are designated. Obviously, the regulations have similarities, but the common and essential element is the requirement for a corporate action. Read more

Like a Vision She Dances Across the Porch As the Radio Plays… Thinking About Equity Practices In the Good Old Days

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Changes and trends in private company equity incentive plan terms over time

by John Ludlum

A client who remembered equity plans from Silicon Valley in years past asked about what has changed in private company equity plans over time. This can be a big topic, with some changes driven by securities compliance considerations, some by accounting (for those of us who remember when options were “free” of compensation expense in the days before SFAS 123R now ASC 718), and some by tax rule changes (what did any of us do before Code Section 409A?). Read more

Even if We’re Just Dancin’ in the Dark… We Should Still Understand the Equity Repurchase Rights

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by John Ludlum

It is common for employees and executives of technology companies to receive a significant portion of their compensation in equity. For executives, the equity often represents the majority of the financial upside of the relationship. Years ago, business practices were more relaxed in Silicon Valley and other technology-favorable business environments with terms like single trigger vesting acceleration baked into equity plans for a change of control, and equity repurchase rights for the company were often quite limited.

Times have changed. While it is fair to say that sometimes terms like single trigger change of control acceleration resulted in unfair windfalls for employees who received equity awards shortly before a change of control, especially during economic cycles where valuations were volatile (rapid value increases for the common stock of private companies seem to go in cycles), there are now several considerations for executives to think about in connection with the likely value of their equity in an employment opportunity. Read more

Oh Won’t You Stay…Until the Bonus is Paid

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by Brenda Berg

A new interpretation by the Colorado Department of Labor and Employment (CDLE) could have significant tax impacts under Internal Revenue Code Section 409A (409A). Many bonus and incentive programs require that the intended recipient remain employed with the employer through the date of payment. If the employee quits before the payment date, the employee is not entitled to receive the bonus. In fact, many bonuses are granted specifically in order to retain the employee.

In Interpretative Notice and Formal Opinion (INFO) #17, the CDLE interprets the Colorado Wage Act as prohibiting an employer from requiring the employee be employed on a certain date in order to receive a bonus, if all other conditions to receive the bonus have been met. See my colleague’s article here for more discussion about the new guidance in general.

If the CDLE interpretation is applied to retention bonuses, the bonuses might not, in fact, be forfeitable if the employee quits before the payment date. Since these bonuses are typically designed to be exempt from 409A tax rules under the “short term deferral” exception which requires there to be a “substantial risk of forfeiture,” this could mean that there is no longer a substantial risk of forfeiture. The amount could be considered deferred compensation that is subject to 409A – and all of 409A’s restrictions and an extra 20% tax for any violation. Earlier “vesting” and disregard of “substantial risk of forfeiture” could have other tax and accounting impacts as well, including the timing of federal/state income taxation and FICA taxation, and which taxable year is allocated the company deduction under the “all-events test” for liabilities. Read more

Surprise, Surprise, Come On Open Your Eyes and Check the Tax Boilerplate and Operating Agreements

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by John Ludlum

We have referenced Code Section 280G and the golden parachute rules recently on this blog, and we have also discussed LLC equity incentives.  It can be fun to see how these concepts play out in a practical way in executive agreements based on some recent experiences in negotiating terms for executives in connection with private equity acquisitions.

For Code Section 280G, there are basically 3 ways that Section 280G golden parachute terms appear in employment agreements:

  1. “Gross-ups” for 280G taxes (where the company makes the executive whole for any Code Section 280G taxes imposed),
  2. “Best-of” provisions (where the executive receives either the total amount of payments and pays the taxes or reduces payments to a level below the threshold where Code Section 280G taxes apply, whichever results in the greatest amount of benefits being paid to the executive), and
  3. “Haircuts” (where the total amount of Code Section 280G benefits are mandatorily reduced to a level below the threshold where Code Section 280G applies).

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In These Headlights Beams, Beyond My Wildest Dreams – An “Affiliated Group” for Section 280G?

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by John Ludlum

In these times of high M&A activity, we see a lot of questions about Code Section 280G (“Section 280G”) which we discussed generally on this blog a few weeks ago. One fine point issue that comes up relates to whether Section 280G applies in the first place.

Section 280G denies a deduction and imposes an additional 20% excise tax on “excess parachute payments” which are payments beyond a certain threshold that are made contingent on a change in ownership or effective control of a “corporation.” The definition of corporation includes all of the normal corporate entities, as well as publicly traded partnerships and foreign corporations, among others. But the Section 280G rules do not apply to partnerships or S-Corporations. Read more

The Music of the Night . . . Phantom Plans for Early Stage Companies

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By Kevin Selzer

Early stage companies that are strapped for cash often turn to long-term incentive compensation plans to attract and retain key employees and service providers. Many of these companies opt to put in place arrangements that grant actual equity interests (e.g., stock options or, in partnership-taxed entity, profits interests).  While these arrangements may be a good match for certain companies and situations, I find that phantom plans often fit better with early stage company/ownership goals. Read more

Free Fallin’…With a Golden Parachute

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by Benjamin Gibbons

For those who have been involved in the sale of a company, Section 280G of the Internal Revenue Code may sound familiar. Section 280G governs what the IRS considers to be “golden parachute payments” and is generally applicable when a corporation is undergoing a change in control (including both stock sales and asset sales). At a high level, Section 280G imposes on disqualified individuals a 20% excise tax on excess parachute payments paid and a corresponding loss of deduction on such payments by the corporation. Read more

Into the Distance, a Ribbon of Black, Stretched to the Point of No Turning Back? Understanding Your Biases in Making Tax Decisions

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by John Ludlum

In a former life, I studied how competent professionals made what turned out to be wrong and sometimes deadly decisions. Often under the general category of “loss of situational awareness,” we had sanitized terms like “target fixation” leading to CFIT or “controlled flight into terrain” (terrain impact caused by continued visual flight into IMC) or “instrument meteorological conditions” (how the mishap is described when a non-instrument rated pilot loses control after flying into clouds). We studied these mistakes to learn from them and to improve our own decision making. Read more