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Transaction issues with equity compensation


Recently, there has been an increase in the number of strategic mergers and foreign inbound investments in the US. These types of transactions raise numerous US tax issues relating to equity compensation. Taxand USA discusses how, if not handled appropriately, the tax exposure to the acquired corporation and its executives can be significant. 

ISOs are stock options that are eligible for favourable tax treatment under Sections 421 and 422. Many requirements must be satisfied for an option to qualify as an ISO, and they are not taxed when exercised. In the event an acquiring corporation assumes the outstanding ISOs, the favourable tax status of the ISOs will only be preserved if the assumption and rollover complies with the requirements of IRC Section 424. 

Alternatively, the transaction may provide for all outstanding stock options to be cashed out at the close of the deal. In this situation, the employee receives ordinary income equal to the cash-out payment (the excess of the merger consideration over the exercise price) for all outstanding stock options. In the case of an ISO, the cash-out will disqualify the award, and the taxation rules related to nonqualified stock options will apply. The cash-out of stock options can be paid at the time of the merger or on the same schedule and conditions applicable to the shareholders ("earn-out payment").

Frequently, restrictions related to restricted stock lapse when an acquisition occurs. Absent a Section 83(b) election at grant, the accelerated vesting of the restricted stock will result in ordinary income to the employee at the time of vesting (equal to the number of shares vested times the merger consideration). The amount of ordinary income recognised by the employee is deductible to the company in the post-close period.

When a corporation is acquired by another company, both the corporation and key executives may be subject to significant adverse tax consequences under the golden parachute provisions of IRC Section 280G. Under these provisions, a payment to an executive of $1 above the golden parachute safe harbour limit creates large penalties for both the executives and the company. Depending on the circumstances and the number of executives affected, the cost to the company and the executives can be significant. 

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Your Taxand contact for further queries is:
Brian Cumberland
T. +1 214 438 1013


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Taxand's Take

While an acquisition may result in a multitude of tax issues and increased demands, the tax implications related to the equity compensation awards must be addressed from both an employee and company perspective. Not only should corporations try to maximise deductions to increase the purchase price, but they should also be sensitive to the tax treatment of their employees in connection with a potential sale. Understanding the potential adverse tax treatment on the individual and the appropriate way to avoid these taxes will help improve employee morale and the likelihood of retaining key talent through this trying process. 

Taxand's Take Author