Compensating Management with Equity In the Post-COVID World
June 29, 2020
Business is back . . . Sort of
As the country begins its hoped-for recovery from the disruptive economic effects of the COVID-19 virus – or, more accurately, from the measures implemented by government to contain the spread of the virus – some closely held businesses will emerge relatively unscathed while others will not survive, and some will be on life support for some time before their fate is settled while others will remain in business, albeit on a different scale than that at which they were operating before the economic shutdown.
For many businesses in this last group, the recent downturn may have represented the proverbial “wake-up call,” having exposed weaknesses in the business, especially the lack of cash reserves or other readily accessible sources of liquidity.[i] In some cases, the owners of the business will seek to redress these problems in order to ensure the business’s continued and, perhaps, more profitable existence. In others, the owners will decide that it is time to prepare the business for sale – whether as a “marriage of survival” or as an exit strategy – to a competitor, a private equity fund, or some other buyer.[ii]
Retention of Key Employees
In several of these scenarios, the successful turnaround of the business, or the preparation of the business for sale, will depend upon the continued employment and efforts of the business’s key service providers.
What’s more, it may be equally as important to ensure that these key people remain with the business after its sale. After all, in light of the havoc wreaked by the coronavirus shutdown upon the finances of so many businesses, it may be difficult for a buyer to determine an accurate purchase price for a target business based upon a typical “multiple of EBITDA”[iii] calculation. Instead, many buyers will likely insist upon making the payment of a significant portion of the purchase price contingent upon the target’s satisfaction of certain defined financial thresholds over some period of time– an “earnout.”[iv] What better way to increase a seller’s chances of hitting these earnout targets than by ensuring that the seller’s key employees remain with the business after its sale?
In either case – be it for purposes of a turnaround or a sale – the owners of the closely held business will have to consider how to retain and reward these key employees. This may present a more difficult challenge today than before the shutdown. Specifically, many owners who have just experienced severe cash flow problems may now be less willing to part with cash, and relatively more receptive to granting equity interests in the business to their key people. By the same token, these key employees may be more insistent upon having an actual ownership stake in the business, along with a say in its operation, not to mention an opportunity to realize the appreciation in the value of their equity[v] as capital gain – rather than as ordinary income[vi] – on the disposition of the business.[vii]
Although the issuance of equity by an employer-business to some of its top employees may seem like a relatively straightforward affair, there are actually many factors to consider before agreeing to such an issuance.
For example, how should the equity be valued; can the terms of the issuance, including transfer restrictions, influence the determination of value; should the employee pay for some portion of the equity; should the employee’s ownership be contingent upon their satisfaction of certain performance criteria; should their equity have voting rights; how will the employee pay any income tax liability arising from the receipt of equity?[viii]
The answers to these questions will help to determine the income tax consequences to the employee arising from their receipt of equity in the employer. In turn, these consequences will influence the employee’s negotiating position.
Before we consider a recent decision[ix] in which the taxpayers received equity in a corporation – ostensibly in exchange for their future services to the corporation[x] –let’s first briefly explore the applicable rules that determine the tax treatment of such a stock issuance. Both the employer and the key employee should be familiar with these rules if they hope to negotiate an equity-based compensation arrangement that makes economic sense for both of them.
In general, under Section 83 of the Code, if a service recipient transfers equity in the service recipient to a service provider as compensation in exchange for their services, the service provider must include the fair market value of such equity in their gross income unless the service provider’s rights in such equity are not transferable and are subject to substantial risk of forfeiture; i.e., “restricted stock.”[xi]
Stated differently, the fair market value of the equity will be includible in the service-provider’s gross income at the time their rights in the equity become transferable or are no longer subject to substantial risk of forfeiture (i.e., when they vest), whichever occurs first.[xii] This amount, which may be greater than the fair market of the equity at the time it was issued to the service provider, will be treated as compensation, which is taxable as ordinary income.[xiii] The service provider’s holding period for the equity will begin with the inclusion of its value in their gross income;[xiv] their basis for the equity will be equal to its fair market value.
For purposes of this rule, an employee’s rights are “subject to substantial risk of forfeiture” if they are conditioned upon the employee’s future performance of substantial services, or upon the satisfaction of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.[xv]
Alternatively, a taxpayer whose rights to the equity are subject to a substantial risk of forfeiture may elect to include in their income for the year in which they receive the equity an amount equal to its fair market value.[xvi] If an employee makes such an election, they will not be required to include the value of the equity in their income when the equity subsequently vests in the hands of the employee. In other words, the election cuts off the compensatory element associated with the equity.[xvii] What’s more, the electing employee’s holding period in the equity will begin with the year it was received; this affords the employee a greater opportunity to recognize any appreciation in the value of the equity as capital gain.
For the year in which the employee is required to include in their gross income the value of the employer stock, the employer is allowed to claim a deduction for an amount equal to the amount included in the gross income of the employee.[xviii]
In the case of an employer that is an S corporation, any stock in the corporation “that is issued in connection with the performance of services . . . and that is substantially nonvested . . . is not treated as outstanding stock of the corporation” for tax purposes.[xix] As such, profits or losses of the S corporation-employer will not flow through to an employee-holder of non-vested stock, and is not required to be included in the holder’s gross income.[xx]
Now we can see how these rules were applied by the taxpayers in the decision discussed below.
Taxpayers owned and operated of a group of corporations and limited liability companies (the “Businesses”). They decided to consolidate these separate entities into a single holding company (“Corp”), for which they elected S corporation status.[xxi] The goals of this restructuring were as follows: (1) to allow assets to be moved more efficiently between the Businesses; (2) to reduce the number of tax and financial filings the Businesses were required to make; and (3) to achieve “substantial tax benefits.”
To effectuate the contemplated reorganization, each Taxpayer transferred the entirety of his equity in the Businesses to Corp in exchange for shares of Corp common stock.[xxii]
Simultaneously with their receipt of the Corp stock, Taxpayers executed two collateral agreements, the Restricted Stock Agreement (“RSA”) and the Employment Agreement (“EA”). Taken together, these agreements provided that either Taxpayer would forfeit at least 50 percent of the value of his Corp stock if he voluntarily terminated his employment with Corp before the fifth anniversary of the EA.[xxiii] In other words, the agreements represented a substantial risk of forfeiture.
The ownership of Corp was further divided over the next few years. An ESOP[xxiv] was organized which purchased shares of Corp common stock; Taxpayers were among the beneficiaries of the ESOP. Each Taxpayer subsequently transferred some of their restricted shares of Corp stock to irrevocable grantor trusts[xxv] established for the benefit of their families. These shares remained subject to substantial risk of forfeiture under the RSA and EA.[xxvi]
Taxpayers hoped to utilize the foregoing structure and agreements to defer their Federal income tax on Corp’s profits.
Relying upon the principles described above, and in combination with the fact that the ESOP was a tax-exempt entity, Taxpayers sought to avoid reporting any income from Corp on their federal tax returns during the years at issue despite the fact that Corp was profitable during that period.
In short, Taxpayers took the position that their stock (and that owned by their grantor trusts) was subject to a “substantial risk of forfeiture” and was thus “substantially unvested.” Because the shares owned by Taxpayers and the trusts were not deemed to be outstanding, Corp allocated 100 percent of its income for the years at issue (the “First Period”) to the tax-exempt ESOP. Consistently with Corp’s reporting, neither Taxpayer reported any flow-through items from Corp on his tax return during the First Period. And because the ESOP was a tax-exempt entity, it likewise reported no taxable income from Corp for the First Period. In other words, no one paid any federal income tax on Corp’s profits.
Taxpayers subsequently undertook to restructure their business operations a second time, in order to attract greater outside investment, which they felt would be difficult while the business continued to operate as an S corporation.
To effectuate this restructuring, Taxpayers formed Holdings, an LLC in which they each held a 50 percent interest. Holdings purchased all of Corp’s operating assets in exchange for an interest-bearing promissory note and the assumption of various liabilities. Though Corp realized millions of dollars of capital gain on this sale, it allocated the entirety of that gain to the tax-exempt ESOP, which, according to Taxpayers, was still the only outstanding shareholder of Corp.
The following year, the restrictions imposed by the RSA and EA on Taxpayers’ Corp stock lapsed and their shares became fully vested, as did those held by the trusts. At that point, based on the rules described above, one would have expected Taxpayers to include the fair market value of the previously restricted stock in their gross income.
Taxpayers, however, entered into identical “surrender” and “subscription” agreements with Corp (the “Surrender Transactions”), pursuant to which Taxpayers purported to (1) return the entirety of their newly vested shares to Corp, and (2) simultaneously purchase an identical number of shares from Corp in exchange for a promissory note. On their tax returns for that year, Taxpayers reported a modest (compared to the value of the formerly restricted stock) amount of compensation income equal to the difference between the fair market value of the new Corp shares and the face amount of the note given to purchase the new shares.
During that same year, Corp redeemed the Corp shares owned by the ESOP, at which point Corp became entirely owned by Taxpayers and their trusts.
The IRS and the Tax Court
The IRS examined Taxpayers’ respective income tax returns for the First Period and for the year that their shares vested.
Following its examination, the IRS issued timely notices of deficiency in which it asserted that Taxpayers’ stock in Corp was substantially vested upon its original issuance to Taxpayers, such that Taxpayers were required to report their pro rata shares of Corp’s income for each succeeding year; and (2) even if the stock did not substantially vest until the RSA restrictions lapsed, Taxpayers should have reported the fair market value of that stock as taxable income in that year, notwithstanding their purported “surrender” of the shares.
Taxpayers disputed the IRS’s findings and sought redetermination in the Tax Court.[xxvii]
The Tax Court held that Taxpayers’ Corp stock remained subject to a substantial risk of forfeiture until the RSA restrictions lapsed. Because Taxpayers’ shares were not substantially vested during the First Period, they were not required to report Corp’s income on their individual returns during that period.
But the Tax Court agreed with the IRS that the fair market value of the restricted stock should have been treated as compensation income to Taxpayers at the time the stock became substantially vested. At that point, the Tax Court stated, each Taxpayer “received taxable compensation” and could not “unring this bell by subsequent actions with respect to the stock, whether that action consisted of sale to a third party or surrender to the corporation.”
Likewise, the Tax Court concluded that both the Surrender Transactions and the promissory notes delivered to Corp as part of those Transactions were “palpably lacking in economic substance” and should be disregarded in calculating their tax liability. According to the Tax Court, the Transactions were undertaken for no purpose other than avoiding tax liability, and had no reasonable possibility of generating an economic profit.
Taxpayers appealed the Tax Court’s decision to the Federal Court of Appeals.
The Fourth Circuit
Taxpayers argued that they were not required to report as compensation income the fair market value of the formerly restricted stock that they realized when their Corp shares vested. Although Taxpayers did not seriously contest this point, they maintained that the subsequent Surrender Transactions effectively negated or reversed their receipt of this compensation, such that they were not required to include it in their gross income.
The Court explained that it is a well-settled principle of tax law that compensation is included in the taxable income of the person who earned it, notwithstanding any assignment or transfer of that compensation to a third party. Thus, the Court continued, the mere fact that Taxpayers purported to return their vested shares back to Corp had no effect on their individual tax liability.
Taxpayers also argued that the Surrender Transactions effectuated a complete rescission of their contractual agreements with Corp, and because that rescission occurred in the same year as Taxpayers’ receipt of compensation income under those agreements, that income should be disregarded for Federal income tax purposes.
Again, the Court disagreed. The Surrender Transactions, it found, did not restore Taxpayers “to the relative positions that they would have occupied had no contract been made,” which is a fundamental requirement for application of the rescission doctrine.[xxviii] “Put simply,” the Court stated, “if you can’t restore, you can’t rescind.”
The contracts at issue were for personal services performed by Taxpayers on behalf of Corp. When a personal services contract has actually been performed, the Court observed, it is essentially impossible for the individual who rendered the services to be “returned” to their position as it was before the services.[xxix] What is more, as part of the underlying contracts, Taxpayers transferred the entirety of their interests in the Businesses to Corp, but they did not receive those assets back in the Surrender Transactions. As such, the Surrender Transactions were completely unlike the prototypical instance of rescission, in which all property that changes hands is returned to its original owner.
Taxpayers asserted that compensation is not taxable to an employee if returned to the employer in the year it was received. The Court found that those precedents were inapposite; they stand only for the limited proposition, it stated, that returned compensation may not be taxable income where “the original salary agreements . . . [were] subject to modification by the taxpayers and their employers and not absolute.” There was no indication, the Court added, that Taxpayers’ compensation agreements with Corp were open-ended in the sense contemplated by those cases, and, according to the Court, Taxpayers’ belated attempt to modify those agreements via the Surrender Transactions could not affect their tax liability.
In any event, even if the Surrender Transactions could somehow be seen as rescinding Taxpayers’ employment and compensation agreements with Corp, the Court agreed with the Tax Court’s conclusion that those transactions were totally devoid of economic substance and had to be disregarded for Federal income tax purposes.[xxx]
The owners of closely held businesses have long recognized the importance of aligning the interests of their key employees with their own. The message underlying this principle is simple: if the owners do well, these employees will do well. It is one thing, however, to convey this message; it is something else to assure the recipients that the promised benefit will materialize.
There are many varieties of incentive compensation arrangement that may be implemented to reward a key employee for the exceptional performance of their duties.
In some cases, for example, the owners of the business may retain discretion over the selection of the key employees to be recognized, as well as over the amount of the compensation to be paid to them. In others, the employees to be paid are predetermined, while the amount of the compensation may be discretionary with the owners. In still other cases, the amount of the reward may be fixed in advance, but will be contingent upon the employee’s (or the business’s) having attained a performance target, the satisfaction of which is determinable by the owners in their discretion.
Then there are equity-flavored alternatives in which the amount of the compensation payable to the employee will be based upon changes in the value of the employer’s stock; for example, as compared to its value on the date of issuance.[xxxi]
In most situations, historically speaking, the foregoing rewards were settled in cash.
Query whether that will continue to be the case in the post-COVID[xxxii] world as to those businesses the owners of which have decided to prepare the business for sale or who have determined to turn the business around in a major way, but who need to incentive their key people to help them reach these goals?
In these instances, it may be sensible for an employer to offer their key employees some “skin in the game,” especially given what may turn out to be a continuing cash flow problem for the short-to-mid-term future, during which any available funds may have to reinvested in the business.
What’s more, it may be sensible for the employee to request some equity in the business, considering the value of the business[xxxiii] – and thus, the resulting tax hit from the receipt of such equity as compensation – has probably been reduced on account of the shutdown; in other words, it may be an opportune time for an employee to become an owner if there is a reasonable possibility of recapturing, and then realizing, much of the value of the business.
Assuming the issuance of equity is reasonable for both the employer and the employee, the employer may be able to negotiate some “substantial risk of forfeiture” conditions as an additional means of incentivizing the employee.[xxxiv]
[i] For example, a line of credit; perhaps a mechanism for a capital call among the owners of the business. That’s why the loans under the Paycheck Protection Program were so important to so many businesses.
Other weaknesses that have come to light include too large a workforce, the failure to discharge poorly performing employees, the continual expenditure of funds without concomitant economic return, the payment of personal expenses, etc.
[ii] How many business owners – and business advisers, for that matter – do you know who would get out of Dodge if they could do so in relative comfort and security?
[iii] Earnings before interest, taxes, depreciation and amortization. This “tool” provides a way for measuring the financial health of a company.
I recently came across a reference to “EBITDAC:” earnings before interest, taxes, depreciation, amortization and coronavirus. No kidding.
[iv] An earnout will be used where the buyer and the seller are unable to agree on the fair market value of the business (the purchase price). They will settle upon an agreed lowest value, with the earnouts – assuming the agreed-upon financial targets are attained – determining the upper reaches of the purchase price. The total gain arising from the sale of the business will be contingent upon the earnout payments; as these are received, the gain therefrom will be reported under the installment method. IRC Sec. 453.
[v] Attributable in no small part to their efforts.
[vi] An employee who is rewarded with a cash bonus upon the sale of the business will be taxed thereon at ordinary income tax rates; at the Federal level, the maximum rate is 37 percent. By contrast, the Federal capital gain rate is 20 percent. IRC Sec. 1.
[vii] I typically advise against the admission of an employee as an owner, except in extraordinary circumstances; compensate them with cash, I say, but don’t let them into the tent. (I think that’s an accepted idiom, right?) Once the employee is brought into the fold, they will have a number of rights as an owner as a matter of state law. Moreover, the original owner will owe certain fiduciary duties to the employee-shareholder. Even the Code bestows certain rights upon such individuals; for example, shareholders generally have the right to request copies of their corporation’s Federal income tax return. IRC Sec. 6103(e).
Where an employee “has to be” admitted as an owner, then the execution of a shareholders’ or operating agreement, as the case may be, will be important; for example, to restrict the transferability of shares, and to provide for the buyout of the employee-owner.
[viii] From the perspective of the employee, for example: will they have to guarantee the debts of the business; will they be subject to capital calls; if the business is formed as a pass-through entity (such as a partnership or S corporation) – the income of which is taxable to its owners whether or not distributed to them – how will the employee satisfy the tax on their share of the entity’s taxable income; if the stock or the assets of the business are sold, will the employee be required to make representations as to the business, and will they be liable for any breaches thereof; if their equity is subject to estate tax, how will their heirs pay for it given the equity’s illiquid nature?
[ix] Estate of Kechijian v. Commissioner, No. 18-2277 (4th Cir. 2020).
[x] As we’ll see, the taxpayers’ arrangement was structured solely for tax avoidance purposes.
[xi] The employer does not recognize gain on the issuance of its own stock as compensation. IRC Sec. 1032.
[xii] Vesting – i.e., the lapse of the risk of forfeiture – may occur at one time (“cliff vesting”; for example, after the completion of a specified number of years of service); or it may occur gradually over a number of years (for example, 20 percent per year over five years of service).
IRC Sec. 409A does not apply to amounts that are includible in income under Sec. 83. Reg. Sec. 1.409A-1(b)(6)(i).
[xiii] The employer must not lose sight of its income tax and employment tax withholding obligations.
[xiv] IRC Sec. 83(f); Reg. Sec. 1.83-4.
[xv] IRC Sec. 83(c); Reg. Sec. 1.83-3(c). For example, 7 years of continual service, or the satisfaction of predetermined performance goals the attainment of which is not a foregone conclusion.
[xvi] This is the so-called “Section 83(b) election.” The election must be made not later than 30 days after the equity is issued. Reg. Sec. 1.83-2.
[xvii] An election would make sense where the employee was reasonably confident that the value of the equity was certain to increase before vesting, and that the equity would not be forfeited. An employee who has to forfeit their equity is not allowed a deduction in respect of the forfeiture. IRC Sec. 83(b)(1).
[xviii] IRC Sec. 83(h).
[xix] Reg. Sec. 1.1361-1(b)(3).
[xx] Under IRC Sec. 1366, every shareholder of an S corporation is required to take into account their pro rata share of the corporation’s income for a taxable year for purposes of determining their income tax liability for such year.
[xxi] IRC Sec. 1361 and Sec. 1362.
[xxii] A tax-free exchange described in IRC Sec. 351.
[xxiii] This five-year period was ostensibly designed to incentivize Taxpayers to continue working for Corp.
[xxiv] An “employee stock ownership plan,” which is exempt from income tax. IRC Sec. 4975(e)(7).
The Small Business Job Protection Act of 1996 amended IRC Sec. 1361(b) to permit certain tax-exempt organizations to hold shares of S corporation stock. IRC Sec. 1361(c)(6).
[xxv] IRC Sec. 671. Each Taxpayer continued to be treated as the owner, for income tax purposes, of the shares held by their trust.
[xxvi] Thus, Taxpayers, their trusts, and the ESOP were the shareholders of Corp.
[xxvii] Tax Ct. Nos. 8967-10; 8966-10.
[xxix] Let’s face it, how does an employee rescind the services already provided?
[xxx] The economic substance doctrine permits the IRS to “ignore for tax purposes any transaction designed to create tax benefits rather than to serve a legitimate business purpose.” A two-prong test is employed to determine if a given transaction should be disregarded pursuant to the doctrine. “To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of profit exists.” The first prong of the test is subjective, and the second is objective; nevertheless, while we examine both the subjective motivations of the taxpayer and the objective reasonableness of the investment, in both instances our inquiry is directed to the same question: whether the transaction contained economic substance aside from the tax consequences.”
Application of the foregoing principles to the instant case revealed that the Surrender Transactions were nothing more than a sham to avoid tax liability and were rightly disregarded.
Even Taxpayers acknowledged that the only reason they executed the Surrender Transactions was to enable Corp to avoid withholding and remitting approximately state and federal payroll and income taxes; i.e., the avoidance of tax obligations, both those of Corp and of Taxpayers. This was enough to satisfy the first prong of the economic substance test, which “requires a showing that the only purpose for entering into the transaction was the tax consequences.”
The second prong of the economic substance test was likewise met. It was inconceivable, the Court stated, that either Taxpayer “could envision a reasonable possibility of profit by surrendering, for no consideration, stock worth” millions. According to the Court, the fact that Taxpayers each gave Corp a promissory note as part of the Surrender Transactions only bolstered this conclusion, as “no rational person” would incur millions of indebtedness “to acquire stock that he already owned free and clear.”
[xxxi] Stock appreciation rights and phantom stock plans are examples of compensation arrangements that seek to mimic stock ownership. Because these types of plans usually provide for deferred compensation, they must comply with IRC Sec. 409A and the Regulations issued thereunder.
[xxxii] I use “post” tentatively as the number of cases in California, Texas, Florida, and elsewhere continue to rise.
[xxxiii] Non-lapse restrictions may also be used to further reduce the value. Reg. Sec. 1.83-5.
[xxxiv] In that case, the employee may want to consider an 83(b) election.