Executives: What to know about your compensation if your company is sold

Executives: What to know about your compensation if your company is sold Please disable popup blocking software before viewing this webcast Original Publication Date: July 20, 2017 CPE Credit is not available for viewing archived programs

CPE reminders To receive CPE, you must be active for the entire webcast and respond to at least 75% of the polls. You will have 90 seconds to answer each poll. CPE is not offered for audio-only attendees or replay viewing. Group participation will not receive CPE. You must be logged in individually to receive CPE credit. Upon conclusion of the program, please complete the final evaluation and your CPE certificate will be available if you have met the minimum CPE requirements. Turn off all pop-up blockers to download your CPE certificate. Use Q&A to ask questions during the webcast. Grant Thornton LLP. All rights reserved. 2

For a better webcast experience Use a wired internet connection from your local office and turn off your computer's Wi-Fi signal. For optimal viewing speed, close all other applications, including Outlook. Most technical issues (e.g., buffering, silenced audio) can be resolved by refreshing your feed using the F5 key. Use the Help button if you have technical difficulties. You can also call 877.398.9939 or contact GTWebcast@Level3.com Click the Resources button to download the presentation materials. Grant Thornton LLP. All rights reserved. 3

Speakers Eddie Adkins Partner Washington National Tax Office +1 202 521 1565 eddie.adkins@us.gt.com Mark Ritter Managing Director Human Capital Services +1 404 704 0114 mark.ritter@us.gt.com Jeff Martin Senior Manager Washington National Tax Office +1 202 521 1526 jeffrey.martin@us.gt.com Grant Thornton LLP. All rights reserved. 4

Learning objectives Identify the various forms of your compensation that may be affected by the sale of your company Specify the tax impact of a sale of your company on your compensation arrangements Explore the implications of the section 280G golden parachute rules as they affect executives Recognize your post-sale compensation Grant Thornton LLP. All rights reserved. 5

Agenda Common forms of compensation Stock options Restricted stock Restricted stock units Deferred compensation Annual and transaction bonuses Severance Golden parachute payments Post-transaction considerations Grant Thornton LLP. All rights reserved. 6

Case study ABC, Inc. (hypothetical corporation) Proposed transaction: Buyer will acquire 100% of ABC's stock on August 1, 2017 Purchase price is $10 per share Negotiating whether part of the purchase price will be held back: Escrow for contingencies Earn-out based on post-closing goals Grant Thornton LLP. All rights reserved. 7

Case study Employee taxes: Ordinary federal income: 39.6% State income: 5% Medicare: 2.35% (regular 1.45% + additional 0.9%) Social Security: 0% (assume threshold already reached) Long-term capital gain: 20% Short-term capital gain: 39.6% Net investment tax: 3.8% (applies to capital gain and other passive income) Grant Thornton LLP. All rights reserved. 8

How are stock options affected? Generally, one of three things happens to stock options in a transaction: Exercised immediately before closing, followed by a sale of the stock to the buyer Cashed out (i.e., the option is canceled in exchange for a right to receive cash) Rolled over or assumed by the acquiring company Let's first consider the tax and economic (cash) differences between exercising an option and cashing out an option Grant Thornton LLP. All rights reserved. 10

Nonqualified stock options Sally is the CEO Holds 100,000 nonqualified stock options Exercise price is $2 60% is vested and 40% is not vested All options will vest on the transaction date Vesting of an option generally does not result in compensation income Grant Thornton LLP. All rights reserved. 11

Nonqualified options Situation #1 No escrow or earn-out Option exercised Sally exercises options before the transaction Pays the $2 exercise price Sells the stock to Buyer for $10 per share Compensation recognized on exercise date = FMV of stock on exercise date, less exercise price Capital gain (loss) = sale price basis Basis = exercise price paid + compensation recognized upon exercise Option cashed out Sally's options are canceled in exchange for a right to receive cash from transaction proceeds in excess of exercise price Compensation = cash received Compensation recognized when cash paid No capital gain or loss Grant Thornton LLP. All rights reserved. 12

Nonqualified options Situation #1 Compensation income recognized on August 1, 2017: Options exercised FMV of stock $10 Exercise price $2 Comp. per option $8 Total comp. $800,000 Tax* $375,600 Net cash $424,400 Options cashed out Cash paid $8 Exercise price $0 Comp. per option $8 Total comp. $800,000 Tax* $375,600 Net cash $424,400 *Taxes include 39.6% federal, 5% state, 2.35% Medicare Grant Thornton LLP. All rights reserved. 13

Nonqualified options Situation #1 Capital gain for options exercised Basis: exercise price + compensation recognized Basis = $10 per share ($2 + $8) Long-term capital gain: stock (not option) is held for more than one year Short-term capital gain: stock is held for one year or less Sally's capital gain: $0 Basis of $10 = purchase price of $10 No capital gain or loss when options are cashed out Grant Thornton LLP. All rights reserved. 15

Nonqualified options situation #2 Sales proceeds subject to escrow and earn-out Structure of the deal $4 paid at closing $2 held back in escrow, subject to contingencies $2 paid only if certain post-transaction performance goals are met Total paid = $8 ($10 purchase price - $2 exercise price) Grant Thornton LLP. All rights reserved. 16

Nonqualified options Situation #2 Sale proceeds subject to escrow and earn-out Option exercised Sally exercises options before the transaction Pays the $2 exercise price Sells the stock to Buyer for $10 per share Compensation recognized on exercise date = FMV of stock on exercise date, less exercise price Capital gain (loss) = sale price basis Basis = exercise price paid + compensation recognized upon exercise Option cashed out Sally's options are canceled in exchnage for a right to receive cash from transaction proceeds in excess of exercise price Compensation = cash received Compensation recognized when cash paid No capital gain or loss Challenge: What is the fair market value of the stock on the closing date? Grant Thornton LLP. All rights reserved. 17

Nonqualified options Situation #2 Fair market value of the stock on the closing date: Should be determined by a valuation expert Minimum fair market value: $6 (amount paid at closing before reduction for exercise price) Maximum fair market value: $10 (maximum amount that can be paid before reduction for exercise price) Likely somewhere between $6 and $10 Must value the $2 of escrow and $2 of earn-out based on likelihood it will be paid Assume ABC, Inc. determines the fair market value is $8.50 Grant Thornton LLP. All rights reserved. 18

Nonqualified options Situation #2 Compensation income recognized on August 1, 2017: Options exercised FMV of stock $8.50 Exercise price $2 Comp. per option $6.50 Total comp. $650,000 Tax* $305,175 Cash at closing $400,000 Net cash $94,825 Options cash out Cash paid $4 Exercise price $0 Comp. per option $4 Total comp. $400,000 Tax* $187,800 Cash at closing $400,000 Net cash $212,200 *Taxes include 39.6% federal, 5% state, 2.35% Medicare Grant Thornton LLP. All rights reserved. 19

Nonqualified options Situation #2 Exercised option: Sally's basis in the stock: $8.50 $2.00 exercise price + $6.50 compensation Assuming Sally elects the installment method for recognizing the capital gain, gain is recognized in 2017 and 2018 We will calculate the capital gain and the tax effect in the aggregate All capital gain is short-term because the transaction closed within one year after Sally exercised her options Grant Thornton LLP. All rights reserved. 21

Nonqualified options Situation #2 Tax Effect of September 1, 2018 when escrow and earn-out are settled Options exercised Total proceeds $10 Basis $8.50 Cap gain $1.50 Total cap gain $150,000 Tax on cap gain* $72,600 Options cash out Cash paid $4 Comp. per option $4 Total comp. $400,000 Tax on comp.** $187,800 *Taxes include 39.6% federal, 5% state, 3.8% NIT **Taxes include 39.6% federal, 5% state, 2.35% Medicare Grant Thornton LLP. All rights reserved. 22

Nonqualified options Situation #2 Cash summary Options exercised Total cash paid $800,000 Comp. taxes $305,175 Cap gain taxes $72,600 Total tax $377,775 After-tax cash $422,225 Options cash out Total cash paid $800,000 Comp. taxes $375,600 Cap gain taxes $0 Total tax $375,600 After-tax cash $424,400 Difference in total tax is the difference between the Medicare tax on compensation (2.35%) and the net investment tax on capital gain (3.8%) Grant Thornton LLP. All rights reserved. 23

Nonqualified options Situation #3 Same facts as situation #2, except only $2 of escrow is paid on September 1, 2018 The $2 of earn-out is not paid and is forfeited because the post-transaction goals were not met Tax on closing date does not change Exercised options: $650,000 of compensation recognized on August 1, 2017 because the fair market value of the stock was determined to be $8.50 Cash ultimately paid does not affect compensation, but it does affect the capital gain Cashed out options: $400,000 paid at closing is compensation Difference is tax in 2018 when the escrow is paid Grant Thornton LLP. All rights reserved. 24

Nonqualified options Situation #3 Tax Effect of September 1, 2018 when escrow and earn-out are settled Options exercised Total proceeds $8.00 Basis $8.50 Cap loss <$0.50> Total cap loss <$50,000> Tax on cap gain $0 Options cash out Cash paid $2 Comp. per option $2 Total comp. $200,000 Tax on comp.** $93,900 **Taxes include 39.6% federal, 5% state, 2.35% Medicare Grant Thornton LLP. All rights reserved. 25

Nonqualified options Situation #3 Cash summary Options exercised Total cash paid $600,000 Comp. taxes $305,175 Cap gain taxes $0 Total tax $305,175 After-tax cash $294,825 Options cash out Total cash paid $600,000 Comp. taxes $281,700 Cap gain taxes $0 Total tax $281,700 After-tax cash $318,300 When options are exercised, Sally pays ordinary income tax and Medicare tax on $50,000 of compensation that she never receives Grant Thornton LLP. All rights reserved. 26

Sally's reaction She is not happy about the possibility of recognizing income that she may never receive as cash She is also not happy about paying tax at a higher rate on short-term capital gain than on compensation income She does not like receiving so little after-tax cash at closing Solution! Cash out the options instead of exercising them Grant Thornton LLP. All rights reserved. 27

Nonqualified options Assumed by Buyer Buyer and ABC, Inc. may agree that any outstanding options at the transaction date will be assumed by Buyer The option becomes an option to purchase Buyer's stock Vesting may or may not be accelerated (depends on the terms of the stock option plan) Assumption must comply with section 409A The exercise price and number of options may be adjusted Aggregate intrinsic value of the options must be the same immediately before and after the assumption Grant Thornton LLP. All rights reserved. 28

Incentive stock options (ISOs) Options designed to meet the requirements of section 422 No compensation upon grant or exercise Capital gain recognized when the stock is sold Exception disqualifying disposition occurs when stock is sold within 2 years after the ISO is granted, or 1 year after the ISO is exercised Grant Thornton LLP. All rights reserved. 29

ISO disqualifying disposition Loss of tax favorable ISO treatment Recognize compensation income in the year of the disqualifying disposition Compensation income is equal to the lesser of: FMV of the stock of the exercise date, less the exercise price, or Sale price of the stock, less the exercise price Income from a disqualifying disposition is not subject to payroll taxes, so no Medicare or social security tax is withheld Grant Thornton LLP. All rights reserved. 30

Alternative treatments of an ISO in a transaction Exercise the ISO immediately prior to the transaction, followed by a sale of the stock Results in a disqualifying disposition Recognize compensation income subject to normal income tax, but avoid Medicare and social security tax Warning: no income tax is withheld, so estimated tax payment may be needed The ISO is canceled in at the time of the transaction in exchange for future cash payments from the transaction proceeds No disqualifying disposition because the ISO was not exercised The cash payment is treated the same as a bonus payment (subject to income tax, Medicare and social security tax withholding) Grant Thornton LLP. All rights reserved. 31

Sally's ISOs Sally holds 100,000 ISOs Exercise price is $2 All vested at the time of the transaction Buyer will pay $10 per share for ABC, Inc.'s stock, all of which is paid at closing Grant Thornton LLP. All rights reserved. 32

ISO example Exercise vs. cash out Compensation income recognized on August 1, 2017: Options exercised FMV of stock $10 Exercise price $2 Comp. per option $8 Total comp. $800,000 Tax* $356,800 Net cash $443,200 Options cash out Cash paid $8 Exercise price $0 Comp. per option $8 Total comp. $800,000 Tax** $375,600 Net cash $424,400 $18,800 more after-tax cash when ISOs are exercised instead of being cashed out because no Medicare tax *Taxes include 39.6% federal, 5% state **Taxes include 39.6% federal, 5% state, 2.35% Medicare Grant Thornton LLP. All rights reserved. 33

ISO Exercise vs. cash out More after-tax cash received when the ISO is exercised Why cash out an ISO? Consider situations where some of the transaction proceeds are held back in escrow or are subject to an earn-out See Sally's concerns with respect to exercising nonqualified options Could receive less cash if the escrow or earn-out is not paid Grant Thornton LLP. All rights reserved. 34

Restricted stock Definition: stock is transferred to Sally on the grant date, subject to vesting conditions Compensation is equal to the FMV of the stock, less the amount paid, if any, for the stock Timing: General: Measured and recognized on the date the stock becomes vested Exception for a section 83(b) election: measured and recognized on the grant date Grant Thornton LLP. All rights reserved. 36

Sally's restricted stock 40,000 restricted shares granted to her on January 1, 2017 Cliff vest on January 1, 2020 as long as Sally remains employed on the vesting date No section 83(b) election All shares vest upon a change in control All of Sally's shares will vest on August 1, 2017 when Buyer purchases 100% of ABC, Inc.'s stock Grant Thornton LLP. All rights reserved. 37

Restricted stock situation #1 Compensation on August 1, 2017: FMV of stock $10 Total compensation $400,000 Tax* $187,800 Net cash $212,200 *Taxes include 39.6% federal, 5% state, 2.35% Medicare Grant Thornton LLP. All rights reserved. 38

Restricted stock situation #1 No capital gain (loss) is recognized when Sally sells her stock to Buyer Basis = compensation recognized ($10) + amount paid ($0) Buyer's purchase price ($10) = basis ($10) There is no "cash out" alternative for restricted stock If ABC cashes out Sally's restricted stock, it is the same as the stock first becoming vested, followed by a sale of the stock back to ABC. The vesting triggers the compensation Grant Thornton LLP. All rights reserved. 39

Restricted stock situation #2 What if Sally made a section 83(b) election on January 1, 2017 when the stock was granted to her? FMV of the stock on January 1, 2017 was $6 Sally paid nothing for the stock Compensation on January 1, 2017 FMV of stock $6 Total compensation $240,000 Tax* $112,680 *Taxes include 39.6% federal, 5% state, 2.35% Medicare Grant Thornton LLP. All rights reserved. 40

Restricted stock situation #2 Sally has basis in her stock of $240,000 ($6 per share) Capital gain holding period begins on the grant date when a section 83(b) election is made Consider two alternative facts: Transaction closes on August 1, 2017 Transaction closes on August 1, 2018 Grant Thornton LLP. All rights reserved. 41

Restricted stock situation #2 August 1, 2017 Sale price $10 Basis $6 Short-term capital gain $160,000 Cap gain tax* $77,440 Compensation tax $112,680 Total tax $190,120 August 1, 2018 Sale price $10 Basis $6 Long-term capital gain $160,000 Cap gain tax** $46,080 Compensation tax $112,680 Total tax $158,760 $31,360 less tax paid when section 83(b) election is made more than 1 year before the transaction *Taxes include 39.6% federal, 5% state, 3.8% NIT **Taxes include 20% federal, 5% state, 3.8% NIT Grant Thornton LLP. All rights reserved. 42

Restricted stock situation #3 Buyer may require Sally's restricted stock be converted into restricted stock of Buyer Vesting does not accelerate The same or an adjusted vesting schedule may apply to the Buyer restricted stock Important: consider making a section 83(b) election on the Buyer restricted stock The ABC, Inc. restricted stock is treated as an amount paid for the Buyer restricted stock If the total FMV of the ABC, Inc. restricted stock on the transaction date equals to the total FMV of the Buyer restricted stock, then $0 compensation as a result of the election If a section 83(b) election is not made on the Buyer stock, then any appreciation between the transaction date and vesting date is treated as compensation See Rev. Rul. 2007-49 for more tax consequences (capital gain) of this type of transaction Grant Thornton LLP. All rights reserved. 43

Restricted stock units (RSUs) Definition: On the grant date, ABC, Inc. promises to transfer stock or cash to Sally at a future date Distinguished from restricted stock stock transferred on the grant date Compensation is recognized when the cash or stock is transferred to Sally Amount of compensation: Amount of cash paid, or The FMV of the stock on the date the stock is transferred to Sally A section 83(b) election cannot be made on RSUs because stock is not transferred prior to vesting date Grant Thornton LLP. All rights reserved. 45

Common RSU designs 1. Subject to vesting requirements, and settled upon vesting The RSU plan or agreement may provide that vesting is accelerated upon a change in control, resulting in compensation when the RSU is settled RSU settlement: may result in cash paid at closing and cash paid from escrow and/or from an earn-out No capital gain with respect to the RSU Grant Thornton LLP. All rights reserved. 46

Common RSU designs 2. Subject to vesting requirements, and settled at a future date after vesting (e.g., separation from service or a change in control) This RSU may be deferred compensation subject to section 409A See the deferred compensation discussion that follows If the terms of the RSU provide for payment upon a change in control, you will receive cash when the change in control occurs and possibly from escrow and/or from an earn-out in the future. Recognize compensation income when the cash is paid Grant Thornton LLP. All rights reserved. 47

Deferred compensation Two types of plans 1. Not subject to section 409A: paid to you within 2½ months after the later of (i) your taxable year when it vests, or (ii) the company's taxable year when it vests Referred to as a short-term deferral, which is exempt from section 409A 2. Subject to section 409A: Will or may be paid after the short-term deferral period discussed above Deferred compensation can be subject to section 409A without triggering a penalty by complying with section 409A If the section 409A rules are not followed, then penalties are triggered, including a 20% additional income tax that is imposed on the employee Grant Thornton LLP. All rights reserved. 49

Plans exempt from section 409A Plan may provide for immediate vesting and payment upon a change in control Results in compensation income when cash is paid to you If the plan does not provide for vesting upon a change in control: The company may decided to vest it anyway, resulting in a payment to you, or You may be required to meet the vesting conditions after the transaction in order to receive payment No compensation income when the transaction occurs Grant Thornton LLP. All rights reserved. 50

Plans subject to section 409A When you begin participating in the plan, the plan must state the payment triggers One of the permissible payment triggers is a change in control If the plan provides for payment upon a change in control, you will receive payment and recognize income in accordance with the plan's payment schedule If the plan does not specify a change in control as a payment trigger: Generally a payment cannot be made when the transaction closes Exception: Section 409A allows the employer to terminate and liquidate the deferred compensation plan for all participants upon a change in control, resulting in a payment to you Be very careful to comply with all section 409A rules to avoid penalty Grant Thornton LLP. All rights reserved. 51

Annual bonus You might participate in an annual bonus plan Discretionary plan or performance-based plan Does the plan provide for payment upon a change in control? Full bonus payment Prorated bonus payment If the plan is informal or does not provide for payment upon a change in control, you may be able to negotiate an early bonus payment Grant Thornton LLP. All rights reserved. 53

Transaction bonus Bonus paid upon the successful completion of the transaction Likely requires you to be employed until the transaction closes May provide for payment upon closing if you are involuntarily terminated without cause within a certain period of time (e.g., 6 months) prior to closing Amount of the bonus: A specified amount Amount is based on a formula (e.g., X% of purchase price over $Y) Discretionary amount Grant Thornton LLP. All rights reserved. 54

Tax treatment of cash bonuses Closing of the transaction generally does not trigger compensation income Generally, included in compensation when paid to you Typical payment structures: Payable immediately upon closing Payable a certain period of time after closing (deferred compensation) Payable only if you work for the buyer for a certain period of time after closing If payable after closing, beware of the section 409A deferred compensation rules Grant Thornton LLP. All rights reserved. 55

Severance agreement It's for your protection Generally payable if you are involuntarily terminated without cause or you voluntarily terminate employment for good reason Change in control provisions: Might be payable only if you are terminated within a certain period of time before or after a transaction Might provide for a larger payment if terminated within a certain period of time before or after a transaction May provide for company-paid heath benefits (and other fringe benefits) after termination Grant Thornton LLP. All rights reserved. 57

Severance agreement Generally included in compensation income when paid Consider when your severance will be paid Lump-sum upon termination Continued salary payments for a certain number of months Annual installments Public companies: might not receive some or all of the severance for at least 6 months after termination (section 409A rule) Grant Thornton LLP. All rights reserved. 58

What are parachute payments? Four elements must be in place for a parachute payment to exist: 1. A change in control ( CIC ) 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 CIC Applies to corporations, both private and public Does not apply to corporations that qualify for S corporation status Does not apply to partnerships Grant Thornton LLP. All rights reserved. 60

Why care about parachute payments? Adverse tax consequences for "excess" parachute payments Employee pays a 20% excise tax Employer loses the deduction Withholding and reporting requirements for employers Gross-up payments may be required under agreements "Hair cut" provisions may be in place Representations in the transaction document Grant Thornton LLP. All rights reserved. 61

Examples of parachute payments Stock options Restricted stock RSUs Deferred compensation Annual bonus Transaction bonus Severance Fringe benefits Retention bonus Loan forgiven Non-compete payment Signing bonus Grant Thornton LLP. All rights reserved. 62

When do the penalties apply? Two-step process 1. Excess parachute payments exist only if the total parachute payments exceed a threshold amount Threshold: Three times average annual compensation over the 5 years prior to the year of the CIC Annual compensation: Amount reported to the disqualified individual on Form W-2 or Form 1099 2. Excess parachute payments equal the total parachute payments, less one times the threshold amount Grant Thornton LLP. All rights reserved. 63

Example 1. First, determine whether excess parachute payments exist 2. Calculate excess parachute payments Total parachute payments: $1,000,000 Less: 1 times average annual comp. <$300,000> Excess parachute payment $700,000 Grant Thornton LLP. All rights reserved. 64

Avoiding the penalties Shareholder approval of parachute payments Available only to private corporations If approved, payments are excluded from parachute payments Greater than 75% approval is required Must disclose all parachute payments to all shareholders prior to the vote Grant Thornton LLP. All rights reserved. 65

Avoiding the penalties Reasonable compensation Parachute payments do not include reasonable compensation for services performed on or after the date of the CIC Most effective because it reduces the parachute payments prior to the three times base amount test Excess parachute payments may be reduced by reasonable compensation for services performed prior to the CIC Reduces the amount subject to the penalties Grant Thornton LLP. All rights reserved. 66

Post-transaction considerations Remaining with the company after the transaction Negotiate a new employment agreement before the transaction closes Retention bonus? Equity awards? Severance provisions? Employee protection: Compensation vests or is paid upon involuntary termination without case or voluntary termination with "good reason" Grant Thornton LLP. All rights reserved. 68

Post-transaction considerations Leaving the company Do you have a severance agreement, and is the value appropriate? Will you be subject to a non-compete? If a non-compete is added to your agreement, it may be appropriate that you receive additional consideration Grant Thornton LLP. All rights reserved. 69

Disclaimer This Grant Thornton LLP presentation is not a comprehensive analysis of the subject matters covered and may include proposed guidance that is subject to change before it is issued in final form. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this presentation. The views and interpretations expressed in the presentation are those of the presenters and the presentation is not intended to provide accounting or other advice or guidance with respect to the matters covered For additional information on matters covered in this presentation, contact your Grant Thornton, LLP adviser Grant Thornton LLP. All rights reserved. 72

Thank you for attending To retrieve your CPE certificate Respond to online evaluation form. Please note you may need to disable pop-up blocking software to complete this evaluation Print your CPE Certificate and retain for your records. Participants are responsible to maintain CPE completion records Those receiving CPE will also receive the certificate at the email address used to register for the webcast We are unable to grant CPE credit in cases where technical difficulties preclude eligibility. CPE program sponsorship guidelines prohibit us from issuing credit to those not verified by the technology to have satisfied the minimum requirements in monitoring response and viewing time If you experience any technical difficulties, please contact 877.398.9939 or email GTWebcast@level3.com Grant Thornton LLP. All rights reserved. 73

Thank you for attending Visit us online at: www.grantthornton.com twitter.com/grantthorntonus linkd.in/grantthorntonus To receive future Grant Thornton CPE tax webcast invites, email Julia.Dolinsky@us.gt.com For questions regarding your CPE certificate, contact CPEEvents@us.gt.com Grant Thornton LLP. All rights reserved. 74