Executive employment relationships are rarely permanent. When an executive or other senior-level employee terminates employment, companies often must deal with difficult tax, equity, and benefits issues that arise in connection with the employee's termination.
This article is the third in a series of articles that address important compliance pointers for structuring post-termination benefits or addressing issues and considerations for companies when an executive terminates employment. In our previous articles we discussed whether ERISA applies to your executive severance plan and whether Code Section 409A applies to severance benefits.
This month, we are diving into issues to consider when an executive is a vested shareholder in the company and/or has outstanding equity incentive grants, like stock options, restricted stock, or phantom equity arrangements, when he or she terminates employment. Specifically, this article identifies key issues and decision points related to executive equity and outstanding equity awards, highlighting the importance of the difference between how equity awards must be treated (mandatory) and what can be negotiated (discretionary). This article also discusses how the Internal Revenue Code (Code) impacts a company's decisions about equity and outstanding equity awards in the context of an executive's termination from employment.
Understand the Current Landscape: Universe of Contracts & Termination Circumstances
- When an executive is terminating employment, the first step is to quickly track down and review the critical documentation that may cover the executive's equity-related rights and obligations. The universe of relevant documents may include employment and severance agreements, equity plans, individual equity awards, severance plans or policies, shareholder agreements, operating agreements, restrictive covenants, and/or company policies or practices. Does the executive already hold vested equity from previously settled equity incentive awards (i.e., previously vested restricted stock grants)? Does the executive have any outstanding vested or unvested equity awards (i.e., unvested or unexercised options)? What does each document call for when the executive terminates employment? It may not be simple to answer these questions because there are often layers of rights and obligations in the documentation that may conflict or include competing language and require a detailed analysis to determine the impact of each document and what provisions will control. A careful and thorough review of all relevant documentation is an important gating item to properly address equity incentive arrangements.
- Beyond a general review of applicable documents, the contractual rights and obligations of the company and the executive will be determined by the circumstances surrounding the executive's termination (voluntary, retirement, for cause, resignation for good reason, non-renewal of employment agreement, change-in-control related termination, etc.). There are usually different rules that will apply to equity awards depending on the characterization of the executive's termination of employment, so the company needs to determine what provisions will control in the particular circumstance. In addition, if the documents use different definitions for "cause," "good reason," or "change in control," then different results could apply under different awards so a careful review of the specific definitions given the current facts will be necessary.
After the company has determined the type of termination and analyzed the universe of documents, issues involving equity incentive awards typically fall into two categories. First, what is the company and/or the executive required to do related to equity incentives or what rights automatically apply (mandatory contractual rights)? Second, what can the company and executive negotiate related to outstanding equity incentives (discretionary contractual rights)? The sections below discuss common equity-related issues and how they can influence the treatment of equity in the context of an executive's termination.
Vested Equity – Share Repurchases
Does the company have a "call" right or obligation to repurchase shares when the executive terminates? Does the executive have a "put" right and could require the company to buy back the executive's equity? Will a separation agreement be negotiated that should include a new repurchase right or surrender an existing one to limit the executive's future ownership rights in the company? Typically, any call or put right will be limited to a short election window after termination, so the company needs to be prepared to quickly make repurchase decisions after an executive terminates employment and/or have sufficient funds to pay the executive for any repurchases.
How will the repurchase price for the outstanding shares be calculated? The governing documents may provide for specific valuation formulas or provide other parameters for how the repurchase price should be calculated. But, this question can be tricky for private companies and valuation decisions here can inadvertently have downstream consequences for all parties (including for other corporate, tax, accounting and financing items unrelated to the equity repurchase).
Stock Options – Extending Exercise Periods
If the separation from service is amicable, often the company may want to (or the executive may request to) extend the exercise period for outstanding vested, unexercised options. Typically, stock option grants provide a limited post-termination window for a departing executive to exercise stock options – 30 to 90 days is most common (and for incentive stock options, no more than 90 days post-termination is allowed for a stock option to remain compliant with the incentive stock option tax rules). While it is possible to extend the exercise period for a departing executive's stock options in many cases, there are a host of rules that need to be considered to appropriately structure any extension, including Code Section 409A limitations, tax and securities considerations for incentive stock options, and financial accounting implications. Companies should always consult with its tax and legal advisors before agreeing to extend the exercise period of a departing executive's options to ensure compliance with those rules.
Outstanding Restricted Stock – Tax Reporting Obligations
When the restricted stock was first granted, did the executive timely make a Code Section 83(b) election (required within 30 days of the grant date) and provide proof to the company? To the extent any outstanding restricted stock awards will vest upon the executive's termination, whether because of a contractual obligation to do so or because the parties negotiate additional vesting as part of the severance package, the company's tax reporting and withholding obligations (and the executive's tax consequences) depend on many factors, including the applicability of a valid 83(b) election. The company should confirm with the executive if a valid 83(b) election was made and consult with its tax and legal advisors to ensure proper tax reporting and compliance. In addition, if restricted stock will become vested, the company may need to address any repurchase rights or obligations that arise due to the executive's termination of employment.
Code Section 409A Compliant Options & Phantom-Equity – Amendment and Substitution Limitations
If an outstanding stock option or phantom-equity award is considered nonqualified deferred compensation that is subject to Code Section 409A rules, it is typically very difficult to change that agreement (even if mutually agreed to by the parties) or replace it with a substitute agreement that has a different form or schedule of payment. Failure to comply with Code Section 409A imposes punitive excise taxes on the taxpayer, and tricky tax reporting rules for the company, as discussed in our previous article. If you think the equity or phantom equity awards may implicate the deferred compensation tax rules, consult with your tax and legal advisors before making any changes to those awards or how payment or settlement will be made, even if the change seems immaterial or the company and executive are in agreement from a business perspective!
Coming to an Agreement and Getting a Release Isn't the End – Post-Termination Considerations
Even if the company and executive mutually agree at the time of (or prior to) the termination about how the executive's outstanding equity awards should be treated, the company may have post-termination obligations outside the scope of the negotiated agreement. If the company has an equity clawback policy, recoupment of compensation, including equity, and equity-like awards (post-termination), may be required in future circumstances that implicate that policy. If the company undergoes a change in control, including up to 12 months after the executive terminates employment, Code Sections 280G and 4999 (the golden parachute payment provisions) can be inadvertently triggered and apply to the terminated executive. If the company is publicly traded, a severance agreement, equity settlement, or repurchase may trigger SEC disclosure(s) depending on the executive's position at the company.
In summary, when an executive's employment terminates, the company must carefully evaluate how the executive's vested equity and any outstanding equity incentive awards should be (or must be) settled, reported to the IRS, and what additional company actions are required or advisable or unintended consequences that could arise in that circumstance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
