September 2003 Executive Compensation Tax Update: Final Golden Parachute Regulations and More This summer has been an unusually busy season for important developments affecting the tax treatment of executive compensation. While some of these actions are of limited scope or remain to be formally adopted, others are long overdue and will have immediate significance. This Jones Day Commentaries provides a brief overview of each of the following developments and related practice points. Final golden parachute tax regulations Introduction of further legislation to overhaul nonqualified deferred compensation arrangements Proposal of comprehensive incentive stock option regulations A surprising appellate decision allowing a deduction for stock compensation that the employee failed to include in income IRS stock option tax shelter guidance Publication of a revenue ruling that analyzes stock option deductions after the issuer is acquired Final Golden Parachute Tax Regulations On August 1, 2003, the Treasury Department released final regulations interpreting the golden parachute tax rules sections 280G and 4999 of the Internal Revenue Code. The most significant aspects of the final regulations are as follows. The major impact is that 19 years after the enactment of section 280G, final interpretive regulations have been published, which will provide greater certainty and predictability in coping with the golden parachute tax rules. This also means that the flexibility in interpreting and applying section 280G that was previously afforded by the limited deference due to the proposed regulations will be replaced by the far greater controlling authority of the final regulations. The new safe harbor for determining the identity of shareholders for the private company shareholder approval exemption has been expanded from three months to six months prior to the section 280G change in ownership or control (a section 280G change ), regardless of when the shareholder approval vote is actually taken. The final regulations make clear that votes are permitted on only part of the payments made to one person and separately on the payments made to each person. The final regulations also permit substitution of an entity shareholder representative if the normal representative is a disqualified individual. The IRS refused, however, to reconcile the shareholder approval regulations with commercial reality by, for example, permitting shareholder approval when a contract is entered into and continued to require that disclosure be made to all of the shareholders even in situations where the necessary 75 percent approval could otherwise be obtained. Pursuant to new authorization provided in the final section 280G regulations, the IRS published additional guidance on the valuation of stock options (Revenue Procedure 2003-68) where the vesting of the option is accelerated in connection with the section 280G change and the option remains outstanding after the section 280G change (i.e., the option is not cashed out). This new guidance creates an 18- month post-section 280G change period in which to redetermine option valuations based on certain events during that period, such as a change in the continued employment of the optionee or in the stock volatility of the grantor of the option. Thus, for example, a reduction in the option term 2003 Jones Day. All rights reserved.
due to a termination of employment of the optionee within the 18-month period may be taken into account to reduce the section 280G option value. This flexibility will be helpful in bringing the computation of section 280G option values more in line with commercial norms. The IRS reiterated its earlier position, however, that option valuation may not be based solely on the option spread. In determining whether a section 280G change has occurred, the IRS did not budge from its denial of the effect of overlapping ownership of the companies participating in the transaction and refused to recognize other commercial realities. Taking overlapping ownership into account more accurately reflects the impact of a transaction on the ultimate shareholders and could in certain circumstances, such as in a so-called merger of equals, mean that no section 280G change would occur with respect to any participant to the transaction. The final regulations stress that in a transaction, a section 280G change will occur as to one and only one company, and that a section 280G change in ownership of assets or stock will always trump a section 280G change in control. Thus, for example, in an all-stock deal, a section 280G change will occur with respect to the smaller of two companies participating in a transaction, even if, in fact, the minnow has swallowed the whale and the board and management of the smaller company predominate after the transaction. The management of the larger company can thus be terminated without application of the golden parachute excise tax. The final regulations will generally apply to payments that are contingent on a section 280G change if the section 280G change occurs after December 31, 2003. Prior to that effective date, taxpayers may rely on the 1989 proposed regulations or the 2002 proposed regulations. In some cases, depending on the section 280G issue, it may be more or less advantageous to be under the final regulations. Consequently, it may be worthwhile to review the timing of potential end-of-year closings in light of the applicable section 280G regulations. Although it is not likely that existing change-in-control arrangements will need to be substantially revised in light of the revisions made in the final section 280G regulations since the effects of the final regulations have generally been anticipated, companies may nevertheless want to review how such arrangements will operate under the final regulations. Nonqualified Deferred Compensation Legislation On July 25, 2003, House Ways and Means Committee Chairman Bill Thomas introduced H.R. 2896, the American Jobs Creation Act of 2003. Section 1091 of the bill represents the latest legislative effort to regulate nonqualified deferred compensation arrangements and related security devices, including rabbi trusts. The proposed legislation is significant, especially in light of the nonqualified deferred compensation provisions that were contained in the May 2003 Senate bill but that were not included in the final bill enacted into law. Chairman Thomas approach is more moderate than that taken in the Senate bill and in other recent proposals aimed at curtailing the use of nonqualified deferred compensation arrangements. The Thomas bill would nevertheless substantially alter how nonqualified deferred compensation plans and related trust agreements are drafted and, if enacted, could necessitate extensive amendments to plans and trust agreements. In addition, careful planning would be needed to make the transition from current law to the new rules, which would become effective next year. The Thomas bill would greatly restrict the flexibility afforded in many nonqualified deferred compensation plans today. Haircut distributions, deferred roll-overs, and accelerated distributions based upon the financial health of the employer would be prohibited. Financial hardship distributions would be restricted to the extent currently provided in the section 457 regulations for plans of tax-exempt entities. Change-in-control payouts would be permitted only to the extent provided by regulation. Deferral election modifications would be subject to substantial constraints that would greatly impair their usefulness. Separation of service distributions for any key employee could commence no earlier than six months after the separation from service. Compared with the recent Senate bill, however, the Thomas bill would not limit deemed investment options nor prohibit stock option gain deferrals. Moreover, the Senate bill would have prohibited all change-in-control accelerations, financial hardship distributions, and deferral modifications. On the other hand, the Thomas bill would apply to all plan participants, whereas the Senate bill would have been limited to corporate insiders (and, in the case of private companies, to persons who would be insiders if the company were an SEC registrant). 2
The Thomas bill basically leaves rabbi trusts alone. Offshore trusts, however, would generally be prohibited. The Senate bill would virtually eliminate any practical use of rabbi trusts. Proposed Incentive Stock Option Regulations On June 6, 2003, the IRS released long-awaited proposed regulations that, in conjunction with existing regulations, will provide comprehensive guidance regarding incentive stock options ( ISOs ). The new proposed regulations replace regulations proposed in 1984 that were never finalized and provide interpretations for many subjects that were not addressed by the 1984 proposals. The new rules will apply to options granted more than 180 days after final regulations are published. Taxpayers are, however, permitted to rely on the new proposals for options granted on or after June 9, 2003. For the most part, the new guidance is helpful because specific rules are set forth where no formal guidance previously existed, ambiguities are clarified, and, in a few cases, prior restrictive interpretations have been relaxed to some extent. Nevertheless, even under the new proposals, obtaining and retaining the desired beneficial tax treatment for ISOs remains a difficult task that requires careful consideration of a multitude of technical rules. Some of the more significant aspects of the proposals include the following: In order to qualify as an ISO, the option must be granted under a shareholder approved plan that is subject to a limitation on the maximum number of aggregate shares that may be issued. The proposed regulations make clear that if the plan authorizes stock-based awards other than ISOs, a limitation on share issuance that satisfies the ISO rules must apply to all such awards. The IRS thus takes the position that the tax code may regulate the need for, and correct formulation of, a limitation on the aggregate number of shares that may be issued under an equity compensation plan as a condition of obtaining qualified status for ISOs. In addition, each such limitation must be expressed in a manner such that a fixed number is stated. For example, a limitation expressed as a percentage of shares outstanding from time to time will not meet this requirement. Also, certain share recycling provisions may violate this requirement. If this rule is included in the final regulations, a careful review of share issuance limitations may be advisable. If existing plans are amended to comply with this requirement, shareholder approval may be necessary ISOs may be granted only to employees (or designated classes of employees). The proposed regulations provide that if, as is often the case, stock-based awards may be made under the plan to individuals other than employees (e.g., outside directors or consultants), the plan must separately designate the employees or classes of employees eligible to receive ISOs. Plans are not necessarily drafted with this degree of precision. If this rule is finalized, these plans will need to be amended. The Code and existing and earlier proposed regulations provide rules for the preservation of ISO status in the event of substitutions and assumptions of ISOs resulting from certain transactions involving the issuer. The new proposed regulations expand upon these earlier rules, provide greater clarity, and, in general, facilitate obtaining favorable tax results. Existing regulations generally preclude adjustments to ISOs in response to a corporate transaction unless either (i) a significant number of employees are fired or transferred to a new employer, or (ii) a parent-subsidiary relationship is either created or terminated. The new proposed regulations sensibly eliminate this requirement. The new proposed regulations continue the earlier interpretation that a corporate transaction does not necessarily trigger further shareholder approval of ISOs or a plan. Generally, the prior approval by the issuing corporation s shareholders will suffice. The new proposed regulations also make clear that ISOs may be appropriately adjusted to reflect the loss of issuer value due to the payment of dividends (other than regular dividends) without forfeiting qualified status. Prior IRS private letter rulings had been inconsistent regarding this situation. One of the most contentious ISO rules is that an ISO that is modified is considered to have been regranted. If the deemed regranted ISO fails any requirement attendant to initial issuance, the most common being that an ISO cannot be in the money on the date of grant, the ISO is disqualified. In addition, the regrant causes the one- and two-year holding periods to restart and requires a retesting under the $100,000 limitation described below. Under existing rules, a modification means the grant of any additional benefit. In the new proposed regulations, the IRS has retreated from its onerous interpretation of this rule in certain limited respects. First, the IRS has eliminated one of the most troublesome sources of a potential modification by providing that no 3
modification occurs merely because an optionee is offered a change in the terms of an option so long as the change is not made. Previously, many practitioners believed, based on earlier authorities, that the mere unilateral offer of an additional benefit could constitute a modification. Second, the IRS has provided limited relief in the case where the original grant expressly reserves the issuer s discretion to provide an additional benefit in the following three areas: the payment of a bonus at exercise, providing a loan to assist exercise, or accepting previously owned shares in payment of the exercise price. Under the proposed regulations, the issuer s exercise of discretion in any of these three areas would not constitute a modification. An issuer s exercise of discretion outside the three areas, or even within the three areas where the original grant does not expressly reserve the discretion, on the other hand, would constitute a modification. Hopefully, the IRS will reconsider its position on this issue in the final regulations and provide greater flexibility. The new proposed regulations caution that good-faith estimates of share value for purposes of determining the ISO exercise price must take into account the effect of nonlapse restrictions and must be determined without regard to lapse restrictions. In addition, issuers must be careful to exclude from the ISO exercise price any amount that would be treated for tax purposes as interest. Failure to do so will violate the good-faith fair market value estimate rule. Compliance requires attention to ISO payment provisions to ensure that deferred payments for ISO shares are identified and properly taken into account in determining whether the full exercise price has been paid. The proposed regulations make clear that once a plan has been shareholder approved, a change in ownership of the issuer does not necessitate further shareholder approval. Thus, for example, if a stock plan has been approved by a subsidiary s sole shareholder and the subsidiary is subsequently spun off or otherwise disposed of, the change in ownership of the subsidiary, in and of itself, does not require plan approval by the new shareholders of the subsidiary. (This rule may be contrasted with the much more restrictive approach taken to shareholder approval in similar situations by the regulations issued under the $1 million cap.) However, if as a result of the transaction, the acquirer substitutes its options or assumes the subsidiary s options, the acquirer s actions must be pursuant to a plan approved by the acquirer s shareholders in order to continue ISO status of the subsidiary s options. The amount of stock subject to ISOs granted to one individual that may first become exercisable in any calendar year may not exceed $100,000. The excess is automatically treated as a nonqualified option. The proposed regulations build upon prior guidance to provide detailed rules explaining how the $100,000 limitation works in a variety of situations. The $100,000 limitation requires careful planning in structuring ISO grants and in planning for the tax consequences of accelerations of exercisability that may be triggered by a change in control, termination of employment, and other events that may be specified in option agreements. Caution is advised prior to including the $100,000 limitation as a contractual restriction on the exercisability of ISOs. Some contractual provisions inadvertently constrain the ability to exercise an option originally intended to be an ISO in a situation where the optionee would prefer to be able to exercise the option without regard to whether ISO tax benefits may be available. ISOs may be transferred to a grantor trust without losing tax benefits if the transferor is considered the sole beneficial owner of the option. ISOs that are transferred incident to a divorce or pursuant to a qualified domestic relations order immediately lose their preferred tax status. However, stock obtained by exercising an ISO may be transferred incident to a divorce without violating the holding period requirements. Unfortunately, the new proposed regulations raise or fail to address a number of important issues: The application of the alternative minimum tax to ISOs. Since taxpayers are permitted to rely on the new regulations for options granted on or after June 9, 2003, it is unclear what law applies to options granted prior to that date. It seems unlikely, however, that the IRS would assert a position that is contrary to the new proposed regulations. The impact on meeting ISO holding period requirements of entering into risk reduction strategies such as hedges with respect to stock obtained by exercising an ISO. Must the Employee Actually Include Stock Compensation Income in Order for the Employer to Get the Deduction? One of the most vexing aspects of whether an employer may obtain a deduction for stock compensation is the IRS insistence that either the employee actually include the amount in income or that the employer correctly report the amount 4
in a timely statement furnished to the employee. In a recent decision, the Court of Appeals for the Federal Circuit declined to follow the lower court decision by the Court of Federal Claims as well as earlier precedential holdings by the Tax Court and the 6th Circuit Court of Appeals, and held that the employer can obtain the deduction even when the employee has not included the compensation in income and the employer failed to report the amount in a timely manner. In Robinson v. U.S., decided on July 15, 2003, the employer sold stock to an employee. The shares were subject to forfeiture on early termination of employment. In order to benefit from capital gains treatment on future stock value appreciation, the employee made a section 83(b) election to include immediately in income the excess, if any, of the value of the stock over the amount paid by the employee. The employee took the position that the amount paid was equal to the value of the shares and did not report any income when the election was made. When the employee s employment was later terminated, the owners of the employer first learned that the section 83(b) election had been made. The owners believed that the value of the shares greatly exceeded their purchase price when the shares were sold and caused the employer to file a refund claim based upon the difference in value. Since the employee had not reported such amount as income, the IRS denied the refund claim based upon its long-standing interpretation of the governing statutory provision that sets the employer s deduction equal to the amount included in the employee s income. After an extensive review of the structure of large parts of the Internal Revenue Code, the Federal Circuit concluded that included meant includible, reversed the lower court, and approved the refund claim. Thus, there is now a conflict in the courts of appeal on the issue. In the meantime, employers may want to review any similar situations and consider filing refund claims where the facts fit within the Federal Circuit s reasoning. For example, it is sometimes unclear when and whether employer shares have vested sufficiently to warrant taxation, and the resulting income may not have been timely reported to the employee nor reported by the employee. In addition, companies may want to be mindful on a termination of employment of whether any of these types of issues exist, and if they do, whether they should be addressed in the termination agreement. Stock Option Tax Shelter Guidance In the days when stock option gains were substantial, one now well-publicized technique to defer, if not eliminate, the tax on the option income was for the option holder to sell the option to a family member, family trust, or family limited partnership in exchange for an unsecured interest-bearing note with a balloon principal payment due 15 years or more after the sale. The parties would take the position that the sale was at arm s length, within the meaning of the applicable tax regulations, thus terminating the compensation phase of the stock option, and that the option holder was entitled to installment sale treatment on the note. Accordingly, the optionee did not report any income upon the sale or the exercise of the option, and presumably would not report any income until the installment obligation was satisfied. The family purchaser of the option did not report any income when the option was exercised and little, if any, income when the option shares were promptly sold. In challenging the alleged tax treatment of the transaction, the IRS published guidance on July 2, 2003, that may have application outside of the specific tax shelter arrangements that inspired the publication of the guidance. New regulations effective July 2, 2003, provide that the disposition of a nonqualified stock option to a person related to the option holder will not qualify as an arm s-length transaction. As a result, when the option is eventually exercised or otherwise disposed of, the option spread or other consideration will be taxed to the original optionee. Because the applicable relationships are defined very broadly, the regulation will apply to many transactions that bear little resemblance to the transactions that were targeted by the IRS. In addition, the IRS formally announced that it will take the position that income cannot be deferred upon a disposition of a typical nonqualified stock option in exchange for an installment payment obligation, without regard to whether or not the disposition occurs in an arm s-length transaction. Thus, an arm s-length sale of a nonqualified stock option to an unrelated third party in exchange for an installment note will, in the view of the IRS, result in the immediate taxation of the seller. 5
Taxation of Target s Stock Options after the Acquisition of Target In Revenue Ruling 2003-98, published on July 25, 2003, the IRS appeared ready to address some of the difficult issues relating to the tax treatment of deductions generated by nonqualified stock options granted by the target corporation when the options are exercised or disposed of after the target has been acquired. Unfortunately, the four situations analyzed by the IRS in the ruling fail to raise issues that most trouble practitioners. In the first situation, all of the target stock is acquired, and the option is exchanged for an acquiring company option and later exercised for shares of the acquiring company. The facts are the same in the second situation, except that the option is canceled by the acquiring company in exchange for cash or acquiring company stock. In the third situation, the option remains exercisable for stock of the target company and is later canceled in exchange for cash or acquiring company stock. The last situation is identical to the first situation except that the target company is later merged with and into the acquiring company and the option is subsequently exercised for shares of the acquiring company. The IRS holds that in the first three situations, the target company gets the compensation deduction, and in the fourth situation, the acquiring company gets the deduction. These holdings are not surprising. In each of the four situations described in the ruling, the optionee remains employed by the issuer of the option or by the issuer s legal successor throughout the entire term of the option. The location of the compensation deduction would appear to be a foregone conclusion. Guidance is needed, however, in similar situations where the employment of the optionee is divided between the issuer and the acquirer during the term of the option and, particularly, where service during the option vesting period is divided between the issuer and the acquirer. There is no definitive authority controlling the location of the compensation deduction attributable to the option in such circumstances, including whether and on what basis, if at all, the deduction is to be allocated between the two employers. In an earlier ruling, Revenue Ruling 2002-1, which addressed the treatment of compensatory stock options in spin-offs, the IRS similarly failed to consider the treatment of the option deduction when the optionee has or had multiple employers during the option term. The absence of authority on these issues may suggest that where their resolution has economic significance, the parties address the issues by contractual provisions allocating the deductions on a mutually consistent basis. In practice, however, such allocations do not appear to be common. Further Information Jones Day Commentaries are a publication of Jones Day and should not be construed as legal advice on any specific facts or circumstances. The contents are for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Please contact your usual Jones Day lawyer or one of the lawyers listed below if we can be of further assistance. Joni Andrioff 312.269.4170 jlandrioff@jonesday.com Jim Carey 214.969.2929 jfcarey@jonesday.com John Cornell 212.326.8332 jrcornell@jonesday.com Dennis Drapkin 214.969.4850 dbdrapkin@jonesday.com Sarah Griffin 213.243.2560 sgriffin@jonesday.com Dan Hagen 216.586.7159 dchagen@jonesday.com Jim Landon 404.581.8907 jhlandon@jonesday.com Rory Lyons 404.581.8550 rlyons@jonesday.com Alan Miller 214.969.4559 asmiller@jonesday.com Ron Rizzo 312.269.1568 rsrizzo@jonesday.com Legal Minds. Global Intelligence. SM 6