Once Upon A Time . . . 

a corporation, Corp, was founded.  The year was 2006, and Employee immediately was hired as Corp’s chief technology officer and received restricted stock grants from Corp. As a “founder” of Corp, Employee initially owned 9.8% of Corp’s stock. However, each time investors infused capital into Corp, Employee’s interest was diluted, and he threatened to leave Corp should his interest ever fall below 3%. In deference to Employee’s concerns, Corp agreed to increase his stock ownership by issuing to him additional restricted stock to satisfy his minimum 3% equity “requirement.”  Nevertheless, by 2011, Employee’s equity in Corp had fallen to less than 1%.  

Earlier in 2011, Google had begun merger negotiations with Corp to acquire Corp as a wholly-owned subsidiary. As part of the merger, Google required that Employee turn over all his intellectual property related to Corp and become a Google employee.

In explaining the merger to Employee, Corp’s chairman informed him that Corp was being sold for $93 million and that his stock holdings were worth approximately $800,000. Employee disagreed with the latter amount because, in keeping with his desire to have at least a 3% ownership interest in Corp, he expected to receive 3% of the cash consideration paid by Google.

Hogs Go To Market . . .

To address his concern, Corp prepared a letter agreement pursuant to which, following the merger, Corp would pay Employee $3.1 million, of the $93 million purchase price offered by Google, in exchange for all of  his shares, warrants and options of  Corp stock, and for his execution of a “Key Employee Offer Letter and Proprietary Information and Inventions Assignment Agreement with Google as required in the Merger Agreement” (the “Employment and Assignment Agreement”).  This agreement also provided that Employee would “not be entitled to the Consideration, except for any amount you would be entitled to receive in exchange for your shares * * * in the absence of this Agreement, if you do not comply with the terms of the Merger Agreement.”

Employee signed a consent of the shareholders assenting to Corp’s entering into the merger agreement, and thereby agreed to be bound by the terms of the merger agreement.  Under the Employment and Assignment Agreement, he also agreed to become a Google employee after the merger. Furthermore, as a condition of his employment with Google, Employee would assign his rights, titles, and interests in certain Corp-related intellectual property to Google.

The merger was consummated in 2011. The total value of Employee’s Corp stock was determined to be almost $800,000. As a result of the merger, Employee became entitled to approximately $3 million and became an employee of Google. However,  he received a paycheck showing “stock compensation pay” of approximately $1.88 million and, because of the tax withholdings, he realized that Corp was treating this amount as ordinary income. Employee contacted Corp to complain about the ordinary income characterization. 

Employee outlined his opinion that the transaction at all times was capital in nature, but that Corp miscast it as ordinary. He stated that he would challenge the tax treatment of Corp’s reporting by providing a detailed explanation on his income tax return as to the erroneous position taken by Corp. His legal advisers suggested that he sue Corp, but, fortunately for Corp, he ignored this advice.

As part of his 2011 Federal tax return, Employee included a substitute Form W-2, reporting amounts different from the Form W-2 issued by Corp. He included an explanation that the $1.88 million of “Stock Compensation” wages was actually part of the stock purchase and not compensation. The IRS disagreed with him.

 The Tax Court Responds

Employee maintained that the income that he received as a result of the merger represented funds derived wholly from the sale of his stock, and thus qualified for long-term capital gain tax treatment. The IRS acknowledged that Employee’s section 83(b) elections with respect to those stock grants issued to him by Corp that were not immediately vested permitted any subsequent appreciation in his Corp stock to be taxable as capital gain, and that any gain recognized from the exchange of stock for consideration in an acquisition is capital in nature. However, the IRS argued, and the Court agreed, that the Taxpayer’s merger-based income in excess of the determined value of his Corp stock was taxable as ordinary income.  

The Court noted that Employee’s aim throughout the merger process was to reduce his tax liability by structuring the amount he would receive as deriving entirely from a stock sale and deserving of preferential tax treatment. In general, the Court stated, though tax reduction is an acceptable goal, it does not allow a taxpayer to ignore relevant information.

Employee chose to ignore a lot of relevant information. He executed the merger agreement, the shareholder’s consent, and the Employment and Assignment Agreement. He disregarded both the $800,000 determined value of his stock and the Corp’s consistent position that treated the balance of the payments as compensation for services. He also did not make himself aware of the merger terms between Corp and Google, which reflected the intent of the two parties that generated the income at issue to have Employee receive both deferred compensation and capital gain income from his execution of the Employment and Assignment Agreement and the sale of his Corp stock. Instead, Employee relied on his letter agreement with Corp, arguing that through the letter agreement, he had negotiated a higher share price than other shareholders and that the $3 million he received was all consideration for the sale of his Corp stock. However, he gave no persuasive reason why Corp would be willing to pay more for his stock than its determined value.

Moreover, the letter agreement was silent as to a specific amount being paid for the stock. Instead, it provided that to receive the merger-based income from Corp, Employee had to fulfill two requirements: (i) he had to sell his stock; and (ii) he had to sign the Employment and Assignment and Agreement. While Employee contended that he gave up only one asset of any value—the stock—Corp obviously considered his employment and assigns to have considerable value with respect to its merger negotiations.

The preponderance of the evidence, the Court concluded, was that Employee received the value of his stock and compensation for service previously rendered or to be rendered in the future. Accordingly, The IRS’s determination was sustained.

And the Moral of Our Story . . .

If you are like me, you are probably thinking, “How did this matter get as far as the Tax Court?” After all, it appears as though the Employee had no leg to stand on.  Nevertheless, he believed, based upon discussions with Corp, that he was to be treated as a shareholder for purposes of participating in the benefits, and beneficial tax treatment, from the sale of the business, and he could have caused Corp some real trouble had he acted more strategically or aggressively. 

            Incentives

First of all, though an employer is not required to provide any sort of change-in-control benefit to its key employees, it may ultimately determine that it would behoove the employer and its owners to do so.   It is not unusual for an employer to incentivize its key employees to remain with and help to grow the business by promising them an interest in the proceeds from the ultimate sale of the business. The “promise” may take the form of unrestricted or restricted shares, a phantom stock plan, or some other form of deferred compensation that is triggered by the sale of the employer’s business. Though most employers will shy away from granting equity to an employee, there of course will be situations where the employee has sufficient leverage to demand and receive equity.

Assuming an employer is inclined to provide such an incentive to an employee, then whatever form the incentive takes, it is imperative that the employee understand the benefit to which he or she may be entitled upon a sale of the business—including the tax treatment thereof. There is no reason for the employee to be surprised; he or she should know in advance whether the benefit will be taxed as ordinary income, and the employer should ensure that the arrangement complies with Code Sec. 409A.

As described above, there will be situations where the acquiring company will require that the key employee, either because of his or her personal goodwill or technical expertise, agree to stay on after the sale as a condition to the sale. In other situations, a portion of the purchase price may be contingent upon the performance of the business after the sale (for example, in an earn-out). These situations may provide the well-advised key employee with a measure of leverage with respect to the employer that, in effect, may enable him or her to draw value (purchase price) away from the employer.

            Conditions on the Incentive

At the same time, the incentive should be coupled with certain conditions or restrictions as to the employee’s behavior, such that the employee’s continued right to the “promised” benefit is contingent upon the employee’s compliance therewith; for example:

–        The employee must have been continually employed by the employer, at the same or at a higher position, during the ten-year period ending with the date of the sale;

–        He/she must have attained certain significant performance goals; or

–        He/she must execute a shareholders agreement (which includes buy-out provisions and a drag-along).

In this way, the employer assures itself of the employee’s commitment and cooperation.

Of course, the employer cannot lose sight of the fact that the compensation arrangement will be less costly from the employer’s perspective if the payment(s) are deductible against its business income or if they reduce the amount realized on the sale of the business. Among other things, that requires that the amount paid must represent reasonable compensation. An employer that is a C corporation (or a partnership with C corporation owners) must be mindful of the deduction disallowance under the so-called “golden parachute rules.”

Conclusion

At the end of the day, the goal is to increase value of the business for the benefit of the employer and its owners. If the business’s reasonably anticipated “return” on the incentive granted to a key employee is significant enough, then the incentive arrangement should be documented so as to ensure the achievement of its goals.  These goals should include protecting the employer from a disgruntled employee’s uncooperative behavior during the course of the sale of the business. In any case, the employee has to understand what is being asked of him/her and what he/she stands to gain.