Tax implications of equity-based compensation from an M&A perspective

Executive summary

Although equity-based compensation plans generally operate similarly from an economic perspective, the tax treatment to the employer and the employee varies based on the specific arrangement. This can include the timing and character of income to the employee, as well as the timing of deductions available to the employer. These income tax considerations may be an important negotiating point in an M&A transaction, namely identifying which party is entitled to deduct and the timing of compensation payments made at closing. Most companies involved in an M&A transaction have some sort of employee compensation in place, and usually the M&A transaction results in some sort of payout to the employees. It is important that the target company, target owners, target employees, and buyer each have a good grasp on the tax implications of the transaction on these compensation plans.

Introduction

In the United States, equity-based compensation arrangements can be a key part of an employer’s ability to attract, develop, and retain talent. This is particularly important in start-ups, technology-based companies and many private equity fund portfolio companies. While equity-based compensation plans generally operate similarly from an economic perspective (i.e., sharing in the growth of equity value), the tax treatment to the employer and the employee varies based on the specific arrangement. As the different types of equity-based compensation described below in this article will illustrate, this can include the timing and character of income to the employee, as well as the timing of deductions available to the employer. These income tax considerations are also an important negotiating point in an M&A transaction, namely identifying which party is entitled to deduct and the timing of compensation payments made at closing. Along with investment banking fees, compensation deductions are generally the largest transaction-related deductions, and therefore a critical negotiating point.

This article addresses the following types of equity-based compensation arrangements: (i) nonqualified stock options, (ii) restricted stock, (iii) restricted stock units, (iv) stock appreciation rights, and (v) phantom stock.

As discussed in further detail below, partnerships¹ often utilize profits interests as a compensatory tool. If the profits interests issued meet the requirements of Revenue Procedures 93-27² and 2001-43³, then the interests result in zero compensation to the service provider and the partnership is not entitled to a compensation deduction. However, subsequent allocations of income to the service provider are economically equivalent to a deduction because less income is allocated to other partners. Note this is not the case from a character perspective if the income allocated to the service partner is long-term capital gain income.

Deferred equity-based compensation payments

Compensation payments are typically deductible by the employer, however, where the arrangement is a deferred compensation plan, the deduction may be deferred under section 404⁴. If subject to these rules, section 404(a)5 requires payment of the compensation  (i.e., payment is included in the employee’s gross income) for the employer to take the deduction.⁵ Generally, payments made within two and a half months after the close of the employer’s tax year in which the right to payment vests, are not presumed as deferred compensation for purposes of section 404 (the “two-and-a-half-month rule”).⁶ In other words, the two-and-a-half month rule is limited to amounts that vested in the tax year immediately prior to the payment.

In the context of M&A transactions, the deduction deferral rules under section 404 are important to remember when planning for or negotiating the tax benefit of compensatory deductions. Consider the following example.

Corporation P is the parent of a consolidated group that has a December 31 tax year-end and acquires the target corporation (T) on June 30, 2022, resulting in the end of the tax year for T on that date. One of T’s employees had a deferred equity-based compensation arrangement (subject to the rules of section 404), that had vested in 2020, and was paid by T on the date of the transaction. The payment is not included in the employee’s gross income until the employee’s tax year end of December 31, 2022. Therefore, T cannot take the deduction until the tax year that includes December 31, 2022 (while a part of the P group), even though the payment was made on June 30, 2022. The two-and-a-half-month rule does not apply to prevent application of the deferral rule under section 404, because the right to the payment vested in 2020.

So, in this case the P group will receive the benefit of the tax deduction in the post transaction tax return filed by P. In the event T had planned to deduct this amount in the return prior to the transaction to offset operating income, T could face an unexpected tax liability. Assuming the T shareholders correctly identify this timing issue, and the liability to pay the compensation was a downward adjustment to the purchase price, they may look to negotiate a payment or upward purchase price adjustment for the tax benefit P will receive on the deduction. 

Vesting of equity-based compensation plans

An employee’s rights under an equity-based compensation plan may vest either all at once (“cliff” vesting) or may vest at various points during a period of time. Understanding when vesting occurs is important for determining the timing of the deduction for those payments. An arrangement subject to cliff vesting may be deferred compensation but not fall subject to the deferral rule of section 404(a)(5). For example, in the many private equity owned portfolio companies utilize compensation plans that vest only upon the closing of a certain future transaction that results in a change of control of the employer entity.

Consider the above example, but instead of the right to payment vesting in 2020, the right vested upon the close of the transaction on June 30, 2022. Since the right to payment vested in the same tax year as the closing of the transaction (i.e., when the payment was made), the deduction is not subject to deferral under the rules of section 404(a)(5). Note in many cases the compensation is not actually paid at closing, but rather shortly after closing on either a special payroll run or the next scheduled payroll. So long as this payment is not more than two and a half months after the closing, T is entitled to take a deduction for the payment on its short-year return ending on the date of the transaction.

As illustrated by the above examples, in the context of an M&A transaction, it is critical to review the equity-based compensation arrangements to understand when vesting occurs, as it may or may not result in the deferral of the deduction for the employer.

The remainder of this article will briefly summarize different types of equity-based compensation arrangements for comparison and deduction timing.

Equity-based compensation arrangements

Consider the below types of equity-based compensation that may be issued in connection with an M&A transaction (and assume where applicable that the compensation plans meet the requirements of section 409A).⁷ Note that while items 1 and 2 generally are not subject to the timing rule under section 404(a)(5), items 3, 4, 5, and 6 may be subject to that rule.

1. Nonqualified stock options (NSOs)⁸ are subject to the rules of section 83 (although a section 83(b) election cannot be made) and are generally taxable when exercised. If the stock is vested on the date of exercise, then the amount that an employee must include in gross income upon exercising the stock is the difference between the option exercise price and the fair market value (FMV) on the date exercised. The income is ordinary in character to the employee. However, capital gain treatment is available upon a subsequent sale of the stock by the employee. The employer generally may take a deduction equal to the income that the employee incurs when the NSOs are exercised.⁹ Stock options are not subject to the deduction deferral rule of section 404(a)(5). If a short tax year results from an M&A transaction, the deduction is generally claimed by the target C corporation on the tax return that ends on the day of the transaction.¹⁰ However, it is important to note that if an S corporation is acquired and joins a consolidated return or is otherwise acquired and becomes a C corporation as a result of the transaction, the final S corporation return year ends on the day before the transaction, and so the S corporation is generally not eligible to claim the deduction on that return.¹¹ This is often an unwelcome surprise to S corporation shareholders that were counting on this ordinary deduction. Like the deferred compensation deduction discussion above, the S corporation shareholders could negotiate for a purchase price adjustment for the tax benefit that the acquirer is receiving.
2. Restricted stock is compensatory either when received or when vesting occurs. If a section 83(b) election is made, the stock is valued when it is granted, resulting in compensation at that time includible in the shareholder’s gross income.¹² However, if no section 83(b) election is made then generally the restricted stock is compensatory when it vests. The amount included in the employee’s income would be the difference between the FMV and the amount paid (if any) at either (1) the time of grant (if a section 83(b) election is made) or (2) at vesting (if no section 83(b) election is made). However, any future appreciation on the value of the restricted stock after either the vesting or section 83(b) election is generally eligible for capital gain treatment. The employer may take a corresponding deduction either in the year of vesting or at grant if the employee makes a section 83(b) election in an amount equal to the compensation reported to the employee.¹³
3. Restricted stock units (RSUs) are similar to restricted stock; however, no section 83(b) election is available for RSUs. Therefore, RSUs are compensatory when they vest, and the employer may take a deduction only upon vesting.¹⁴ The value of those shares (i.e., the number of shares times the FMV of each share) over any amount paid by the employee for such shares upon their transfer is taxable as compensation the employee. For further information on RSUs, see Frequently asked questions about restricted stock units.
4. Stock appreciation rights (SARs) provide an employee with the right to a future payment based on the increase in value of stock over a certain period. This payment in the amount of the appreciation of value is ordinary income to the employee. The employer may take the corresponding deduction for the amount of cash paid, but the deduction is subject to the section 404(a)(5) timing rule.
5. Phantom stock provides an employee with a grant for a certain number of phantom stock units, with each unit equal in value to one share of common stock. Phantom stock economically operates very similarly to SARs, however future payment is based on the full value of the share. When payment is made, it results in ordinary income to the employee, and the employer has a corresponding deduction that is subject to the timing rules of section 404(a)(5). For more detail on phantom stock, see 9 frequently asked questions about phantom stock plans.
6. Bonus arrangement plans provide an employee with future payment based on equity value of the corporation. Often these plans are subject to cliff vesting and require that the service provider is employed at the time of a specified future transaction. As with SARs and phantom stock, payment from a bonus arrangement plan results in ordinary income to the employee, and the employer has a corresponding deduction that is subject to the timing rules of section 404(a)(5).

M&A transactions involving a rollover or retained interest

In many situations, particularly those involving private equity portfolio companies, a retained interest in the target company, or rollover into the buyer often occurs with both equity holders and target employees. As a result, the question often arises as to whether the equity-based compensation plans can be rolled over in a transaction that defers taxation to a subsequent taxable year.

The types of deferred compensation discussed above can be utilized in M&A deals where there is rollover; however, it is important to note that the arrangements retain their compensatory taint. Rights to compensation plans can be rolled over to the acquiring entity, provided the requirements of section 409A are met. For example, corporation P (or “Buyer”) purchases corporation T (or “Target”), and certain employees of Target that hold SARs roll over their SARs into Buyer. Assuming the rules of section 409A are met, the employees may roll over their SARs without triggering a compensatory event to the employees, thereby retaining the deferred compensation status of that equity. Similarly, certain employees of Target that hold stock options could exchange those options for stock options of Buyer, and such exchange may occur on a tax-deferred basis. In these scenarios, there would be no deduction available to the corporation until a later date on which the compensation vests and payment occurs. As stated above, a rollover of an equity-based compensation arrangement, that has not yet resulted in compensation to the service provider, retains its compensatory nature. As a result, the subsequent vesting, exercise, or payment (as applicable to the arrangement) occurring under that plan are taxable as compensation to the employee. Profits interests in a partnership generally provide more favorable results to the service provider. As discussed above, assuming the profits interest was issued in accordance with applicable revenue procedures, there was no compensation to the service provider upon grant, and the profits interest represents a capital asset in the hands of the service provider. As a result, the interest is generally eligible for rollover in a tax-deferred transfer such as a section 721 or 351 transfer. Note that new restrictions placed on these interests could result in a compensatory transfer requiring an additional section 83(b) election to avoid a compensation pick-up by the employee.¹⁵

Conclusion

Most companies involved in an M&A transaction have some sort of employee compensation in place, and usually the M&A transaction results in some sort of payout to the employees. It is important that the target company, target owners, target employees, and buyer each have a good grasp on the tax implications of the transaction on these compensation plans. As the above examples illustrate, the timing rules under section 404 for employer deductions can provide surprising results. Further, equity-based compensation payments made at the time of closing of an M&A transaction may be an important negotiating point, as these payments are generally one of the largest transaction-related deductions. In addition, the rules under section 409A and section 280G should be taken into consideration. Taxpayers should consult with their tax advisors to ensure proper analysis of the rules around equity-based compensation arrangements and payments in connection with M&A transactions.

_{1. Including limited liability companies electing partnership treatment for Federal income tax purposes.}

_{2. 1993-2 C.B. 343.}

_{3. 2001-2 C.B. 191.}

_{4. Note that if there is a change in control of a C corporation, the deductions may be disallowed or limited under section 280G. The rules of section 280G are outside the scope of this article. Note that the deduction is also subject to the rules under section 162.}

_{5. Further, Treasury Regulations provide “[d]eductions under section 404(a) are generally allowable only for the year in which the contribution or compensation is paid, regardless of the fact that the taxpayer may make his returns on the accrual method of accounting.” Reg. section 1.404(a)-1(c).}

_{6. Reg. section 1.404(b)-1T(b)(1).}

_{7. The rules of section 409A are outside the scope of this article. For further information, see Nonqualified deferred compensation plan FAQs for employers; Operating nonqualified deferred compensation plans FAQs for employers.}

_{8. Incentive stock options are outside the scope of this article. For further information on stock options, see Frequently asked questions about stock options and tax implications.}

_{9. Reg. section 1.83-6(a)(1),(3).}

_{10. However, as illustrated by the example above involving the acquisition of T by P (the parent of a consolidated group), under application of what is commonly referred to as the “next day rule” in Treas. Reg. section 1.1502-76(b)(1)(ii)(B), it may be possible for T to claim the deduction on the post transaction return while a member of the of the P group.}

_{11. Treas. Reg. section 1.1502-76(b)(1)(ii)(A)(2). See also section 1362(e)(1). The short year for an S corporation that ceases to be an S corporation is defined as “the portion of such year ending before the 1st day for which the termination is effective shall be treated as a short taxable year for which the corporation is an S corporation.”}

_{12. Section 83(b) allows a taxpayer to elect to be taxed on the value of their equity at the time of its grant instead of at its later vesting date. For more detail on restricted stock, see Frequently asked questions about restricted stock.}

_{13. Reg. section 1.83-6(a)(1). Note that although restricted stock is not subject to the timing rule under section 404(a)(5), the rules under Reg. section 1.83-6(a)(1) provide a similar result.}   

_{14. Reg. section 1.83-6(a)(3).}

_{15. See Rev. Rul. 2007-49, 2007-2 CB 237, for an example of the treatment of restricted stock in a section 368 reorganization. It is generally assumed that similar rules would apply in the context of transfers pursuant to sections 721 and 351.}