60 th Annual MNCPA Tax14Conference. Equity Compensation for Private Companies: Current Practices, Trends and Potential Pitfalls.

Transcription

1 60 th Annual MNCPA Tax14Conference Equity Compensation for Private Companies: Current Practices, Trends and Potential Pitfalls November 18, 2014 Mark D. Salsbury Introduction Important role in attracting, retaining and incentivizing employees Type of equity compensation must be tailored for the circumstances (e.g., sophistication of the employees) Tax is not sole consideration Non tax consideration include Voting Economics Shareholder rights Repurchase obligations Other financial commitments Not uncommon to have several types of equity compensation 2

2 Agenda Overview regarding Section 83 Final regulations under Section 83 issued in February 2014, T.D (Feb ) Equity compensation for corporations Equity compensation for partnerships/llcs Crescent Holdings, LLC, et al. v. Commissioner, 141 T.C. No. 15 (2013) (non vested capital interest received for services) 3 Section 83 Applies to transfers of property in connection with the performance of services Functions: Whether SP has income In what year SP has income The amount of income SP recognizes Amount and timing of SR's deduction Timing is often critical Stakes can be high 4

3 Section Property transferred in connection with performance of services. (a) General rule. If, [in connection with the performance of services], [property] is [transferred] to any person other than the person for whom such services are performed, the excess of (1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for such property, shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are [transferable] or [are not subject to a substantial risk of forfeiture], whichever is applicable. The preceding sentence shall not apply if such person sells or otherwise disposes of such property in an arm's length transaction before his rights in such property become transferable or not subject to a substantial risk of forfeiture. 5 Section 83 In connection with the performance of services Broadly defined Transfers of property for past, present or future services are subject to Section 83 Alves v. Commissioner, 16 T.C. 864 (1982), aff d 734 F.2d 478 (1984) ( 83 can apply to a transfer at fair market value) Congress permitted those who bought stock at FMV after June 30, 1976 and on or before Nov. 18, 1982 (the date the Tax Court decision in Alves to make a 83(b) election without regard to the 30 day limit Family businesses 6

4 Section 83 Property Includes real and personal property Excludes and unfunded obligation Deferred compensation Right to receive property in the future is not property for purposes of 83 7 Section 83 Property must be transferred A transaction in which a person receives a beneficial ownership interest in property Grant of an option to acquire property is not a transfer of property for purposes of 83 Acquisition of property with non recourse debt Treated the same as an option 8

5 Section 83 Property must be transferred Non recourse note not treated as an option where the employee has a substantial amount at risk with respect to the stock Employee s note is partially recourse Employee pays for a portion of the purchase price in cash Non recourse note is secured by other property 9 Section 83 Property must be transferred Recourse note Forgiveness triggers ordinary income under 83 Not cancellation of indebtedness income eligible to be excluded from income under 108(e)(5) (purchase money debt exception) See Rev. Rul

6 Section Property must be transferred Rev. Rul vested shares become non vested shares Situation 1 Owner agrees to impose forfeiture conditions on shares that were vested shares for purposes of 83 No Transfer under 83 Imposition of new restrictions has no effect for purposes of 83 Situation 2 Owner exchanges vested shares for non vested shares in a tax free reorganization Non vested shares are treated as transferred for purposes of 83 Failure to make a 83(b) election could result in compensation income when shares become vested for purpose of 83 Situation 3 Owner exchanges vested shares for non vested shares in a taxable acquisition Non vested shares are treated as transferred for purposes of 83 Failure to make a 83(b) election could result in compensation income when shares become vested for purpose of 83 Section 83 Substantial risk of forfeiture ( SRF ) Future performance of substantial services Discharge for crime or misconduct Noncompetition Enforcement of forfeiture restrictions Possibility that such circumstances will occur is substantial Forfeiture at fair market value Repurchase price at book value if FMV of stock will substantially exceed book value constitutes a forfeiture price Repurchase provisions in shareholder agreements, buy sell agreements, etc. 12

7 Section 83 Substantial risk of forfeiture ( SRF ) T.D (Feb. 26, 2014) final regulations under Proposed regulations were issued in May 2012 (REG ) A condition that establishes a SRF must generally be related to the purpose of the transfer In determining whether a SRF exists you must consider both Likelihood that the forfeiture event will occur Likelihood that the forfeiture event will be enforced Transfer restrictions do not create a SRF 13 Section 83 Transferability For taxable event to be delayed under 83, property must be both subject to a substantial risk of forfeiture and nontransferable Property is transferable if the employee can sell, assign, or pledge the employee s interest in the property to any person and the transferee is not required to give up property in the event the SRF materializes Legend specifically referring to SRF should be on stock certificate If no legend, stock may be transferable under state law 14

8 Section 83 Tax Consequences to Employee When Employee has gross income equal to excess of FMV of property, over Amount paid for the property Even if employee paid an amount equal to the FMV of such property at the time of transfer Tax basis equals amount paid for the property plus the amount the employee includes in income Holding period Begins at the earlier or of the date the property is not subject to a substantial risk of forfeiture, is transferable If a 83(b) election is made, at the time the property is transferred 15 Section 83 Tax Consequences to Employee Before the restrictions lapse, the transferor (employer) is treated as the owner of the property Income (e.g., dividends) on the property taxable as compensation 16

9 Section 83 Tax Consequences to Employer Employer is generally entitled to a deduction equal to the amount of income recognized by the employee If recipient is an employee, the employee s income is subject to withholding Source of cash to pay employment tax obligation Employee makes payment to employer Withhold from normal salary Bonus to employee 17 Section 83 83(b) Election Where property is subject to a substantial risk of forfeiture and is non transferable, employee is allowed to elect to accelerate the taxable event by making a 83(b) election Compensation element is closed at the time of transfer Employee treated as owner of property Accelerates employer s deduction 18

10 Section 83 83(b) Election Continued Election must be made no later than 30 days after the date of the transfer Filed with the IRS office at which the employee regularly files his or her tax returns Written statement must be attached to the employee s tax return for the year of the transfer Employee must send a copy of the 83(b) election to the employer Rev. Proc includes sample language 19 Section 83 Consequences of 83(b) Election No deduction allowed for decline in value If property is forfeited, employee is entitled to a loss (capital loss) to the extent the amount paid for the property exceeds the amount received upon forfeiture No deduction allowed for spread recognized as ordinary income 20

11 Restricted stock Corporations Overview Purchase with non recourse note Purchase of stock with recourse note Non qualified option Incentive stock option Phantom stock Stock appreciation rights 21 Corporations Non qualified Stock Options (NQSOs) NQSO is not in the money at the time of grant 409A issues Neither granting nor vesting of NQSOs constitutes a transfer of property Difference between FMV of the stock and exercise price (the Spread ) is OI If stock is not subject to SRF or transferable, OI when exercised If stock is subject to a SRF and is non transferable, taxation is postponed until the SRF lapses or the employee makes a 83(b) election 22

12 Corporations Incentive Stock Options (ISOs) Neither granting nor vesting of an ISOs constitutes a transfer of property No gain or loss for regular tax purposes upon the exercise of an ISO Spread is an included in alternative minimum taxable income and may trigger AMT tax Disposition of stock triggers capital gain or loss if the stock is owned for at least two years after the ISO was granted and one year after the ISO was exercised If a disqualifying disposition occurs, employee recognizes OI equal to the lesser of (i) the Spread at the time the ISO was exercised or (ii) gain recognized upon disposition of the stock 23 Corporations Incentive Stock Options (ISOs) Optionee must be an employee Option must be granted within 10 years ISO plan was adopted or approved by shareholders Option cannot be exercised after 10 years from date of grant Exercise price must equal FMV at the time of grant Option must be non transferable Person to whom option is granted cannot own more than 10% of the corporation s stock at the time of grant unless certain special requirements are satisfied The aggregate FMV of stock that is first exercisable in a calendar year cannot exceed $100,000 Option plan must meet certain technical requirements (e.g., shareholder approval) Option must not state that it is not an ISO 24

13 Corporations Phantom Stock Contractual right to receive compensation (i.e., bonus) at certain times (e.g., sale of company) that is measured by the value of the stock of the corporation Often structured to give the employee a share of the appreciation of the value of the stock of the company from the date of grant Economically similar to an stock option Typically no requirement to pay an exercise price Amounts paid are taxed as compensation income 25 Corporations Stock Appreciation Rights Right to receive a payment equal to the increase in the value of the stock of a company over a specified period of time Normally paid out in cash but can also be paid in shares SARs are often exercisable after they vest Typically no requirement to pay an exercise price Amounts paid are taxed as compensation income 26

14 Corporations S Corporation Rules Stock that is subject to a SRF is not treated as outstanding until the forfeiture restrictions lapse or a 83(b) election is made (See Treas. Reg (b)(3)) No allocations of tax items if non vested with no Section 83(b) election Any distributions received are taxed as compensation income Second class of stock rules of Treas. Reg (l) 27 LLCs and Partnerships Overview Profits interests Capital interests (like restricted stock) Phantom equity 28

15 LLCs and Partnerships Profits Interests Background Right to share in the profits and appreciation in the value of the business that accrue after the grant of the interest Grant and vesting generally non taxable Gain on disposition often qualifies for LTCG treatment 29 LLCs and Partnerships Profits Interests Background Section 721 The value of an interest in partnership capital transferred to a partner as compensation for services constitutes income under Section 61 Diamond v. Commissioner (7 th Cir. 1974) Profits interest taxable sold within three months of grant Campbell v. Commissioner (8 th Cir. 1991) Profits interest not taxable because they were without fair market value when issued 30

16 LLCs and Partnerships Profits Interests Safe Harbor Rev. Proc Safe Harbor IRS will not treat the receipt of a profits interest as a taxable event for a person who receives a profits interest for services provided to a partnership Profits interest defined Partnership interest other than a capital interest Capital interest is an interest that would give the holder a share of the proceeds of the partnership s assets were sold at FMV and the proceeds were distributed in complete liquidation of the partnership 31 LLCs and Partnerships Profits Interests Safe Harbor Rev. Proc Safe Harbor Doesn t Apply When the interest relates to a substantially certain and predictable stream of income When the recipient disposes of the interest within two years of receipt If the interest is a limited partner interest in a publicly traded partnership 32

17 LLCs and Partnerships Profits Interests Non Vested Interests Rev. Proc non vested interests qualify for safe harbor treatment under the following conditions: Recipient must be treated as the owner from the date of grant Recipient must take into account the distributive share of income, gain, loss, deduction and credit associated with the interest for the entire period during which the recipient has held the interest Neither the partnership nor any of the partners may take a deduction for the FMV of the interest at the time of the grant or the vesting of the interest 83(b) election is not required Deemed 83(b) Election 33 LLCs and Partnerships Profits Interests Proposed Guidance Proposed regulations issued in 2005 All partnership interests issued in exchange for services will be treated as property subject to Section 83 No deemed 83(b) election as per Rev. Proc Liquidation value safe harbor Notice Rules would apply to partnership interests granted after regulations are finalized 34

18 LLCs and Partnerships Non Vested Capital Interests Crescent Holdings, LLC, et al, v. Commissioner, 141 T.C. No. 15 (2013) Reg (b)(1) a partner who receives a capital interest in exchange for services must recognize income equal to the FMV of interest received Reg (b)(1) doesn t address what happens if the capital interest is subject to a SRF Reg (a)(1) Transferor of the property is the owner of the property until the property becomes substantially vested 35 LLCs and Partnerships Non Vested Capital Interests Court in Crescent Holdings holds that 83 applies to a capital interest received in exchange for services Since the interest was subject to a SRF and no 83(b) election was made, under Reg (a) the transferor is treated as the owner of the property No income allocated in respect of the non vested capital interest Contrast with profits interests 36

19 LLCs and Partnerships When is a Partnership Interest a Profit Interest? Key to profits interest treatment is that the recipient must be entitled to receive nothing if the LLC s assets were sold for FMV and then distributed to the members on liquidation (Rev Proc ) Liquidating distribution provision of the LLC Agreement Priority for unreturned capital Liquidation based on capital accounts and capital accounts booked up Crescent Holdings, LLC, et al, v. Commissioner, 141 T.C. No. 15 (2013) Court concluded that employee entitled to participate in distributions from the partnership on liquidation in proportion to his percentage interest Liquidation in accordance with Percentage Interests without priority for unreturned capital would generally not qualify as a profits interest 37 LLCs and Partnerships Profits Interests Practical Issues Two year holding period What happens if holding period is not satisfied Transfers to affiliated entities Section 83(b) Elections Why make them? Rev. Proc treatment does not apply if the interest does not qualify as a profits interest under the Rev. Proc safe harbor Vesting of profits interest could trigger ordinary income Two year holding period and valuation issues 38

20 LLCs and Partnerships Profits Interests Practical Issues Tax Reporting Schedule K 1 with salary reported as guaranteed payments Form W 2? See Rev. Rul (partners may not be treated as employees) Self employment taxes Valuation Issues Appraisals? Good faith valuation Leveraged distributions Do holders of profits interests participate? 39 LLCs and Partnerships Profits Interests Potential Future Legislation Carried interest legislation Investment services partnership interests Profits interest granted in connection with the performance of services in an investment partnerships (e.g., private equity funds, hedge funds, and real estate investment funds) Capital gain allocated to the holder or realized by the holder from a sale of the partnership interest is taxed as ordinary income 40

21 LLCs and Partnerships Design Issues Profits interests need not be limited to a percentage of future profits Distribution waterfalls with catch ups Example First, to the holders of Capital Units, pro rata, in proportion to each holder s Unreturned Capital until each holder s Unreturned Capital is reduced to zero; Second, to the holders of the vested Profits Interest Units, pro rata, in accordance with the number of such Units held by each such holder until the total amount Distributed pursuant to Section 4.2(a) and this Section 4.2(b) is pro rata in accordance with the number of Profits Interest Units held by the holders of such Units; and Third, the balance, if any, to the holders of Units, pro rata in proportion to the Units held by each such holder. 41 LLCs and Partnerships Design Issues S corporations Drop down of assets to an LLC F reorganization transaction Rev. Rul

22 Thank You Contact Information Mark D. Salsbury Phone: (612) E mail: msalsbury@lindquist.com Lindquist & Vennum LLP 4200 IDS Center 80 South Seventh Street Minneapolis, MN 55402