Golden parachute payments

Golden parachute payments Understanding how stock options and restricted stock can cost both corporations and executives during a merger or acquisition Jeffrey A. Martin

Golden parachute payments 2 Corporations planning for a merger or acquisition have an extensive list of issues to address in their preparation for the transaction, and golden parachute payments must be among them. If top executives, shareholders or other highly compensated employees stand to receive compensation in connection with a merger or acquisition of a corporation, both the individuals and the corporation could be subject to the Section 280G golden parachute payment rules and significant adverse tax consequences. Whether the rules under Section 280G apply, and how they apply, can often hinge on a corporation s outstanding stock options and restricted stock. Executives are frequently compensated with restricted stock and stock options, and as a result, executives will often hold stock options and restricted stock at the time of the merger or acquisition. It is critical to understand the significant effect stock options and restricted stock have on almost every aspect of the parachute payment rules, from determining if Section 280G applies at all and, if so, whether an individual is subject to the rules, to calculating the amount of parachute payments and the adverse tax consequences under Section 280G. To assist planners who are working with these issues, this article will explore the application of Section 280G to stock options and restricted stock. 1 Throughout this article, we will refer to hypothetical examples involving Jill and ABC Corporation. Jill is an employee of ABC Corporation. ABC Corporation is a private corporation, and Private Equity owns a portion of ABC Corporation s stock. Exhibit 1 outlines the stock options and restricted stock held by Jill and the aggregate outstanding stock options and restricted stock granted by ABC Corporation to all employees. Exhibit 1 Jill s holdings Vested nonqualified options 100,000 Unvested nonqualified options 200,000 Restricted stock with a Section 83(b) election 50,000 Restricted stock without a Section 83(b) election 100,000 Previously vested stock 100,000 ABC Corp. Vested nonqualified options 400,000 Unvested nonqualified options 200,000 Restricted stock with a Section 83(b) election 100,000 Restricted stock without a Section 83(b) election 200,000 Overview of Section 280G The importance of the parachute payment rules under Section 280G becomes clear when considering the adverse tax consequences associated with excess parachute payments: the loss of a deduction for the employer and a 20 percent additional tax imposed on the individual. The Section 280G parachute payment rules apply only to corporations, 2 both private and public, but do not apply to small business corporations. 3 Partnerships and other noncorporate entities are generally not subject to the parachute payment rules.

Golden parachute payments 3 In general terms, a parachute payment is any payment in the nature of compensation made to a disqualified individual 4 if the payment is contingent on a change in control. This includes all payments or benefits that would not have been made if no change in control had occurred. Parachute payments exist under Section 280G if the total parachute payments made to a disqualified individual exceed a defined threshold amount: three times the disqualified individual s base amount. However, the adverse tax consequences apply only to excess parachute payments. The excess parachute payments are the difference between the parachute payment and the individual s base amount. Thus, parachute payments exist where the payments contingent on a change in control exceed three times the base amount and the total excess parachute payments equal the total parachute payments less one times the base amount. The disqualified individual s base amount is the individual s average annual compensation during the base period. 5 Generally, the base period is the individual s five taxable years preceding the year of the change in control. 6 Excess parachute payments result in negative tax consequences for both the employer and the disqualified individual. The disqualified individual must pay a 20 percent excise tax on the excess parachute payments. 7 This is in addition to the ordinary income taxes the disqualified individual must pay related to the excess parachute payments. In addition, the employer may not deduct the excess parachute payments for federal income tax purposes. 8 Given the size of some golden parachutes paid to executives, the increase in taxes paid by the executive and employer can be substantial. Exhibit 2 Parachute payments Three times base amount Threshold exceeded Parachute payments One times base amount Excess parachute payment Excess parachute payments 20% excise tax Excise tax ABC s lost deduction ABC s effective tax rate Additional cash taxes $1,000,000 * $900,000 $100,000 $1,000,000 * $300,000 $700,000 $700,000 X 20% $140,000 $700,000 X 40% $280,000 As we will discuss below, Jill is a disqualified individual and ABC Corporation experiences a change in control. Jill receives parachute payments with a value of $1 million. Her base amount is $300,000. Jill s parachute payments exceed three times her base amount. As illustrated in Exhibit 2, Jill receives $700,000 of excess parachute payments and must pay an excise tax of $140,000 with respect to the payments. This is in addition to the ordinary federal income tax Jill must pay on the $1 million of parachute payments. Assuming ABC Corporation has taxable income and a 40 percent effective tax rate, it will pay an additional $280,000 of taxes because of the lost income tax deduction. As discussed above, a parachute payment is any payment in the nature of compensation made to a disqualified individual if the payment is contingent on a change in control. Thus, four elements must be in place in order for a payment to be considered a parachute payment: 1 A change in control of a corporation occurs. 2 A payment is made to a disqualified individual. 3 The payment is in the nature of compensation. 4 The payment is contingent on the change in control. Each of these elements is important, so we will explore each of them separately. Also, we will demonstrate how stock options and restricted stock affect each of these elements.

Golden parachute payments 4 Change in control The first element required for a parachute payment to occur88a change in control of a corporation88is established by one of three possible events: (1) a change in the ownership of the corporation s stock, (2) a change in ownership of a substantial portion of the corporation s assets or (3) a change in effective control of the corporation. 9 We will examine each of these events. A change in ownership of a corporation s stock occurs when a person 10 or more than one person acting as a group 11 acquires ownership of the stock of the corporation, which, combined with the stock already held by the person or group, has more than 50 percent of the total fair market value or total voting power of all classes of the corporation s stock. 12 Private Equity owns stock that represents 45 percent of the total fair market value of ABC Corporation s stock. On July 1, 2011, Private Equity acquires an additional 6 percent of the fair market value of ABC Corporation s stock. This is considered a change in ownership of ABC Corporation because Private Equity now owns 51 percent of the fair market value of ABC Corporation s stock. On July 1, 2012, Private Equity acquires an additional 10 percent of ABC Corporation s stock, increasing Private Equity s ownership of the fair market value of ABC Corporation s stock from 51 percent to 61 percent. This is not considered a change in ownership of ABC Corporation because Private Equity already held more than 50 percent of ABC Corporation s stock. 13 Stock options and restricted stock play an important role in determining whether a change in ownership of the corporation s stock has occurred. For this purpose, the stock underlying a vested option is treated as outstanding and owned by the option holder, while the stock underlying an unvested option is not treated as outstanding. 14 The term vested refers to the point in time when the stock option (or restricted stock) either becomes transferrable or is no longer subject to a substantial risk of forfeiture. A substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance of substantial services by any person. 15 An example of a vesting condition that requires the future performance of services is a requirement that an employee continue employment with the employer for three years after the grant of the option. If the employee severs employment before the three8year period has expired, the employee forfeits the option. The vesting condition can also relate to agreement to refrain from providing services. 16 This is typically found in noncompetition agreements executed with an employee when employment is terminated. 17 Under a noncompetition agreement, the former employee will forfeit the options if the employee competes with the employer (e.g., gains employment with a competitor or provides services to an existing client of the employer) for a certain period (e.g., two years after the employee separates from service). Vesting can be based on the occurrence of a condition related to the purposes of the property transfer. 18 For example, the stock option plan may provide for vesting only if the corporation meets one or more performance metrics, such as earnings per share, return on equity, revenue or gross income. If the performance metric is not met, the employee forfeits the option. The parachute payment rules do not distinguish between nonqualified stock options and incentive stock options, so both vested nonqualified stock options and vested incentive stock options are treated as outstanding stock. 19

Golden parachute payments 5 Unvested shares of restricted stock for which a Section 83(b) election has been made are also treated as outstanding and owned by the restricted stock holder for purposes of determining whether ownership has changed. 20 An individual is permitted to make a Section 83(b) election when unvested stock is transferred to the individual. By making this election, the individual includes the fair market value of the stock, less the amount paid for the stock (if any) in gross income on the grant date. 21 Unvested shares of restricted stock for which a Section 83(b) election has not been made are not treated as outstanding for purposes of determining whether ownership has changed. Private Equity owns 45 percent of the fair market value of ABC Corporation s stock. ABC Corporation has 10 million shares of outstanding stock (each share has the same fair market value), so Private Equity owns 4.5 million shares stock. As outlined in Exhibit 1, ABC Corporation s employees hold 400,000 vested stock options and 100,000 unvested shares of restricted stock for which employees made a Section 83(b) election. Private Equity purchases an additional 600,000 shares of ABC Corporation s stock. Because the 400,000 vested stock options and 100,000 unvested shares of restricted stock for which employees made a Section 83(b) election are treated as outstanding stock, Private Equity s acquisition of additional shares does not result in a change in ownership. As illustrated in Exhibit 3, Private Equity will own less than 50 percent of ABC Corporation s stock after the acquisition. The shares underlying ABC Corporation s outstanding unvested stock options and the unvested shares of restricted stock for which employees did not make a Section 83(b) election are not treated as outstanding stock. Exhibit 3 Outstanding shares Vested stock options Restricted stock 83(b) election Total considered outstanding Private Equity s ownership Total considered outstanding Private Equity s ownership % 10,000,000 400,000 +100,000 10,500,000 5,100,000 7 10,500,000 48.57% The second event that can establish a change in control of a corporation (one of the four elements of a parachute payment) is a change in ownership of a substantial portion of a corporation s assets. This occurs when one person or more than one person acting as a group acquire during a 128month period 22 assets from the corporation that have a total gross fair market value equal to or more than one8third of the total gross fair market value of all the corporation s assets. 23 The fair market value of the corporation s assets is determined immediately before the acquisition and is determined without regard to liabilities associated with the assets. Thus, liabilities assumed by the buyer in the acquisition are not taken into account to reduce the fair market value of the assets. The third event that can establish a change in control is a change in effective control of a corporation. This is presumed to occur when one person or more than one person acting as a group acquire during a 128month period 24 ownership of stock of a corporation possessing 20 percent or more of the total voting power of the corporation s stock. 25 As with determining whether a change in ownership has occurred, stock underlying vested stock options is considered outstanding, and unvested shares of restricted stock for which a Section 83(b) election has been made are treated as outstanding. 26 A change in effective control of a corporation is also presumed to occur when a majority of members of the corporation s board of directors are replaced during any 128month period by directors whose appointment or election is not endorsed by a majority of the members of the corporation s board of directors prior to the date of the appointment or election. 27

Golden parachute payments 6 The presumption that a change in effective control has occurred is rebuttable by establishing that the acquisition of the corporation s stock or the replacement of the board members does not transfer the power to control the management and policies of the corporation. 28 Disqualified individual As discussed above, four elements must be in place for parachute payments to exist. After establishing a change in control, the second element requires that a payment be made to a disqualified individual. Disqualified individuals include shareholders who own more than 1 percent of the fair market value of the corporation s stock, officers of the corporation and highly compensated individuals. 29 A disqualified individual can be an employee, an independent contractor or a director. Disqualified individuals are identified during the disqualified individual determination period. This is the 128 month period prior to and ending on the date of the change in control. 30 Thus, an individual is a disqualified individual only if the individual is a shareholder, an officer or a highly compensated individual during the 12 months leading up to the change in control. Jill is not an officer or a highly compensated individual of ABC Corporation, but she owns 100,000 vested shares of ABC Corporation s stock. If Jill did not hold any vested stock options or restricted stock for which she made a Section 83(b) election, she would not be a disqualified individual, because her stock ownership would be less than 1 percent of ABC Corporation s 10.5 million shares of stock that is treated as outstanding. ABC Corporation s outstanding stock includes vested stock options and restricted stock for which employees made a Section 83(b) election. However, as outlined in Exhibit 1, Jill holds 100,000 vested nonqualified stock options and 150,000 shares of unvested restricted stock. Jill made a Section 83(b) election on 50,000 shares of her restricted stock. The stock underlying Jill s 100,000 vested nonqualified stock options is treated as outstanding shares of stock owned by Jill for purposes of determining whether she is a disqualified individual. 31 In addition, Jill s 50,000 unvested shares of restricted stock for which she made a Section 83(b) election are treated as outstanding shares of stock. 32 As illustrated in Exhibit 4, assuming that ABC Corporation s total outstanding shares of stock is 10.5 million, including vested stock options and restricted stock with a Section 83(b) election, Jill is treated as owning 2.38 percent of the fair market value of ABC Corporation s stock. Therefore, Jill is considered a shareholder and a disqualified individual. Exhibit 4 Vested stock Vested stock options Restricted stock 83(b) election Jill s total stock owned ABC s outstanding stock Jill s ownership % Payment in the nature of compensation After establishing a change in control has occurred and identifying the disqualified individuals, the third element that must be present for a parachute payment to exist is that a payment in the nature of compensation be made to a disqualified individual. The regulations under Section 280G provide that all payments in whatever form are payments in the nature of compensation if they arise from an employment relationship or are associated with the performance of services. 33 Jill holds 100,000 vested nonqualified stock options. 34 Jill also holds 200,000 unvested nonqualified stock options. Conventional wisdom may lead one to believe that Jill doesn t receive a payment in the nature of compensation until Jill exercises her nonqualified stock options. 100,000 100,000 +50,000 250,000 250,000 7 10,500,000 2.38%

Golden parachute payments 7 Under Section 83, an employee recognizes compensation income when property is transferred to the employee and the property becomes vested. 35 The term property includes stock. The amount of income recognized by the employee is equal to the fair market value of the stock, less the amount paid, if any, by the employee for the stock. 36 For purposes of Section 83, the grant of a stock option is generally not treated as the transfer of property. 37 Therefore, the employee generally does not recognize compensation income when an employer grants a stock option or when the option becomes vested. 38 The employee recognizes compensation income when the option is exercised and vested stock is transferred to the employee. If unvested stock is transferred to the employee upon exercise of the option, the employee recognizes income under Section 83 when the stock becomes vested. The general rules under Section 83 that determine when an employee recognizes compensation income with respect to a stock option do not apply for purposes of Section 280G and the parachute payment rules. Instead, stock options are treated as property, and the vesting of a stock option is treated as a payment in the nature of compensation. 39 The transfer of stock to the employee upon exercise of options is not treated as a payment in the nature of compensation. 40 This brings us back to Jill s outstanding stock options. When Jill s unvested stock options become vested, the vesting event is considered a payment in the nature of compensation for purposes of Section 280G. When she exercises those stock options, the transfer of stock to her will not be considered a payment in the nature of compensation for purposes of Section 280G even though Jill will recognize compensation under Section 83. The treatment of restricted stock is quite different from the treatment for stock options. In addition to her stock options, Jill holds 150,000 shares of restricted stock. She made a Section 83(b) election on 50,000 of the shares. For purposes of Section 280G, a transfer of stock is considered a payment in the nature of compensation in the taxable year in which the stock is includible in the disqualified individual s gross income under Section 83. 41 In other words, the transfer of stock is considered a payment in the nature of compensation when it has been transferred to the disqualified individual and the stock becomes vested. Thus, the vesting of restricted stock is the payment for purposes of Section 280G. This general rule aligns with the application of Section 83 because the disqualified individual generally recognizes compensation income under Section 83 when the restricted stock becomes vested. However, just as with stock options, the application of Section 280G to restricted stock does not align exactly with the application Section 83. As discussed earlier in this article, when a disqualified individual makes a Section 83(b) election, the disqualified individual includes the fair market value of the stock, less the amount paid for the stock (if any), in gross income on the grant date. Under the Section 280G parachute payment rules, a Section 83(b) is disregarded. 42 When restricted stock on which a disqualified individual made a Section 83(b) election becomes vested, the vesting is considered a payment in the nature of compensation for purposes of Section 280G even though the disqualified individual already recognized compensation income under Section 83 on the grant date of the restricted stock. Thus, Jill s total 150,000 unvested shares of restricted stock, including the 50,000 for which she made a Section 83(b) election, will be treated as a payment in the nature of compensation when the restricted stock becomes vested.

Golden parachute payments 8 Contingent on the change in control The fourth and final element that must be in place for a payment to be treated as a parachute payment is that the payment must be contingent on the change in control. To meet that requirement, the payment must fit into one of the following six categories: 1. The payment would not have been made had no change in control occurred. 43 2. The payment is made as a result of an event closely associated with a change in control, and the event occurs within one year before or one year after the change in control, even if the payment is not directly contingent on the change in control. 44 3. The payment is made under a new agreement entered into within one year before the change in control or the payment is made under an existing agreement that is amended within one year before the change in control. 45 4. The payment is made earlier than otherwise scheduled due to the change in control. 46 5. The vesting of a payment is accelerated upon a change in control. 47 6. The payment is made under an agreement entered into after the change in control, and the agreement relates to an agreement that existed prior to the change in control. 48 As discussed earlier, ABC Corporation experienced a change in control on July 1, 2011. Under the terms of ABC Corporation s stock option and restricted stock plan, Jill s 200,000 unvested stock options and 150,000 unvested shares of restricted stock became vested immediately prior to the closing of the transaction on July 1, 2011. As discussed earlier in this article, the vesting of a stock option or share of restricted stock is considered a payment in the nature of compensation. The accelerated vesting of the stock options and restricted stock falls under the fourth category listed above, which is the accelerated vesting of a payment upon a change in control. Thus, the accelerated vesting of Jill s stock options and restricted stock is a payment in the nature of compensation that was contingent on the change in control (i.e., a parachute payment). Consider an alternative situation in which Jill s 200,000 unvested options instead became vested on June 15, 2011, under the original vesting terms of the stock option plan. ABC Corporation did not amend the plan or change the terms of the options to accelerate the vesting. Instead, the options vested 15 days prior to the change in control. Thus, the vesting would have occurred without regard to the change in control. Vesting didn t occur as a result of an event that occurred within one year before or after the change in control, and the vesting didn t occur under a new or amended agreement entered into within one year prior to the change in control. The payment was not made earlier than scheduled, and vesting was not accelerated. Finally, the vesting did not occur after the change in control under a replacement agreement. Therefore, the vesting of Jill s stock options was not contingent on the change in control, and the vesting is not a parachute payment. The results might have changed if Jill was involuntarily terminated on Dec. 1, 2010, seven months before the date of the change in control. Jill s restricted stock plan provided for vesting upon the earlier of Jan. 1, 2012, or an involuntary termination. Thus, Jill s restricted stock became vested on Dec. 1, 2010. A payment is presumed to be contingent on a change in control if the payment occurs as a result of an event closely associated with a change in control that occurs within one year before or one year after the change in control, even if the payment is not directly contingent upon the change in control. Involuntary termination is considered an event that is closely associated with a change in control. 49 Because Jill s involuntary termination occurred within one year before the change in control, it is presumed that the vesting of her restricted stock was contingent on the change in control. Thus, the vesting of Jill s restricted stock would be considered a parachute payment.

Golden parachute payments 9 Jill and ABC Corporation may be able to rebut this presumption by showing clear and convincing evidence that Jill s involuntary termination was not an event related to the change in control. Clear and convincing evidence includes facts such as the reason for her termination and whether ABC Corporation was considering a change in control at the time of termination. Assume in an alternative scenario that Jill s restricted stock provides for vesting upon the earlier of Jan. 1, 2012, or an involuntary termination of employment, but her restricted stock does not provide for vesting upon a change in control. On Sept. 1, 2011, two months after the change in control that occurred on July 1, 2011, Jill is involuntarily terminated. As a result, her restricted stock becomes vested. The vesting of Jill s restricted stock is presumed to have occurred as a result of an event closely associated with a change in control within one year after the change in control (category 2), and the vesting is presumed to be contingent on the change in control. This presumption may be rebutted. Parachute payment amount As previously discussed, the vesting of restricted stock and stock options is considered the payment of a parachute payment. The next step is to determine the amount of the parachute payment. As we will discuss below, the amount of compensation income recognized by the disqualified individual for federal income tax purposes will not necessarily match the amount that is taken into account in the parachute payment calculation. Determining the amount of the parachute payment is a two8step process: (1) determine the value of the payment and (2) determine the amount of the payment that is treated as contingent on the change in control. Each of these steps is discussed below. Step 1 Value of the payment The rules for deterring the value of the payment differ slightly between restricted stock and stock options, so we will address them separately. Restricted stock The value of Jill s restricted stock is determined under Section 83 on the vesting date. Under Section 83, the value is equal to the fair market value of the stock on the vesting date, over the amount paid (if any) for the stock. 51 Jill holds two tranches of restricted stock, one tranche of 100,000 shares that would have vested on Jan. 1, 2012. absent the accelerated vesting and a second tranche of 50,000 shares that would have vested on Jan. 1, 2014. absent the accelerated vesting. The value of the payment for both tranches of Jill s restricted stock is determined July 1, 2011, because that is the date the restricted stock becomes vested. Therefore, the fair market value of Jill s stock must be determined on that date. This should be fairly simple if another entity acquires Jill s stock or the stock of ABC Corporation in the change in control. The fair market value of her stock on the date of the change in control will generally be the value paid by the acquiring company for her stock. This value would include any cash or acquiring company stock transferred to Jill in exchange for her stock. Instead of acquiring an additional 6 percent of ABC Corporation s stock as described in earlier examples, consider a situation in which Private Equity purchases the remaining outstanding shares of ABC Corporation s stock, including Jill s restricted stock, for $12 per share on July 1, 2011, resulting in 100 percent ownership of ABC Corporation by Private Equity. As illustrated in Exhibit 5, the value of Jill s payment on the vesting date is $1.8 million.

Golden parachute payments 10 Not all changes in control result from the acquisition of the corporation s stock. Earlier in this article we discussed that a change in control includes a sale of a substantial portion of the corporation s assets and a change in effective control of the corporation. These types of changes in control may not result in a sale of stock. Thus, a different method may be required to determine the fair market value of Jill s restricted stock on the vesting date. If ABC Corporation s stock was Exhibit 5 Restricted stock (vests 1/1/12) Restricted stock (vests 1/1/14) Total restricted stock Fair market value Value of the payment 100,000 +50,000 150,000 X $12.00 $1,800,000 publicly traded, it may be reasonable to determine the fair market value of the stock based on the stock s trading price on the day of the change in control. However, ABC Corporation is a private corporation, so determining the fair market value of Jill s stock absent a stock acquisition will be more difficult. Sections 280G and 83 do not provide guidance on how the fair market value of a share of stock should be determined. The most recent guidance provided by the IRS on determining the fair market value of stock in a compensation context is included in the 2007 final regulations under Section 409A. Under these regulations, the fair market value of stock means a value determined by the reasonable application of a reasonable valuation method. 52 Factors that must be considered under a reasonable valuation method include, as applicable, the following: The value of tangible and intangible assets of the corporation The present value of anticipated future cash8flows of the corporation The market value of stock in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation whose stock is to be valued; the value can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm s length private transaction) Recent arm s length transactions involving the sale or transfer of the stock Other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders or its creditors 53 A valuation method for purposes of Section 409A is not reasonable if the method fails to account for all available information material to the value of the corporation. Similarly, the use of a value calculated as of a date that is more than 12 months earlier than the date for which the valuation is being used is not reasonable. 54 The Section 409A regulations also provide certain safe harbor valuation methods for private company stock. If one of these methods is used, the value is presumed to be reasonable. 55 The IRS can rebut the presumption only if the method was grossly unreasonable. These safe harbor methods include: (i) an independent appraisal, (ii) a value based on a nonlapse formula (as defined under Section 83), and (iii) a reasonable and good faith valuation documented in a written report (completed by any individual, including someone who is not independent) that takes into account all of the factors listed above. 56 It is important to determine the fair market value of the stock using a reasonable method because the fair market value of the stock is the basis for determining the amount of the parachute payment. 57 In a situation where the corporation s stock is acquired as part of the change in control, the purchase price is a good indication of the fair market value of the stock. When the corporation s stock is not acquired as part of the change in control, a reasonable valuation method must be applied to determine the fair market value of the stock. If the valuation

Golden parachute payments 11 method is later determined not to be reasonable, the value of the payment may increase, resulting in a larger parachute payment than anticipated. Stock options The rules for determining the value of restricted stock may seem straightforward and even easy in situations where the corporation s stock is acquired as part of the change in control. The rules for valuing the payment associated with a stock option are much more complex. As discussed earlier, stock options are treated as property transferred when the option becomes vested. Thus, the stock option itself is treated as property, rather than the stock underlying the option. Similar to restricted stock, a value must be assigned to the stock option. There is an important distinction between the value of the option and the difference between the fair market value of the stock underlying the option and the option s exercise price. The regulations under Section 280G provide that the value of an option is determined based on all of the facts and circumstances, including the following: The difference between the option s exercise price and the value of the stock subject to the option at the time of vesting The probability of the value of the stock increasing or decreasing The length of the period during which the option can be exercised 58 In 2003, the IRS issued Rev. Proc. 2003868 59 to update procedures for valuing stock options. The IRS made it clear that the value of a stock option will not be considered properly determined if the option is valued solely by reference to the spread between the exercise price of the option and the value of the stock at the time of the change in ownership or control. 60 Instead, the valuation method must take into account all relevant factors. The revenue procedure provides multiple methods that may be used to calculate the value of an option. The value may be determined using any method that is consistent with generally accepted accounting principles (GAAP). Specifically, Accounting Standard Board Topic 718 61 provided that the method take into account the factors listed earlier in this article from the Section 280G regulations. These methods include the Black8Sholes and binomial models. The revenue procedure also provides a safe harbor valuation method that is based on the Black8Sholes model. This safe8harbor method takes into account the following factors: The volatility of the underlying stock The exercise price of the option The value of the stock at the time of the valuation The term of the option on the valuation date Rev. Proc. 2003868 provides an outline and example of how the safe8harbor valuation method should be applied to determine the value of options. 62 Jill holds 200,000 unvested stock options that have an exercise price of $5 and were originally scheduled to vest on April 1, 2013. As described in an earlier example, consider a situation in which Private Equity purchases the remaining outstanding shares of ABC Corporation s stock for $12 per share on July 1, 2011, resulting in Private

Golden parachute payments 12 Equity s 100 percent ownership of ABC Corporation As a result, all of Jill s options become vested. As part of the transaction, ABC Corp.oration is required to cancel all outstanding stock options on July 1, 2011. On July 1, 2011, ABC Corporation cancels Jill s stock options and makes a cash payment to Jill of $7 per share, which is equal to the difference between the price paid by Private Equity for the stock and the options exercise price. Exhibit 6 Jill s options Value per option Value of the payment 200,000 X $7 $1,400,000 Absent other facts, it is reasonable to conclude under the Rev. Proc. 2003868 safe8harbor valuation model that the value of Jill s stock options on July 1, 2011, is $7 per option. The term of the options as of the valuation date is nil because the option is required to be canceled on July 1, 2011 (i.e., the change in control date). The volatility of the underlying stock is also zero as of the valuation date because the value of the stock underlying the option will not change over the remaining term of the option. Thus, the value of the option is based on the difference between the fair market value underlying stock on the valuation date and the exercise price of the option. The result is a value of $7 per option. As illustrated in Exhibit 6, the total value of Jill s payments with respect to the options is $1.4 million. Instead of requiring Jill s stock options to be canceled, consider a situation in which Jill s options will remain outstanding and exercisable after the change in control for the remaining term of the option. Jill decides to exercise her options on July 1, 2011. The value of Jill s options must be determined under a reasonable method, such as the safe8harbor method under Rev. Proc. 2003868 or the Black8Sholes model, and must take into account the full term of her options and the volatility of the underlying stock. Because the stock options are not required to be exercised or canceled upon the change in control, the term of the option will extend beyond the valuation date. This will most likely result in a value that differs from the $7 in the earlier example, even though Jill exercised the stock options on the valuation date. Assume that under the Black8Sholes model, Jill s stock options have a value of $8 per option. As illustrated in Exhibit 7, the value of Jill s payment is $1.6 million. After determining the value of the payment related to the restricted stock and stock options, the next step is to determine the amount of the payment that is treated as contingent on the change in control. Exhibit 7 Jill s options Value per option Value of the payment 200,000 X $8 $1,600,000 Step 2 Amount contingent on the change in control If certain requirements are met, only a portion of the value of a payment related to Jill s restricted stock and stock options is treated as contingent on the change in control. In the earlier examples, we determined the value of Jill s payments for the restricted stock and stock options is $1.8 million and $1.4 million, respectively, assuming that Jill s stock options were required to be canceled on July 1, 2011. The amount of these payments that are treated as contingent on the change in control can be significantly less if the requirements below are met. First we will discuss the three requirements Jill s restricted stock and stock options must meet in order to be eligible for the reduced parachute payments treatment. Then we will discuss how the reduced parachute payments are calculated. Qualifying requirements The first requirement is that the vesting of the stock option or restricted stock must be at least partly attributable

Golden parachute payments 13 to the performance of services before the date the accelerated vesting occurs or becomes certain to occur. 63 Obviously, stock options and restricted stock granted on the change in control date (i.e., the date of accelerated vesting) will not meet this condition, because the vesting was not at least partly attributable to the performance of services before the accelerated vesting date. It becomes less clear whether restricted stock and stock options granted prior to, but in close proximity to, the date of the accelerated vesting is considered attributable, at least in part, to the performance of services before the date the accelerated vesting becomes certain to occur. 64 If vesting is accelerated on the date of the change in control, but only if the change in control actually occurs, an argument could be made that the accelerated vesting is not certain to occur until the change in control transaction closes. Thus, a vesting period that begins months or even weeks before the change in control may be considered at least partly attributable to the performance of services before the date the accelerated vesting became certain to occur. The second requirement is that, without regard to the change in control, the vesting of the option must be based on the continued performance of services for a specified period of time. 65 As discussed above, Jill holds 200,000 stock options that are set to vest on April 1, 2013, if she continues employment until that date. Vesting in this situation requires Jill to remain continuously employed for a specified period of time. Thus, Jill s options meet this requirement. If the vesting of Jill s options is based on continuous employment, but no specified period of time is stated, her options would not meet this condition. An option or share of restricted stock does not meet this second requirement if vesting is based on the occurrence of an event, and that event does not occur prior to the change in control. 66 Suppose Jill s stock options instead vest upon the earlier of a change in control or the date that earnings per shares reach $5. On July 1, 2011, ABC Corporation has a change in control, and the vesting of her options is accelerated. Before July 1, 2011, earnings per share had not reached $5. Thus, the vesting event does not occur before the vesting of Jill s stock options is accelerated, and her stock options do not meet the second requirement. A stock option or restricted stock plan that includes a performance condition or other event as the vesting condition should be scrutinized to determine whether it may indeed meet the second requirement. It is possible that the performance condition occurred prior to the accelerated vesting date. For example, in another situation, suppose Jill s stock options vest if she continues employment until the earlier of a change in control or April 1, 2013, but only if ABC Corporation s earnings per share reach $5 in any fiscal year ending before April 1, 2013. ABC Corporation experiences a change in control on March 15, 2012. For the fiscal year ended Dec. 31, 2011, ABC Corporation s earnings per share equal $6. In this situation, the performance goal was met before the accelerated vesting occurred. Without regard to the change in control, the only remaining vesting condition was for Jill to perform services until April 1, 2013. Thus, at the time of the change in control, the vesting of the stock options was based only on the continued performance of services for a specified period of time. In this situation, Jill s stock options meet the second requirement. The third requirement is that the grant of the restricted stock or stock option cannot be contingent on the change in control. A presumption is made that the full value of a payment is contingent on the change in control if the stock option or restricted stock was granted to Jill within one year prior to the change in control. 67 For example, assume Jill s restricted stock was granted to her on Jan. 15, 2011, and the change in control occurs on July 1, 2011. The vesting of Jill s restricted stock is accelerated to July 1, 2011, and the value of the payment is $12 per share of restricted stock. The grant of the restricted stock is presumed to be contingent on the change in

Golden parachute payments 14 control because the grant occurred within one year prior to the change in control. Thus, the third requirement is not met, and the full value ($12 per share) of Jill s restricted stock is considered a parachute payment. This presumption may be rebutted by showing clear and convincing evidence that the stock option or restricted stock grant was not contingent on the change in control. Factors that should be taken into account in showing clear and convincing evidence include, but are not limited to, the content of the agreement or amendment and the circumstances surrounding the execution of the agreement or amendment, such as whether it was entered into at a time when a takeover attempt had commenced, and the degree of likelihood that a change in control would actually occur. 68 As with the example above, Jill s restricted stock was granted to her on Jan. 15, 2011, and the change in control occurs on July 1, 2011. ABC Corporation granted the restricted stock to Jill after her annual performance assessment and in connection with her annual incentive bonus. Also, on Jan. 15, 2011, ABC Corporation was not considering a change in control. These factors indicate that Jill s restricted stock grant was not contingent on the change in control, and thus, the presumption is rebutted. Calculation If the three requirements discussed above have been met, the amount of the payment that is treated as contingent on the change in control is reduced under a special provision provided in the Section 280G regulations. The amount of the parachute payment (i.e., the amount treated as contingent on the change in control) comprises two parts. The first represents a value assigned to the accelerated timing of the payment, and the second represents a value assigned to the accelerated vesting of the payment. The amount representing the accelerated timing of the payment is equal to the amount by which the value of the restricted stock or stock option on the accelerated vesting date exceeds the present value of the amount absent the accelerated vesting date. The present value of the amount of the restricted stock or stock option is determined on the accelerated vesting date. 70 Jill holds two tranches of restricted stock, one tranche of 100,000 shares that would have vested on Jan. 1, 2012, absent the accelerated vesting and a second tranche of 50,000 shares that would have vested on Jan. 1, 2014, absent the accelerated vesting. The change in control occurs on July 1, 2011, and the vesting of both tranches of Exhibit 8 First tranche Second tranche Restricted shares Value per share First tranche total value Restricted shares Value per share First tranche total value 100,000 X $12 $1,200,000 50,000 X $12 $600,000 Jill s restricted stock is accelerated to the change in control date. In an example above, the value of Jill s restricted stock was $12 per share. As illustrated in Exhibit 8, the value of Jill s first tranche of restricted stock is $1.2 million on the accelerated vesting date, and the value of Jill s second tranche of restricted stock is $600,000 on the accelerated vesting date. The present value is calculated by applying the 120 percent applicable federal rate (AFR), as determined under Section 1274(d), compounded semiannually. 71 The AFR used in this calculation is the rate in effect on the date vesting is accelerated. The IRS publishes the AFR monthly in a revenue ruling. 72 Section 1274(d) provides a short8term, mid8term and long8term rate. 73 The AFR used to determine the present value of the payment is based on the length of the remaining vesting period on the date of the accelerated vesting. For example, the short8term AFR is used for Jill s first and second tranches of restricted

Golden parachute payments 15 stock because the restricted stock was schedule to vest without regard to the change in control within three years of the accelerated vesting date. Once the appropriate AFR has been identified, the present value of the payment can be calculated. For example, the short8term 120 percent AFR compounding semiannually for July, 2011, is 0.44 percent. The present value of Jill s first tranche of restricted stock is approximately $1,197,344. The present value of Jill s second tranche of stock is approximately $593,425. The portion of the parachute payment attributable to the accelerated timing of the payment is equal to the difference between the current value of the restricted stock and the present value of the restricted stock. As illustrated in Exhibit 9, this portion of the parachute payment is Exhibit 9 First tranche Second tranche $2,656 for Jill s first tranche of stock and $6,575 for Jill s second tranche. The second portion of the parachute payment is attributable to the accelerated vesting of the payment. The amount representing the accelerated vesting of the payment is equal to 1 percent of the current value of the restricted stock or stock option multiplied by the number of full months between the date vesting was accelerated and the date the restricted stock or stock option would have vested without regard to the change in control. Only full months are used for this purpose, and partial months are disregarded. Jill s first tranche of restricted stock was scheduled to vest on Jan. 1, 2012, but vesting was accelerated to July 1, 2011, because of the change in control. Thus, the number of full months of accelerated vesting is six. Consider an alternative scenario in which Jill s first tranche of restricted stock was instead scheduled to vest on Dec. 15, 2011. In this situation, the number of full months of accelerated vesting is five. The half month (Dec. 1 through Dec. 15) is not factored into this calculation. As established above, Jill s second tranche of stock was scheduled to vest on Jan. 1, 2014. Thus, the number of full months of accelerated vesting is 30 for the second tranche. Considering that Jill s first tranche of stock was scheduled to vest on Jan. 1, 2012, and the second Exhibit 10 First tranche Second tranche Current value Present value Parachute payment Current value Present value Parachute payment $1,200,000 * $1,197,344 $2,656 $600,000 * $593,425 $6,575 Current value 1% per full month of accelerated vesting Parachute payment Current value 1% per full month of accelerated vesting Parachute payment $1,200,000 X 6% $72,000 $600,000 X 30% $180,000 tranche on Jan. 1, 2014, the portion of the payment attributable to the accelerated vesting is $72,000 for the first tranche and $180,000 for the second. This is illustrated in Exhibit 10. The first and second portions of Jill s parachute payment related to the restricted stock have been calculated in the earlier examples. These amounts are combined to reach the total parachute payment that is treated as contingent on the change in control with respect to her restricted stock. The total parachute payment for the first tranche of restricted stock is $74,656, and the total parachute payment for the second tranche of restricted stock is $186,575, resulting in a total parachute payment with respect to her restricted stock of $261,230.

Golden parachute payments 16 Earlier in this article, we discussed that this method for calculating the parachute payment was not available if the vesting of the restricted stock or stock options, without regard to the change in control, was based on an event and the event did not occur prior to the change in control. Assume that the vesting of Jill s restricted stock was based on ABC Corporation reaching an earnings per share target of $5, and that this target was not reached prior to the change in control. In that situation, Jill s total parachute payment with respect to the restricted stock would be $1.8 million. Jill s parachute payment for her restricted stock is $1,538,770 less because the vesting was based on the continued performance of services, rather than an event, such as the attainment of a performance goal. Conclusion Stock options and restricted stock significantly affect the application of the Section 280G parachute payment rules. As we discussed, a corporation s outstanding stock options and restricted stock can make the difference in whether a corporation experiences a change in control. Also, an individual s stock options and restricted stock may result in the individual s being treated as a disqualified individual. The amount of the parachute payment related to the stock options and restricted stock may vary significantly depending on whether the vesting is based on continued employment or an event, such as the attainment of a performance goal. The dollar amounts included in the examples were modest. Parachute payments can reach multimillions of dollars, which can result in significant tax consequences for the disqualified individual and corporation. Thus, corporations that are considering or engaging in a change in control should pay close attention to these rules, especially the effect stock options and restricted stock can have on the parachute payment calculation.

Golden parachute payments 17 Notes 1. Corporations may be required to address parachute payments in no8tax environments, such as in compensation disclosures for public companies and the new shareholder vote requirements under the Dodd8Frank Wall Street Reform and Consumer Protection Act. A discussion of these requirements is outside the scope of this article. 2. For purposes of Section 280G, the term corporation has the meaning given under Section 7701(a)(3), and includes entities such as publicly traded partnerships, real estate investment trusts and corporations with mutual or cooperative ownership, rather than stock. See Reg. 1.280G81, Q&A 45. 3. Section 280G(b)(5). For purposes of Section 280G, a small business corporation is defined under Section 1361(b) without regard to Section 1361(b)(1)(C). In general, these are the requirements a corporation must meet in order to make an election to be treated as an S corporation, but for purposes of Section 280G, the corporation may have nonresident shareholders. 4. As discussed later in this article, the term disqualified individual refers to individuals who provides services to the corporation and receive parachute payments. A disqualified individual includes certain shareholders, officers and highly compensated individuals. 5. Section 280G(b)(3)(A). 6. Section 280G(d)(2). If the disqualified individual was not an employee or independent contractor of the corporation for the entire five years preceding the year of the change in control, the individual s base period is the portion of the five8year period during which the individual provided services to the corporation. See Reg. 1.280G81, Q&A 35(a). 7. Section 4999(a). 8. Section 280G(a). 9. These events are referred to in this article collectively as a change in control. 10. The term person includes an individual, trust, estate, partnership, association, company or corporation. Section 7701(a)(1). 11. People are considered acting as a group if they are owners of a corporation that enters into a merger, consolidation, purchase or acquisition of stock, or similar business transaction with the corporation. People are not considered to be acting as a group merely because they happen to purchase or own stock of the same corporation at the same time, or as a result of the same public offering. Reg. 1.280G81, Q&A 27(b). 12. Reg. 1.280G81, Q&A 27(a). 13. Id. 14. Reg. 1.280G81, Q&A 27(c). 15. Reg. 1.8383(c)(1). 16. Id.

Golden parachute payments 18 17. Many factors must be taken into account in determining whether a noncompetition agreement results in a substantial risk of forfeiture, including the enforceability of the agreement under state law, the age of the employee, the availability of alternative employment opportunities, the likelihood of the employee s obtaining the other employment, the degree of skill possessed by the employee and practice of the employer to enforce the agreement. 18. Reg. 1.8383(c)(1). 19. Incentive stock options are options that Section 421 applies because the options meet the requirements of Section 422. Nonqualified stock options are options that Section 83 applies because the options do not meet the requirements of Section 422. 20. Rev. Rul. 2005839, 200582 CB 1. 21. Reg. 1.8382(a). 22. The 128month period ends on the date of the most recent acquisition. 23. Reg. 1.280G81, Q&A 29(a). 24. The 128month period ends on the date of the most recent acquisition. 25. Reg. 1.280G81, Q&A 28(a). 26. Reg. 1.280G81, Q&A 27(f). 27. Id. 28. Reg. 1.280G81, Q&A 28(b). 29. Reg. 1.280G81, Q&A 15(a). The number of officers is limited to the lesser of (1) 50 employees or (2) the greater of three employees or 10 percent of the corporation s employees. Highly compensated individuals include members of the group consisting of the lesser of the highest paid 1 percent of employees, or the highest paid 250 employees. 30. Reg. 1.280G81, Q&A 20. 31. Reg. 1.280G81, Q&A 17(b). 32. Rev. Rul. 2005839, 200582 CB 1. 33. Reg. 1.280G81, Q&A 11(a). Notwithstanding, payments to and from a tax8qualified retirement plan or 403(b) plan are not included. See Reg. 1.280G81 Q&A 8. 34. In our examples, Jill holds only nonqualified stock options. As mentioned earlier in this article, Section 280G does not distinguish between nonqualified stock options and incentive stock options. Thus, the Section 280G rules discussed in this article apply to both nonqualified stock options and incentive stock options. 35. Section 83(a). 36. Id. 37. Reg. 1.8383(a)(2). 38. An employee recognizes compensation income under Section 83(a) on the grant date if the stock option has a readily ascertainable fair market value of the date of grant. See Reg. 1.8387(a). 39. Reg. 1.280G81, Q&A 13(a). 40. Reg. 1.280G81, Q&A 13(b). 41. Reg. 1.280G81, Q&A 12(a). 42. Reg. 1.280G81, Q&A 12(b). 43. Reg. 1.280G81, Q&A 22(a). 44. Reg. 1.280G81, Q&A 22(b) (3).

Golden parachute payments 19 45. Reg. 1.280G81, Q&A 25. 46. Reg. 1.280G81, Q&A 22(c). 47. Reg. 1.280G81, Q&A 22(a). 48. Reg. 1.280G81, Q&A 23(a). 49. Reg. 1.280G81, Q&A 22(b)(2). A voluntary termination is also considered an event closely associated with the change in control. 50. Reg. 1.280G81, Q&A 12(a). 51. Section 83(a). 52. Reg. 1.409A81(b)(5)(iv)(B)(1). 53. Id. 54. Id. 55. Reg. 1.409A81(b)(5)(iv)(B)(2). 56. Id. 57. The application of the valuation methods and factors discussed within this article is outside the scope of this article. The fair market value of stock should be determined by an experienced valuation specialist. 58. Reg. 1.280G81, Q&A13(a). 59. 200382 CB 398. 60. Rev. Proc. 2003868, 200382 CB 398. 61. Formerly Financial Accounting Standards No. 123R. 62. The application of the safe harbor valuation method is outside the scope of this article. The value of a stock option should be determined by an experienced valuation specialist. 63. Reg. 1.280G81, Q&A 24(c)(1)(ii). 64. Id. 65. Reg. 1.280G81, Q&A 24(c)(1)(i). 66. Reg. 1.280G81, Q&A 24(d)(3). 67. Reg. 1.280G81, Q&A 24(a)(1). 68. Reg. 1.280G81, Q&A 26(a). 69. Reg. 1.280G81, Q&A 24(b). 70. Reg. 1.280G81, Q&A 24(e). 71. Reg. 1.280G81, Q&A 32. 72. For example, the 120 percent short8term AFR compounding semiannually for July 2011 was 0.44 percent, as provided in Rev. Rul. 2011814, 2011827 IRB. 73. The short8term rate is used when the remaining vesting term is equal to or less than three years; the mid8term rate is used when the remaining vesting term is greater than three years but equal to or less than nine years; and the long8term rate is used when the remaining vesting term is more than nine years.

Golden parachute payments 20 About the author Jeffrey A. Martin, CPA, is a senior manager in the Washington National Tax Office (WNTO) of Grant Thornton LLP in Washington, D.C., where he specializes in the taxation of compensation and employee benefits. In this role, he tracks new legislation and guidance, and advises Grant Thornton s offices and clients regarding tax issues that affect compensation and employee benefits. Prior to joining WNTO in 2006, Martin worked in Grant Thornton s McLean, Va., office, where his role included federal tax and state and local tax consulting and compliance. Martin is a CPA and an active member of the AICPA. He has written for the Journal of Taxation, the BNA Daily Tax Report, Tax Analysts publications and The Tax Adviser. He has spoken at the AICPA National Conference on Employee Benefit Plans. Martin earned his bachelor s degree in business administration and his master s degree in professional accountancy from West Virginia University.

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