S R E D S A R E E L D S A X R E A E L D T S - - PowerPoint PPT Presentation

Future Tax Leaders Presentation – Executive Compensation Future Tax Leaders Presentation Executive Compensation

November 27, 2017

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Topics to be Covered

• Non-Qualified Stock Options (“NSO”)
• Incentive Stock Options (“ISO”)
• Restricted Stock

Restricted Stock

• Restricted Stock Units (“RSU”)
• Phantom Stock
• Stock Appreciation Rights (“SAR”)
• Stock Appreciation Rights ( SAR )
• Profits Interests
• Deferred Compensation Plans (incl. 409A)
• Change in Control and Severance (incl. 280G)
• THEMES:

B h i Ri k Ri k ff Sh L

• Behavior: Risk-on vs. Risk-off; Short-term vs. Long-term
• Currency: Stock or Cash
• Tax Treatment: Ordinary Income vs. Capital Gains

| 1 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Stock Options

General Overview

• Stock options were the most popular equity award during the 1990’s tech boom.
• Since then its usage has been tempered by the requirement to expense them

Since then, its usage has been tempered by the requirement to expense them under accounting rules and an overall reduction in risk appetite for employee incentives.

• Most popular amongst start-up and technology companies – no cash commitment

and no realization of awards unless the company has increased in value and no realization of awards unless the company has increased in value.

• HIGH RISK/HIGH REWARD

| 2 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Stock Options

Definition/Risks

• A stock option is a right (not obligation) to purchase a fixed number of company

shares (“option shares”) at a fixed price (“exercise price”) within a fixed period of ti (“ i i d”) t i ll f ll i th ti f ti f t i ti b d time (“exercise period”), typically following the satisfaction of certain time-based or performance-based conditions (“vesting”).

• Participant generally has control over:
• The timing of exercise (although the company can place restrictions on the

g ( g p y p timing of exercise); and

• Subsequent disposition of such shares, thus maximizing the ability for the

employee to boost his or her profit with respect to such award.

• However with potential high return comes high risk
• However, with potential high return comes high risk.
• Options generally have no value if the share price does not exceed the

exercise price.

• The timing of exercise is critical since the ordinary income tax liability can

significantl erode the a ard al e (i e e ercise is made hen the share significantly erode the award value (i.e., exercise is made when the share price is high but the shares later experience a significant decrease in value).

• Exercise price must be at FMV at the time of grant or else option is subject to IRC

§409A.

• Participant cannot control option exercise dates – must be predetermined at

grant. | 3 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Stock Options

Key Components

• Option Shares: To be determined by the company – typically taken from an option

“pool” of a percentage of company capitalization (e.g., 10%).

• Exercise Price: Under IRC 409A rules, the exercise price must be at fair market

value at the date of grant (or else the option is subject to 409A) and must reflect the most liquid stock of the company (e.g., typically common shares).

• Exercise Period: Typically 10 years but the company has the opportunity at grant
• Exercise Period: Typically 10 years, but the company has the opportunity, at grant

date, to lengthen or shorten the time period.

• Vesting: Either time-based on employment (e.g., three-year or five-year vest) or

performance-based (e.g., upon company EBITDA at or above $10,000,000). Cliff (100% vested at one specific time) vs graded (partial vesting each year) (100% vested at one specific time) vs. graded (partial vesting each year). | 4 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Differences between NSO and ISO

NSO ISO Income Tax Treatment Ordinary (exercise) Capital gain on subsequent disposition Capital gain (stock sale) subsequent disposition FICA taxes Yes (exercise) None Alternative Minimum Tax Not an issue An issue Company Tax Consideration Deduction (exercise) Not a deduction Subject to 409A Yes (if not FMV price) No (must be FMV price) Qualifying Recipients Employees, directors Employees only and other service providers ** ISOs have specific requirements in order to qualify as such: shares must be held for at least two years following the grant date and at least one year following exercise date exercise price must be years following the grant date and at least one year following exercise date, exercise price must be at FMV. Failure to adhere to these requirements will result in a disqualifying disposition, whereupon the ISO will be categorized as a NSO.

| 5 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Restricted Stock

General Overview

• Most popular award for public companies.
• Not as popular with private companies because of shareholder rights

Not as popular with private companies because of shareholder rights.

• Has gained in popularity as appetite for options has faded.
• More prevalent with steady, lower-beta type companies (e.g. manufacturing,

construction, healthcare). )

• LOW RISK/STEADY EDDIE AWARD

| 6 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Restricted Stock

Definition

• Restricted stock is an award of actual shares of company stock that is subject to

forfeiture pursuant to a predetermined vesting schedule.

• Vesting can be time based on employment (e.g., three-year) or performance based

(e.g., upon EBITDA target).

• Because the award consists of actual shares, restricted stock is entitled to voting

and dividend rights vis a vis the class of stock subject to the award as well as any and dividend rights vis a vis the class of stock subject to the award as well as any information rights of a shareholder (especially in a private company).

• Restricted stock awards are generally taxed as ordinary income on the date they

vest and are taxed as capital gains when ultimately sold.

• Exception is so-called Section 83(b) election.

| 7 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Restricted Stock

83(b) Election

• Restricted stock awards are eligible for 83(b) election where the participant

recognizes ordinary income of the stock value as of the grant date (as opposed to i iti t ti bl l b i if th income recognition at vesting – presumably a lower basis if the company appreciates during the vesting period).

• However, (i) 83(b) must be made within 30 days of grant and (ii) if the shares are

later forfeited (e.g., termination before vesting), no tax deduction is allowable for f f f the loss in respect of the forfeited shares.

• Risks to the employee on 83(b) election are (i) stock depreciation and (ii) forfeiture
• f shares pre-vesting.

| 8 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Restricted Stock

Restricted Stock Income Tax Treatment Ordinary income *at grant (yes 83(b) election) **at vesting (no 83(b) election) at vesting (no 83(b) election) Capital gains on subsequent disposition Employment Taxes Follow income tax rules Alternative Minimum Tax Not an issue Company Taxation Deduction (at recognition of di i )

• rdinary income)

| 9 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Restricted Stock Units

General Overview

• RSUs have traditionally been a popular equity-based award vehicle for public

companies.

• Private companies have tended to avoid them because they do not provide as

much upside on share appreciation as compared to stock options or stock appreciation rights.

• However for companies that have current high valuations (based on most recent
• However, for companies that have current high valuations (based on most recent

share offerings) for which stock options and stock appreciation rights would have difficulty creating incentive (since the realization of such valuation could take time), RSUs can be an effective substitute.

• For this reason high valuation startups such as AirBnB Square Facebook and
• For this reason, high valuation startups such as AirBnB, Square, Facebook and

Twitter have utilized RSUs during their private company phase. | 10 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Restricted Stock Units

Definition

• RSUs represent the right to receive a share of stock or cash value thereof upon

satisfaction of vesting conditions.

• Receipt of stock or cash at either company or employee discretion and baked

into the RSU plan or agreement.

• It is not the receipt of actual stock, unlike restricted stock, and therefore the

participant does not have dividend or voting rights. p p g g

• However, RSUs may accrue dividend equivalents which become payable upon

vesting.

• Vesting does not have to trigger distribution of such award and can be a fixed date

b h l i l i h IRC §409A but the election must comply with IRC §409A.

• This further deferral can be an effective strategy to delay recognition of

income even after the participant has vested in his or her award. | 11 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Restricted Stock Units

RSU Income Tax Treatment Ordinary at receipt of distribution (may be later than vesting if deferred) Capital gains on subsequent disposition (if settled in stock) Employment Taxes At vesting Alternative Minimum Tax Not an issue Alternative Minimum Tax Not an issue Company Deduction at distribution | 12 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Phantom Stock

General Overview

• If a company wishes to incentivize employees using its company stock value but

does not wish to issue actual shares of stock, then phantom stock can be an ff ti i ti d effective incentive award.

• Does not want to dilute current shareholders, shift partial control to an

employee, or provide voting rights or dividend rights to an employee shareholder)

• Generally more popular with privately held companies and especially family owned

companies who do not want additional shareholders.

• Companies that grant phantom stock will need to budget for cash expenses with

respect to distributions for such awards. respect to distributions for such awards.

• The cash payments require the company to be sensitive that payouts can disrupt

cash flow and, therefore, need to plan carefully (either through reserving capital and/or restricting the distribution events to times when cash flow is adequate).

• LOW RISK/STEADY EDDIE

| 13 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Phantom Stock

Definition

• Phantom stock is a notional share of stock that is typically subject to vesting and

distributed either at vesting or at a predetermined distribution date such as fixed d t h i t l d/ t i ti f l t ( bj t t IRC §409A date, change in control, and/or termination of employment (subject to IRC §409A requirements). Distribution dates can be at the control of the company.

• If distribution is later than vesting date, then such distribution election and

timing must conform to IRC §409A requirements.

• Phantom stock is subject to ordinary income tax at distribution and FICA at vesting.

The company receives compensation deduction at distribution.

• Since there is no distribution of actual stock, there are no capital gains involved. An

83(b) election is not available for phantom stock. 83(b) election is not available for phantom stock.

• It is an award that is taxable as ordinary income, so the participant will not enjoy

any tax efficiencies based on capital gains treatment, but the company will receive the compensation deduction. | 14 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Stock Appreciation Rights

General Overview

• If a company wants to incentivize employees using the appreciation in company

stock value but does not wish to issue actual shares of stock pursuant to stock ti th SAR b tili d

• ptions, then SARs can be utilized.
• SARs offer same considerations as phantom stock – doesn’t dilute current

shareholders, shift partial control to an employee, or provide voting rights or dividend rights to an employee shareholder.

• Popular amongst private companies.
• Companies that grant SARs need to budget for cash expenses with respect to

distribution triggers for such awards. Th f h h i h b i i h

• The nature of the cash payments requires the company to be sensitive that

payouts can disrupt cash flow and therefore need to plan carefully (either through reserving capital and/or restricting the timing of exercise).

• MEDIUM RISK/HIGH REWARD

| 15 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Stock Appreciation Rights

Definition

• SARs are notional stock options that are payable in cash in an amount equal to the

difference between the stock’s fair value at distribution and exercise price at grant (j t lik ti th i i t b t FMV) (just like options, the exercise price must be at FMV).

• Exercise price must be at FMV at the time of grant or else SAR is subject to IRC

§409A.

• If SAR is subject to IRC §409A, participant cannot control option exercise

j § , p p p dates – must be predetermined at grant.

• Distributions are made upon exercise at the election of the employee following the

satisfaction of vesting requirements (although the company can place restrictions

• n the timing of exercise).
• n the timing of exercise).
• SARs are taxed at ordinary income and FICA on the spread between exercise

price and FMV at the time of exercise with corresponding company deduction.

• Since no company shares are transferred, there are no capital gains

considerations. | 16 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Profits Interests

General Overview

• In order for partnerships and LLCs, which are taxed as partnerships, to retain and

incentivize key employees, a profits interest is a popular form of incentive ti compensation.

• There is tax efficiency to profits interests as all appreciation is taxed at capital

gains (i.e. no ordinary income assessed).

• Profits interests are typically held until the partnership is sold thus the real value in
• Profits interests are typically held until the partnership is sold, thus the real value in

a profits interest is upon a sale event.

• If the contemplation is to sell the partnership within a fixed period of time (such as

a private equity portfolio company), then profits interests are certainly an appropriate equity award vehicle appropriate equity award vehicle.

• Otherwise, if there is no such sale contemplation, employees can lose faith in an

award for which there is no clear path to liquidity.

• Subject to certain regulatory and reporting requirements.

Subject to certain regulatory and reporting requirements.

• CHANGE IN CONTROL – LIQUIDITY AWARD

| 17 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Profits Interests

Definition

• A profits interest is a partnership or LLC interest where the participant has a share

in the future profits and appreciation in the value of the LLC following the date of t h ki t ti ( i FMV i i ) grant, much akin to an option (assuming a FMV exercise price).

• The assumption is that upon complete liquidation of the LLC at the grant date, the

value of the profits interest is zero.

• Consequently the common practice is to make an 83(b) election at the date of
• Consequently, the common practice is to make an 83(b) election at the date of

grant and since the value of the award is zero, then no income tax is recognized.

• There is a safe harbor where no income tax is recognized as well.
• The redemption or sale of profits interest generally results in capital gains

treatment.

• Participants are entitled (but not required) to share in any annual or other periodic

distributions from the company (which may be tiered based on participant date of hire/rank).

• Participants are treated as equity owners in the LLC under the LLC agreement.

The participant should receive a K-1 and pay taxes on income that is passed through from the LLC.

• The LLC will typically reserve cash distributions to the participants to pay for

The LLC will typically reserve cash distributions to the participants to pay for such taxes. | 18 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Deferred Compensation Plans (409A)

General Overview

• A deferred compensation plan allows employees to defer salary, bonus, or other compensation

in one year but receive it (along with any income tax recognition) in a later year.

• By doing this employees can reduce income tax payable on current income and pay
• By doing this, employees can reduce income tax payable on current income and pay

income tax in a future year when they presumably will be in a lower tax bracket.

• In addition, earnings on the deferred compensation can grow tax free (i.e., no capital

gains), and income tax is not assessed until distribution.

• Employees often like to use deferred compensation plans to supplement retirement income
• Employees often like to use deferred compensation plans to supplement retirement income

(since qualified retirement plans such as 401(k) have strict contribution limits) or one-time large capital expenses (such as tuition or home purchase).

• The deferred amounts can be invested in notional investments such as mutual funds, fixed

income, or even company stock and funded through a separate rabbi trust, although such trust , p y g p , g does not provide any protection from bankruptcy.

• LOW RISK OTHER THAN BANKRUPTCY

| 19 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Deferred Compensation Plans (409A)

Regulatory/Tax Considerations

• Deferred compensation plans are typically subject to two statutory requirements. In order to

circumvent strict ERISA requirements, these plans are typically designed as “top hat” plans (e.g., covering the top 15% of all company employees). In addition, these plans must adhere to (e.g., covering the top 15% of all company employees). In addition, these plans must adhere to IRC 409A.

• IRC 409A codified constructive receipt and created specific rules around (i) timing of

election to defer compensation and (ii) around payout of deferred compensation.

• Typically must elect to defer in the year prior to the year in which the compensation is

d earned.

• Distribution events limited to those enumerated under IRC 409A (separation from service,

death, disability, fixed date, change in control and hardship).

• Participants are assessed FICA at deferral and recognize ordinary income at distribution.
• If the company is located in a high tax jurisdiction, the plan typically offers a 10-year installment
• ption in order to take advantage of the source-tax rules (i.e., if distributions are 10+ years,

then subject to state tax where participant resides at receipt, not state tax at work).

| 20 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S

Change in Control and Severance (280G)

• Some companies offer benefits to its employees upon a change in control (single

trigger) or employment termination following a change in control (double trigger). Benefits may include cash severance, additional benefits, continuing benefits coverage (e.g., health insurance), outplacement services and/or vesting g ( g , ), p g acceleration of stock awards.

• The critical IRC provision governing CIC and severance is 280G (and 4999).
• If the value of payments/benefits that are contingent upon a change in control

f f (“ exceeds 3x the average W-2 compensation for the preceding five years (“base amount”), then the ramifications are that such value in excess of 1x the base amount is (i) subject to 20% excise tax on the employee and (ii) loss of compensation deduction on the employer.

• Definition of what’s contingent is tricky – defer to experts.
• Shareholders of a private company may approve payments/benefits so that they

are not considered parachute payments (such approval must come prior to closing

• f the transaction). Public companies may not utilize this exception.

) p y p | 21 |

F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S F U T U R E T A X L E A D E R S