Presenting a live 90-minute webinar with interactive Q&A Executive Compensation Tax Issues in Mergers and Acquisitions Navigating Tax Rules for Stock Options, Deferred and Equity Compensation, Golden Parachutes, and More TUESDAY, APRIL 22, 2014 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: David A. Calder, Morgan Lewis & Bockius, Irvine, Calif. Gina L. Lauriero, Morgan Lewis & Bockius, New York Mims Maynard Zabriskie, Partner, Morgan Lewis & Bockius, Philadelphia The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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webinar Executive Compensation Tax Issues in Mergers and Acquisitions Mims Maynard Zabriskie David A. Calder Gina L. Lauriero April 22, 2014 www.morganlewis.com
Executive Compensation Tax Issues in Mergers and Acquisitions Introduction Planning for a change in control: Rationale for change in control arrangements Overview of potential issues Say on golden parachute pay Closing the deal: Deal structure Overview of issues Treatment of equity compensation Severance arrangements and other sources of potential unfunded liabilities Internal Revenue Code Section 409A Internal Revenue Code Section 280G Q&A 6
Executive Compensation Tax Issues in Mergers and Acquisitions Planning for a Change in Control 7
Purpose of Change in Control Provisions in Employment Agreements and Change in Control Agreements Goal is to balance the legitimate interests of both the executive and the employer Executive needs to be sure that there is some level of protection against a successor employer terminating the relationship or otherwise materially changing the business deal Employer needs to be sure that the change in control provisions don t negatively impact its ability to effectuate a change in control at an appropriate price 8
Change in Control Provisions in Employment Agreements and Change in Control Agreements Companies will often provide enhanced severance protection if a termination occurs upon or within one to two years after a change in control Severance multiple is often greater (e.g., two times compensation vs. one times compensation) Severance otherwise paid in installments is often paid in a lump sum All or a portion of outstanding equity awards vest 9
Reasons Companies Are Willing to Provide Change in Control Protection Benefits to the employer: Helps attract and retain qualified personnel Need to provide retention protection if the employer is a possible target company in a consolidating industry Change in control protection makes top management members neutral regarding acquisition offers and allows them to focus on the successful completion of the transaction Encourages key personnel to continue in employment through completion of a change in control Maximizes shareholder value by retaining key transition personnel Protects the company in the event the transaction is not completed 10
Employer Concerns in Providing Change in Control Protection Need to balance employer concerns: If the employer needs to deliver an intact management team, change in control terms should not give executives the incentive to leave upon closing Making executives too wealthy may reduce motivation after the closing Shareholder concerns Public companies will need to disclose arrangements in their annual proxy statements 11
Arrangements Addressing Change in Control Benefits Severance Plans and Agreements Enhanced severance Bonus Plans Accelerated vesting or payout Deferred Compensation Plans Accelerated vesting or payout Additional service credit under executive retirement plans Equity Compensation Plans Single-trigger or double-trigger vesting Assumption or cash-out of equity awards 12
Triggering Events Single-Trigger Equity vesting upon the occurrence of the change in control Executive has the right to voluntarily quit on or following the change in control and receive change in control benefits Double-Trigger Executive will only receive change in control benefits upon a qualifying termination in connection with or within a specified period following the change in control 13
Employer-Initiated Termination Cause Defining Cause is a balancing act Executive wants to remove subjectivity to be sure only specific, objective events are included Employer wants to retain subjectivity to allow flexibility in light of uncertain circumstances Notice and cure periods Due-process right to Board review 14
Executive-Initiated Termination Good Reason Good reason essentially amounts to constructive termination without cause, and thus generally results in the same economics to the executive Successor employer should not be permitted to materially change the initial business deal (e.g., CEO becomes part of the janitorial staff) Notice and cure periods Section 409A considerations 15
Current Trends Limited group of executives covered by change in control arrangements Lower severance multiples Trending away from three times multiple Severance multiples of more than three times base salary plus target/average/last paid bonus are considered a problematic pay practice by ISS Shift to double-trigger 16
Current Trends Elimination of 280G gross-ups Addition of 280G best net provisions Clawbacks Impact of say on golden parachute payments 17
Disclosure of Change in Control Obligations Proxy/CD&A Disclosure Must describe severance and change in control benefits Must calculate value of benefits Must quantify any gross-ups on excess parachute payments (280G) 18
Shareholder Vote on Golden Parachute Arrangements Say on golden parachute provisions apply where: Seeking shareholder approval of an acquisition, merger, consolidation, or proposed sale or disposition of all or substantially all of a public company s assets Disclosure also required in connection with going-private transactions and third-party tender offers Requirements: Disclosure Non-binding shareholder advisory vote 19
Shareholder Vote on Golden Parachute Arrangements Disclosure requirements: Disclosure must be in a clear and simple form in accordance with the regulations and must include the aggregate total of all such compensation that may (and the conditions upon which it may) be paid or become payable to or on behalf of [named executive officers]. Disclosure of the golden parachute arrangements required for all agreements and understandings that the acquiring and target companies have with named executive officers of both companies. Rules require a narrative and a table for disclosing golden parachute compensation. 20
Shareholder Vote on Golden Parachute Arrangements Sample Table Elements that are separately quantified and included in the total are any cash severance payments (e.g., base salary, bonus, and pro rata non-equity incentive plan compensation payments) (column (b)); the dollar value of accelerated stock awards, in-the-money option awards for which vesting would be accelerated, and payments in cancellation of stock and option awards (column (c)); pension and nonqualified deferred compensation benefit enhancements (column (d)); perquisites and other personal benefits and health and welfare benefits (column (e)); and tax reimbursements (e.g., Internal Revenue Code Section 280G tax gross-ups) (column (f)). The Other column of the table includes any additional elements of compensation not specifically includable in the other columns of the table (column (g)) and requires footnote identification of each separate form of compensation reported. The table requires separate footnote identification of amounts attributable to singletrigger arrangements and amounts attributable to double-trigger arrangements, so that shareholders can readily discern these amounts. 21
Shareholder Vote on Golden Parachute Arrangements A separate shareholder advisory vote is not required on golden parachute compensation if disclosure of that compensation was included in the executive compensation disclosure subject to a prior advisory vote of the shareholders (say on pay) Rare that previous say on pay disclosure is sufficient for this purpose Companies are not required to use any specific language or form resolution for the say on golden parachute vote 22
Shareholder Vote on Golden Parachute Arrangements Say on golden parachute vote only needs to address arrangements between the soliciting target company and the named executive officers of the target and acquiring companies 23
Executive Compensation Tax Issues in Mergers and Acquisitions Closing the Deal 24
The Deal Structure and Players What type of transaction? Stock purchase/merger (buyer gets everything) Asset deal (buyer can pick and choose) Public company deal Private company deal Considerations will vary for sell-side vs. buy-side vs. management 25
Equity Plan/Award Structure What does the plan require? Single-trigger or double-trigger vesting Consider treatment of performance-vested awards What does the plan permit? Unilateral right to cancel and terminate Ability to cancel underwater options Consent requirements; timing issues if notice is required 26
Equity Plan/Award Structure What are the deal terms regarding equity awards? What are the business risks? Lillis v. AT&T Corp.: officers and directors whose underwater options were canceled without consideration in a cash acquisition argued that the acquiring corporation should have provided cash consideration based on the Black-Scholes value of the canceled options 27
Equity Plan/Award Structure Assumption of Grants Options remain in place, but the underlying shares and the exercise price are adjusted to reflect the transaction The buyer s shares are used upon the exercise of the assumed options but do not count against the buyer s plan reserve May require Form S-8 registration for shares issuable under assumed options 28
Equity Plan/Award Structure Substitution The old option is cancelled and a new option is issued under the buyer s plan The number of shares and exercise price in effect under the new option are based on the number of shares and exercise price in effect under the old option, and adjusted to reflect the transaction 29
Equity Plan/Award Structure Substitution The buyer s shares are used upon option exercises and may be charged against the buyer s plan May require Form S-8 registration for shares issuable under substituted options 30
Equity Plan/Award Structure Adjustment Assumption or substitution of incentive stock options must comply with Section 424 regulations Assumption or substitution of nonqualified stock options must comply with Section 409A regulations, which refer to certain regulations under Section 424 31
Equity Plan/Award Structure Adjustment IRC Section 424 Principles Aggregate Spread Test: The excess of the aggregate fair market value of the shares subject to the new or assumed option immediately after the transaction over the aggregate exercise price must not exceed the excess of the fair market value of the shares subject to the old option immediately before the transaction over the aggregate exercise price 32
Equity Plan/Award Structure Adjustment Example: Old option for 100 shares with $10 per share exercise price. At time of acquisition, target s stock is worth $20 per share = $1,000 spread. If fair market value of acquirer s stock is $40 per share at time of acquisition, adjusted option will be for 50 shares of acquirer s stock with exercise price of $20 per share = $1,000 spread. 33
Equity Plan/Award Structure Adjustment IRC Section 424 Principles Exercise price to fair market value ratio: On a share-by-share basis, the ratio of the exercise price to the fair market value of the shares subject to the new or assumed option immediately after the transaction is not more favorable than the ratio of the exercise price to the fair market value of the shares subject to the old option immediately before the transaction 34
Equity Plan/Award Structure Adjustment Example: Old option for 100 shares with $10 per share exercise price and $20 per share fair market value at time of transaction yields 1:2 ratio. If fair market value of acquirer s stock at time of transaction is $40 per share, then option for 50 shares with $20 exercise price per share also satisfies ratio test: $20 to $40 yields 1:2 ratio 35
Equity Plan/Award Structure Adjustment IRC Section 424 Principles No new benefits: The new or assumed option must not give the optionee additional benefits Vesting acceleration is permissible 36
Equity Plan/Award Structure Adjustment IRC Section 424/409A Principles Determination of fair market value: Any reasonable method of valuation may be used to determine the fair market value of the shares subject to the option immediately before the assumption or substitution and the fair market value of the shares immediately after the assumption or substitution 37
Equity Plan/Award Structure Adjustment Determination of fair market value: For an arm s-length transaction, the fair market value of the stock subject to the option before and after the assumption or substitution may be based upon the values assigned to the stock for purposes of the transaction 38
Equity Plan/Award Structure Cash-Out Cash-Out of Options Seller stock option is cancelled for a payment made in cash or stock of the acquirer Amount of the cash-out is typically equal to the intrinsic value ( spread ) of the option at the closing of the transaction 39
Equity Plan/Award Structure Cash-Out Issues relating to cash-out of options Loss of ISO status Cash-out is taxed as ordinary income Cash-out of ISO = withholding taxes and employment taxes Disqualifying disposition of ISO shares = no withholding taxes and no employment taxes Underwater options: make sure the plan allows for the cash-out without having to pay consideration 40
Potential Severance Obligations Stock Deal: Buyer assumes liability for existing arrangements Consider whether any severance or change in control plans prohibit amendment for a specified period following a change in control Determine potential liability under: Offer letters and employment agreements Severance plans and agreements Change in control plans and agreements 41
Potential Severance Obligations Asset Deal: Transferred employees will experience termination of employment, absent special provisions in plans and agreements Consider whether the transaction triggers severance pay 42
Additional Unfunded Liabilities Types of Liabilities: Supplemental executive retirement plans; excess plans Incentive plans (annual or long-term) Other nonqualified deferred compensation plans Payment Triggers Does the plan or agreement provide for payment (or funding) upon a change in control? Is the payment hardwired into the deal document? 43
Additional Unfunded Liabilities Which party will be obligated to pay: Nonqualified plans/serps Buyer assumes plans and all liabilities (or just those with respect to transferring employees) Buyer establishes mirror plans In an asset deal, transferring employees will have termination of employment triggering payment upon termination, unless terms provide otherwise 44
Additional Unfunded Liabilities Which party will be obligated to pay: Incentive plans Seller pays pro rata bonuses (employees may or may not then be eligible to participate in buyer s incentive plans) Buyer pays bonuses for full year (may be problematic if bonuses are based on seller s performance) Retention concerns 45
Section 409A Compliance of Existing Arrangements Frequently encounter a lack of compliance especially private companies Requires careful and creative planning when considering potential acquisitions Must lay out business deal risks for acquirer (employee penalty tax, reporting and withholding obligations, potential gross-up) 46
Section 409A Compliance of Existing Arrangements Individuals in noncompliant plans are subject to tax at the time of vesting, plus (i) an additional 20% federal income tax and (ii) interest at the underpayment rate plus 1% California taxpayers are also subject to an additional 5% state income tax Employer has tax reporting and withholding obligations and may incur penalties if it does not properly report and withhold 47
Section 409A Compliance of Existing Arrangements Equity plans Fair market value documentation for stock right grants is key in private company transactions (especially if stock rights will be assumed) Stock rights are options and stock appreciation rights Stock rights must be granted on service recipient stock Common stock of the company that employs the grantee or a parent company RSUs must have Section 409A-compliant payment terms, or must meet an exemption from Section 409A 48
Section 409A Compliance of Existing Arrangements Change in control provisions Does the time or form of payment vary after a change in control? Is the change in control definition compliant with Section 409A? Can equity grants or other arrangements be terminated/cashed out under Section 409A? Substitution issues 49
Section 409A Compliance of Existing Arrangements Severance Plan/Employment Agreement Review payment provisions Look out for differing forms of payment (installments before change in control and lump sum after change in control) Good Reason trigger Look out for weak Good Reason definitions and walk rights Six-month delay for specified employees in public companies Release timing issues 50
Section 409A Extension of Vesting Extension of vesting of awards or other compensation that otherwise would vest on the change in control: Extended vesting condition must constitute a substantial risk of forfeiture Extension must occur before and in connection with the change in control 51
Section 409A Amounts Payable on a Change in Control Amounts subject to Section 409A can only be paid on a change in control if the change in control meets the requirements of a 409A-compliant change in control Keys off of employer (or payor) corporation or any corporation up the chain, linked by majority ownership note distinction from Section 280G, which looks to the controlled group in determining whether a change in control has occurred Change in ownership acquisition of more than 50% Change in effective control acquisition of 30% or more or turnover of a majority of the board of directors within 12 months Change in ownership of a substantial portion of assets more than 40% within 12 months Note that spinoffs and IPOs typically do not satisfy the requirements for a change in control 52
Section 409A Separation from Service Separation from Service: Generally requires substantial, permanent reduction in service level with direct employer and its controlled group In stock sale, there is continuity of employment with direct employer, and generally no separation from service (even though there may be a change in control) In asset sale transactions, default is that there would be a separation from service for transferring employees Parties may agree to not treat as separation from service, but must be consistent 53
Section 409A Amounts Subject to Earn-Out Earn-out Consideration Earn-out consideration will be subject to Section 409A if not payable within the short-term deferral period Short-term deferral period is generally payment within 2-1/2 months after the year in which the compensation vests 54
Section 409A Amounts Subject to Earn-Out Earn-out will satisfy Section 409A if: Earn-out must be paid on the same schedule and under the same terms and conditions as apply to the shareholder payments, and must be paid within 5 years after the change in control Earn-out constitutes a substantial risk of forfeiture and is payable upon the same terms and conditions as apply to the payments made to the shareholders in such event the legally binding right to the earn-out is treated for purposes of the short-term deferral exception as arising on the date it became subject to the substantial risk of forfeiture 55
Section 409A Plan Termination Change in control plan termination Regulations provide special opportunities to terminate Section 409A arrangements pursuant to a change in control Must terminate all plans of the same type for all participants experiencing a change in control Note plan aggregation categories Termination must occur within 30 days before or within 12 months following a change in control All payments must be made within 12 months following the date of the action to terminate 56
The Golden-Parachute Tax 20% excise tax on the employee/independent contractor Loss of tax deduction to employer Imposed by IRC Sections 280G and 4999 on excess parachute payments 57
The Golden-Parachute Tax Parachute payments: Payments in the nature of compensation Made to certain disqualified individuals Company service provider who is an officer, 1% or more shareholder, or highly compensated employee (highestpaid 1%, not to exceed 250 employees) Contingent on a change in control (i.e., change in the ownership or control of a corporation or in the ownership of a substantial portion of its assets) 58
The Golden Parachute Tax Calculation of the Excise Tax If an executive receives parachute payments on a change in control that equal or exceed three times the executive s base amount, then A 20% excise tax on all amounts in excess of one times the executive s base amount, except to the extent those payments represent reasonable compensation Base amount is the executive s average annual W-2 compensation for the most recent five calendar years (or period worked, if less) ending before the change in control 59
The Golden Parachute Tax Impact of the Excise Tax Executives care because they could owe a 20% excise tax Corporations care because parachute payments are not deductible, and corporations are required to report parachute payments on Form W-2 and withhold taxes correctly If a corporation fails to withhold and an executive does not pay, the government may try to collect the tax from the corporation 60
The Golden Parachute Tax Exemptions Payments made by a tax-exempt entity, partnership, or corporation that satisfy most of the requirements to be a small business corporation (commonly referred to as an S corporation ) 61
The Golden Parachute Tax Exemptions Payments made by privately held companies when shareholder approval requirements are met Payments must be approved by more than 75% of the disinterested shareholders entitled to vote immediately before the change in control Adequate disclosure of all material facts regarding all material payments that otherwise would be parachute payments is provided to ALL persons entitled to vote Payments must be contingent on the vote 62
The Golden Parachute Tax Contingent on a Change in Control When is a payment contingent on a change in control? Payment would not have been made absent the change in control If it is substantially certain at the time of the change in control that a payment would be made regardless of whether a change in control occurs, it is not contingent on a change in control A payment made as a result of an event that occurs within one year of a change in control is presumed to be contingent on a change in control, but the presumption is rebuttable 63
The Golden Parachute Tax Transactions That Trigger Parachute Payments What is a change in control under Section 280G? Change in the ownership of a corporation Acquisition of more than 50% of the vote or value Change in the effective control of a corporation Presumption upon acquisition of more than 20% of the voting power or replacement of a majority of directors during a 12-month period, which presumption may be rebutted Transfer of a substantial portion of assets Assets with a value of at least one-third of the value of all assets, determined without regard to any liabilities Determined on a controlled group basis 64
The Golden Parachute Tax Parachute Payments What is a parachute payment? Payment in the nature of compensation, such as Transaction bonus Cash severance Continued health and welfare benefits Outplacement services Option and restricted stock vesting Accelerated payment of deferred compensation 65
The Golden Parachute Tax Excess Parachute Payments Special valuation rules under the 280G regulations can minimize the amount included as a parachute payment The portion of a parachute payment that exceeds the base amount allocated to it is referred to as an excess parachute payment The base amount is allocated pro rata among all the actual parachute payments 66
The Golden Parachute Tax Reasonable Compensation Before a Change in Control If the portion of a parachute payment that can be justified as reasonable compensation for services rendered before a change in control exceeds the base amount allocated to that parachute payment, the excess amount also will be subtracted from the excess parachute payment. 67
The Golden Parachute Tax Reasonable Compensation After a Change in Control If compensation is reasonable in amount for services to be rendered after the change in control, such amount is subtracted from the payments (i.e., essentially treated as an exempt payment) for all purposes of Section 280G Payments may only be made for the period the individual actually performs services If duties don t substantially change, compensation should not be significantly greater than it was prior to the change in control If duties substantially change, compensation should not be significantly greater than that paid in the market 68
The Golden Parachute Tax Reasonable Compensation After a Change in Control Restrictive covenants Compensation paid for a noncompete covenant may be considered reasonable compensation for services rendered after a change in control Enforceability of a noncompete covenant is required The IRS has opposed excessive values attributable to reasonable compensation, especially where noncompetes are adopted shortly before a change in control 69
The Golden Parachute Tax Strategies to Avoid Excise Taxes Gross-up provision for excise taxes Most companies no longer provide gross-ups Best-net provision for parachute payments Reduce payments to avoid excise tax if it puts an executive in a better net-tax position If paying excess parachute payments is better for the executive, the company loses the deduction Parachute cap 70
The Golden Parachute Tax Strategies to Avoid Excise Taxes Increase the executive s base amount Attach a valid, enforceable noncompete to parachute payments (but note the audit risk previously discussed) Waiver and shareholder approval for private company 71
Presenters Mims Maynard Zabriskie mzabriskie@morganlewis.com David Calder dcalder@morganlewis.com Gina Lauriero glauriero@morganlewis.com 72
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