Executive Compensation Planning for Privately-Held …€¦ · · 2016-08-09Executive Compensation Planning for Privately- ... EXECUTIVE COMPENSATION PLANNING FOR PRIVATELY-HELD

College of William & Mary Law SchoolWilliam & Mary Law School Scholarship Repository

William & Mary Annual Tax Conference Conferences, Events, and Lectures

2004

Executive Compensation Planning for Privately-Held BusinessesJeffrey R. Capwell

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Repository CitationCapwell, Jeffrey R., "Executive Compensation Planning for Privately-Held Businesses" (2004). William & Mary Annual Tax Conference.Paper 113.http://scholarship.law.wm.edu/tax/113

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EXECUTIVE COMPENSATION PLANNING FOR

PRIVATELY-HELD BUSINESSES

by

Jeffrey R. Capwell*McGuireWoods LLP

Charlotte, [email protected]

INTRODUCTION

A. Preliminary Considerations

1. How is the business organized?

a. Tax status.

b. Ownership structure.

2. What are the long-term objectives for the business?

a. Continue indefinitely as closely-held.

b. Position for an ultimate sale of the business.

c. Sell shares in the public market.

3. What are the characteristics of the management group?

a. Executives are already owners, either directly or through family

relationships.

b. Managers have little or no ownership interests.

4. What are the specific compensation objectives?

a. Incentivize long-term performance.

b. Attract/retain key managers.

c. Other objectives.

© Jeffrey R. Capwell 2004. All rights reserved.

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5. What are the desired tax consequences?

a. Timing/character of income.

b, Deductibility by the employer.

6. How much complexity can be tolerated?

a. Administrative complexity.

b. Perceptions of affected employees.

B. The Planning Process

I1. Consider What Forms of Incentive Compensation Will Further theBusiness Objectives

a. The various methods incentive compensation should be weighedand compared to determine the optimal mix of compensation formsfor the company's workforce.

b. This analysis should take into account the tax consequences both toemployees and to the company of each form of compensation, andother factors, such as the relative financial accounting impact ofeach form of compensation.

2. Develop and Implement Incentive Compensation Plans

a. Plans should be designed to provide the selected forms ofcompensation. These plans should be flexible enough to providethe company with an ability to alter its compensation practices asdictated by business circumstances.

b. Care should be taken in addressing securities, ERISA and potentialemployment law concerns before the plans are implemented.

3. Periodically Assess Effectiveness of Existing Programs

a. It is helpful to have a framework for periodically assessing theeffectiveness of the company's compensation programs.

b. Periodic assessments should measure whether currentcompensation programs are working to attract and retain keyemployees, and otherwise meeting other business goals.

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I. FORMS OF INCENTIVE COMPENSATION

A. Incentive Stock Options (ISOs)

1. Description

a. Incentive stock options (ISOs) are a form of tax-advantaged stockoption. They may only be granted by corporate employers to theiremployees.

b. In order to provide employees with the tax advantages of ISOs,employers must comply with a number of conditions andlimitations. These conditions and limitations can make ISOs arelatively inflexible device for meeting all of an employer'scompensation objectives.

2. Tax Treatment

a. There are no income or alternative minimum tax consequenceswhen an ISO is granted to an employee. See I.R.C. §§ 421(a),56(b)(3) (tax event is the transfer of a share, not the transfer of theright to purchase a share).

b. As a general rule, option holder does not recognize any income onexercise of the option or upon receipt of the underlying the shares,and the employer is not entitled to any deduction for transferringthe shares, if both of the following requirements are met:

(1) At all times during the period beginning with the date ofoption grant and ending three months before the date ofexercise, the option holder was an employee of theemployer or of a parent or subsidiary of the employer(except in the case of option holder's disability, in whichcase the period is extended to 1 year before the date ofexercise), and

(2) The option holder makes no disposition of the stock duringtwo years from the date of option grant or during one yearfrom the date of option exercise.

See I.R.C. §§ 421(a), 422(a).

c. If the option holder meets the conditions described in above, hewill have basis in the shares equal to the exercise price, and anygains recognized on disposition of the shares will be taxed at long-term capital gains rates. See I.R.C. §§ 421(a)(3), 1222(3)

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d. If the option holder does not meet the employment conditiondescribed in subsection (b)(1) above, the option will be treated as anonstatutory stock option, and the option holder will recognizeordinary income at the time of option exercise on the amount bywhich the FMV of the stock exceeds the option exercise price.The employer is entitled to a deduction of an equivalent amount inthe year of exercise. See I.R.C. § 83 (discussed in greater detailbelow).

e. If the option holder does not meet the condition described insubsection (b)(2) above, the holder will recognize ordinary incomeequal to the lesser of:

(1) The option spread at the time of exercise (i.e., differencebetween FMV of stock and exercise price), or

(2) The excess of the amount realized upon disposition of theoption and the option exercise price

The employer is entitled to an equivalent deduction in the sametaxable year. See I.R.C. § 421(b).

f. The spread between the fair market value ("FMV") of the stockand the option exercise price is alternative minimum taxableincome to the holder of the ISO when the ISO is exercised. SeeI.R.C. §§ 55, 56(b)(3).

g. Employers are not required to withhold FICA or FUTA taxes onthe option spread at the time the ISO is exercised. Likewise, noFICA, FUTA or income tax withholding is required for anyincome recognized as a result of disposition of shares before theend of the holding periods described in subsection (b)(2) above.See I.R.C. §§ 3121(a)(22), 3306(b)(1 9), 421(b) (as added oramended by the American Jobs Creation Act of 2004).

3. ISO Qualification Requirements.

a. ISOs may only be granted by corporations to their employees orthe employees of affiliated corporations. At all times during theperiod beginning on the date of grant to three months beforeexercise, the option holder must be an employee of the corporationthat granted the option or an employee of a "parent" or"subsidiary" of the granting corporation. A parent or subsidiaryrelationship exists if there is an unbroken chain of ownership of atleast 50% of the voting power at each corporate level. See I.R.C.§§ 422(a)(2), 424(e), 424(t).

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b. ISOs may only be granted with respect to stock of a corporation.Any type of stock will qualify (voting, nonvoting, common,preferred, etc.). See Treas. Reg. § 1.421-1(d).

c. ISOs must be granted under a written or electronic plan that wasapproved within 12 months before or after the plan was adopted bythe corporation's board of directors. A change in the class ofeligible employees, the number of shares reserved for issuance, thecorporation granting options or the stock available for ISOs istreated as the adoption of a new plan which requires newshareholder approval. See Treas. Reg. § 1.422-2(b)(1), (2).

d. The written plan must (1) state the employees or class ofemployees who are eligible to receive ISOs, and (2) state theaggregate number of shares that may be issued as ISOs under theplan. Provisions which permit increases in the number of sharesauthorized for issuance are permitted under certain limitedcircumstances. See Treas. Reg. § 1.422-2(b)(4), (3).

e. Neither the option plan nor the ISOs granted under it may have aterm of more than ten years. In determining whether the planmeets this rule, the term is measured from the earlier of the datethe plan was adopted or the date on which it was approved byshareholders. See I.R.C. § 422(b)(2), (3).

f. The exercise price of the ISO must be at least equal to the FMV ofthe stock on the date the ISO is granted. The employer may use"any reasonable valuation method" for determining the exerciseprice. Even if this requirement is not met, the option will qualifyas an ISO if, under the facts and circumstances, there was a goodfaith attempt to set the option exercise price at no less than theFMV of the stock on the date of option grant. For a privatecompany, a good faith attempt is deemed to have been made if theprice was determined based on the average of appraisals by"'completely independent and well-qualified experts." See Treas.Reg. §§ 1.421-1(e), 1.422-2(e);

g. The ISO must state that it cannot be transferred, except by will orby descent and distribution. In addition, the ISO cannot beexercised during the optionee's lifetime by anyone other than theoptionee (or his representative in the event of his death). SeeI.R.C. § 422(b)(5); Treas. Reg. § 1.421-1(b)(2). Under this rule, atransfer of an ISO to a grantor trust established by the optionholder does not disqualify the ISO. However, a transfer incident todivorce or a domestic relations order would disqualify the ISO.

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h. No more than $100,000 worth of shares under the option can firstbecome exercisable in any one year. The limit is determined at thetime of grant, is based on the FMV of the shares at the time ofgrant and is determined without regard to how many shares theemployee actually exercises- See I.R.C. § 422(d); Treas. Reg. §1.422-4.

(1) For example, assume an employer wants to grant to anemployee 60,000 shares under an ISO when the shares areworth $2 per share. A maximum of 50,000 shares canbecome exercisable in the year the ISO is granted (50,000 x$2 = $100,000). The remaining 10,000 shares can becomeexercisable in the second year (10,000 x $2 = $20,000),along with the 50,000 that first became exercisable in theprior year.

(2) All of the ISOs held by an employee are taken into accountin applying the limit. The limit is applied by taking optionsinto account in the order in which they were granted.

i. Special limitations apply to ISOs that are granted to persons whoown more than 10% of the total combined voting power of allclasses of stock of the employer corporation or any parent orsubsidiary corporation (a "10% shareholder"). First, the optionterm can be no longer than five years. Second, the option exerciseprice must be at least 110% of the FMV of the underlying shares atthe time of grant. See I.R.C. § 422(c)(5); Treas. Reg. § 1.422-2(f).

A modification, extension or renewal of the terms of an ISO isconsidered the granting of a new option. As a result, themodification, extension or renewal can cause the option to loseISO status if it does not meet all of the ISO requirements as of thedate of modification, extension or renewal (such as the exerciseprice requirement). See I.R.C. § 424(h)(1); Treas. Reg. § 1.424-1(e). There are a number of rules for determining which types ofchanges to an ISO constitute a "modification." See Treas. Reg. §1.424-1(e)(4)(i), et seq.

k. ISO option agreements and ISO plans are not required to specifythe three month exercise condition described in Section II.A.2.b.(1)above. An ISO that by its terms permits exercise beyond the three-month period following termination of employment will stillqualify for ISO treatment if it meets the other requirementsapplicable to ISOs and it is in fact exercised within that period.See Treas. Reg. § 14a.422A-1, Q&A 23 (transition rules which

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predate final regulations). If the option is exercised after the endof the three-month period, the option is treated as a nonstatutorystock option and is taxed under the rules applicable to suchoptions. See Treas. Reg. § 1.422-1(c).

4. ERISA Considerations. Stock option plans and the options granted underthem generally do not constitute welfare benefit plans or pension plans forpurposes of the Employee Retirement Income Security Act of 1974("ERISA"). See, e Department of Labor ERISA Adv. Op. 79-80A;Oatway v. American International Group, Inc., 325 F.3d 184 (3 rd Cir.2003).

B. Nonstatutory Stock Options (NSOs)

I1. Description

a. A nonstatutory option (NSO) is any type of option that does notmeet the requirements described above for ISOs. See Treas. Reg.§ 1.83-7(a).

b. Although NSOs do not provide option holders with the same taxadvantages of ISOs, they are not subject to the numerousqualification requirements applicable to ISOs and thus provide agreater degree of flexibility than ISOs. Furthermore, NSOsprovide employers with a deduction, while ISOs generally do not.

2. Tax Treatment

a. The tax treatment of NSOs is governed under Section 83 if grantedto an employee or another service provider in connection with theoption recipient's performance of services for the grantor of theoption. See Treas. Reg. § 1.83-7(a); T.A.M. 200043013 (warrantsgiven by bankrupt company to bank creditor are not taxable underthe rules of Section 83, and therefore do not give rise to acompensation deduction, because they were not granted inconnection with the bank's performance of services to thecompany).

b. There are no income tax consequences upon grant of an NSOunless the NSO has a "readily ascertainable fair market value" atthe time of grant. In order for an option to have a readilyascertainable FMV, the NSO must either be traded on a establishedmarket (which is rarely, if ever, the case), or each of the followingfactors must exist:

(1) the option is transferable,

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(2) the option is immediately exercisable in full,

(3) there are no conditions or restrictions on the optionproperty which affect the FMV of the option, and

(4) the option privilege can be valued with reasonableaccuracy.

See Treas. Reg. § 1.83-7(b)(1), (2).

c. When an NSO is exercised, the optionee recognizes ordinaryincome on the amount by which the FMV of the underlying sharesat the time of exercise exceeds the amount paid by the optionee toexercise the option. However, if the shares are subject to asubstantial risk of forfeiture when issued, the taxable spread is notdetermined until the time the risk of forfeiture lapses. The spreadis also considered to be wages for purposes of FICA and FUTAwithholding. There are no alternative minimum tax consequenceswith respect to the exercise of a NSO. See I.R.C. § 83(a); Treas.Reg. § 1.83-7(a).

d. The recipient of the optionholder's services is allowed a deductionequal to the amount included in the optionholder's taxable income.See I.R.C. § 83(h), Treas. Reg. § 1.83-6; see also Rev. Rul. 2003-98 (corporation that was the recipient of the services performed bythe optionholder is entitled to a deduction in connection withoptionholder's exercise of a replacement option granted byacquirer).

e. The optionholder's basis in the shares acquired under an NSO isgenerally equal to the exercise price of the NSO, and the holdingperiod generally runs from the date of exercise. See Treas. Reg. §1.83-4.

3. ERISA Considerations. As described in Section lI.A.4 above, stockoption plans and the options granted under the plan generally are notconsidered to be ERISA welfare benefit plans or pension plans.

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C. Restricted Stock

1. Description

a. The term "restricted stock" broadly refers to shares that are grantedoutright or sold for some consideration to an employee or otherservice provider. The stock is generally not transferable and issubject to forfeiture if certain conditions are not met during aspecified period of time (typically, the recipient's continuedservice for the employer).

b. Restricted stock has gained in popularity as a result of perceivedlimitations associated with stock options and due to proposals toeliminate the preferential financial accounting treatment affordedstock options under current accounting standards.

2. Tax Treatment

a. There are no income tax consequences to the recipient of the stockat the time of receipt, so long as the stock is "substantiallynonvested." Stock is substantially nonvested so long as it is (1)nontransferable, and (2) subject to a substantial risk of forfeiture.The employee (or other service provider) is taxed on the FMV ofthe restricted stock in the first taxable year in which the stockbecomes transferable or is no longer subject to a substantial risk offorfeiture. Only one of these restrictions needs to lapse in order tocause the stock to become taxable. See I.R.C. § 83(a); Treas. Reg.§ 1.83-3(b).

b. Stock is considered nontransferable if the holder cannot transferany interest in the stock to any person other than the transferor.Stock is not considered transferable merely because the holder candesignate a beneficiary to receive the stock in the event if his orher death. See Treas. Reg. § 1.83-3(d).

c. A "substantial risk of forfeiture" exists where the holder's rights inthe stock are conditioned, directly or indirectly, on either:

(1) the performance of future substantial services (or refrainingfrom the performance of such services), or

(2) the occurrence of a condition related to the purpose of thetransfer, and the possibility of forfeiture is substantial if thecondition is not satisfied.

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The determination of whether a risk of forfeiture is substantial isdependent upon the individual facts and circumstances surroundingthe transfer. See Treas. Reg. § 1.83-3(c).

d. The employer is entitled to a compensation deduction equal to theamount that the employee recognized in income. The deduction isallowed in the same taxable year in which the holder of the stockrecognized income, or the taxable year in which ends the holder'staxable year. See I.R.C. § 83(h).

e. However, the deduction may be lost if the employer does notproperly report the income recognized by the holder on Form W-2or Form 1099, as applicable. See Treas. Reg. § 1.83-6(a)(1), (2).

3. The Section 83(b) Election

a. If restricted stock is nontransferable and subject to a substantialrisk of forfeiture when transferred, the recipient of the restrictedstock may make an election to be taxed on the FMV of the stock atthe time of transfer. See I.R.C. § 83(b).

b. The advantages of making a Section 83(b) election are that (1) theholder limits the amount of ordinary income that he must pay if thestock appreciates in value during the restriction period, and (2) hewill start a holding period for purposes of qualifying for long-termcapital gain treatment upon a later disposition of the shares. SeeI.R.C. § 1.83-4(a).

The disadvantage of the election is that the recipient may end uppaying more ordinary income than he would have paid in the event.that the shares decrease in value over the restriction period. Inaddition, the recipient will not be entitled to any loss deduction forthe taxes he paid in the event that he ultimately forfeits the shares.See Treas. Reg. § 1.83-2(a).

d. A Section 83(b) election is subject to a number of requirements.The election must be made within 30 days of transfer of therestricted stock, and must contain specified information concerningthe transfer. The election is filed with the IRS office where thetaxpayer files his income tax return. Additional copies of theelection must be filed with the transferor of the restricted stock andmust be included with the taxpayer's income tax return for thetaxable year of the transfer. The election cannot be revoked unlessconsented to by the IRS. See Treas. Reg. § 1.83-2.

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c. Section 83(b) elections can even be made in circumstances inwhich the employee has paid an amount equal to fair market valuefor the stock. This may be desirable in those cases where theemployer can repurchase the shares for a period of time at a priceequal to the employee's original purchase price or some formulaprice. Such a call right will generally be treated as creating asubstantial risk of forfeiture. See Treas. Reg. § 1.83-3(c)(4),Example 1.

f. The employer is entitled to a compensation deduction in thetaxable year in which the employee or other service providerrecognizes income as a result of the election, equal to the amountof income recognized by the employee. See I.R.C. § 83(h).

4. ERISA Considerations. Restricted stock awards are generally notconsidered to be ERISA welfare benefit plans or pension plans. However,if awards are structured so as to permit shares to continue to vestfollowing termination of employment, the arrangement could constitute anERISA pension plan. See Department of Labor ERISA Adv. Op. 80-29A.

D. Stock Appreciation Rights (SARs)

I1. Description

a. A stock appreciation right (SAR) gives the holder the right toreceive a benefit equal to the appreciation in value of theemployer's stock over a period of time. SARs can be settled incash, stock or a combination of the two.

b. SARs are very similar to stock options in that the holderdetermines when he or she will exercise the SAR. At exercise, theholder receives the difference between the value of the shares onthe date of exercise and the exercise price, without having toactually pay the exercise price. SARs can be granted in tandemwith stock options. A common reason for using tandem SARs is toprovide the employee with funds to pay taxes on the exercise of aNSO. There are restrictions on the use of tandem SARs inconnection with ISOs. See Treas. Reg. § 1.422-5(d)(3).

2. Tax Treatment

a. There is no tax to the holder of an SAR at the time of grant. Theholder is taxed on any amounts received upon exercise of the SARat ordinary income rates. See Rev. Rul. 80-300, 1980-2 C.B. 165;Rev. Rul. 82-121, 1982-1 C. B. 79. The amount received under theSAR is also subject to FICA and FUTA tax at the time of exercise.

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See Treas. Reg. § 31.3121(v)(2)-1(b)(4)(ii) (SARs are not subjectto the special early inclusion rule applicable to nonqualifieddeferred compensation plans, thus FICA tax is payable only whenthe SAR is exercised).

b. The employer is permitted a compensation deduction for theamount income recognized by the holder of the SAR at the time ofexercise. See I.R.C. § 162(a)(1).

c. ERISA Considerations. SARs are generally not considered to beERISA welfare benefit plans or pension plans. However, SARsthat provide for automatic settlement upon termination of theholder's employment or retirement may constitute ERISA pensionplans. See ERISA § 3(2).

E. Phantom Stock Plans

I1. Description

a. Phantom stock shares are units that typically are assigned a valueequal to the value of the employer's stock. The units give a holderthe right to receive the original value of the unit and anysubsequent appreciation in value if certain conditions are met, suchas the holder's completion of a specified period of future servicewith the employer. However, a phantom stock plan can bestructured to provide a benefit based only on the appreciation invalue of the units over time, instead of on the value of the entireunit.

b. Payment of benefits under a phantom stock plan can be structuredin a variety of ways. For example, payment can be made in asingle lump sum immediately following completion of a vestingschedule. Alternatively, payment can be delayed to termination ofemployment or some later specified date (such as attainment ofretirement age) and can be paid in installments.

2. Tax Treatment

a. If the payment date for any benefits under the plan is fixed at thetime the employee receives the phantom stock units, or is payablesolely at the discretion of the employer, the employee willrecognize ordinary income at the time payment is actuallyreceived. Income will be based on the amount of cash or the FMVof the property received by the employee. See I.R.C. § 451; Treas.Reg. § 1.451-2(a); P.L.R. 9501032.

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b. If the payment date is instead subject to the employee's discretion,the employee is taxed on the value of the phantom stock unit as ofthe first date on which the employee had a vested right to the unitor when the employee first had a right to direct payment. SeeI.R.C. 451; Treas. Reg. § 1.451-2(a); P.L.R. 8829070; T.AM.8632003.

c. FICA and FUTA taxes must generally be withheld at the later ofwhen the phantom units are awarded to the employee or when theemployee has a vested right to receive a benefit with respect to theunits. See I.R.C. § 3121(v); Treas. Reg. 31.3121(v)(2)-1(b)(4)(ii).

3. ERISA Considerations. Phantom stock plans may be ERISA pensionplans if benefits are payable at termination of employment or retirement,or if benefits are deferred to a date at which employees can generally beexpected to retire or terminate employment. See Department of LaborERISA Adv. Op. 79-60A. For this reason, phantom stock plans are oftendesigned to pay benefits at the end of specified measurement periods,without any acceleration or deferral of payment on account of early or lateretirement. See Department of Labor ERISA Adv. Op. 84-12A.Alternatively, phantom stock plans are structured to limit participation toonly a select group of executive employees so that the plan may qualify asa "top-hat" plan. See discussion in Section II.F below.

F. Deferred Compensation Arrangements

I1. Description

a. The traditional method to compensate employees is with cash.Deferred payment of cash is frequently used to retain executivetalent or as an incentive for attainment of specific performanceobjectives. In addition, deferred compensation is used to providesupplemental retirement income.

b. Deferred payment of cash raises a number of tax and ERISAconsiderations that must be taken into account in designing andimplementing a deferred compensation plan.

2. Tax Treatment

a. Amounts payable under a deferred compensation plan are taxed atordinary income rates. The benefits are generally taxed only at thetime of actual receipt, unless the recipient is deemed to be inconstructive receipt of the benefits. See Treas. Reg § 1.446-l(c)(1)(i).

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b. The question of whether and when an employee is in constructivereceipt of deferred compensation benefits is not always clear. TheIRS has traditionally taken a very conservative approach. Under along line of rulings, the IRS takes the position that taxation ofdeferred compensation will be deferred so long as:

(1) The employer's obligation to pay the deferredcompensation is merely a contractual obligation notevidenced by notes or secured in any way against theclaims of the employer's general creditors

(2) The deferral agreement or plan was entered into before theexecutive performs the services to which the compensationrelates

(3) The deferral agreement or plan specifies the time when orcircumstances under which the deferred compensation willbe paid.

See Rev. Rul. 60-31, 1960-1 C.B. 174; Rev. Proc. 71-19, 1971-1C.B. 698, as amplified by Rev. Proc. 92-65, 1992-33 C.B. 428.Although the 1971 and 1992 revenue procedures are only astatement of the criteria that a plan must meet in order for the IRSto issue a private letter ruling, they have traditionally been viewedas representing the IRS's general position on constructive receiptfor non-qualified deferred compensation plans.

c. The courts typically have not applied as strict an interpretation ofconstructive receipt as has the IRS. Se e.g., Veit v.Commissioner, 8 T.C. 809 (1947); Commissioner v. Oates, 207F.2d 711 (7th Cir. 1953), aff.g 18 T.C. 570 (1952) Martin v.Commissioner, 96 T.C. 814 (1991); Childs v. Commissioner, 103T.C. 634 (1994). As a result, deferred compensation plans aregenerally not designed to satisfy all of the conditions contained inthe revenue procedures described above.

d. Although deferred compensation benefits generally are not subjectto income tax until received, such benefits are subject to FICA andFUTA taxes at the later of (1) when the benefits are earned or (2)when the benefits are no longer to a substantial risk of forfeiture.See I.R.C. § 3121(v)(2); Treas. Reg. § 31.3121(v)(2)-(1).

3. Recent Legislative Changes

a. As of the date of this outline, both chambers of Congress passedthe American Jobs Creation Act of 2004 which contains extensive

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new requirements that a deferred compensation plan must satisfy,both in form and in operation, in order to avoid current taxation ofamounts deferred under those plans. See Section 885 of the AJCA(expected to be signed by the President).

b. The new requirements apply to all "nonqualified deferredcompensation plans" ("NDCPs"), a term which is broadly definedto mean any plan that provides for a "deferral of compensation."See I.R.C. § 409A(d). The only statutory exceptions are for (1)qualified retirement plans and certain other tax-advantaged savingsand retirement vehicles, and (2) plans providing vacation leave,sick time, compensatory time, disability pay or death benefits. Inaddition, the Conference Report indicates that the following are notto be considered NDCPs:

(1) Arrangements under Code Section 83 providing for thegrant of an option on employer stock with an exercise pricenot less than the fair market value of such stock on the dateof grant, as long as the arrangement does not include adeferral feature other than allowing the optionee to exercisethe option in the future. As a result, arrangements whichpermit the deferral of gain on the exercise of stock optionswill be NDCPs.

(2) Incentive stock options and qualified employee stockpurchase plans.

(3) Annual bonuses or other annual compensation amountspaid within 2/2 months after the close of the taxable year inwhich the relevant services required for payment have beenperformed.

c. Section 409A imposes specific conditions that a NDCP mustsatisfy to avoid current taxation of compensation deferred underthe plan. If the plan fails to meet one or more of these newrequirements, there will be several adverse tax consequences. Thenew requirements to avoid constructive receipt are in the followingareas:

(1) Restrictions on deferral elections under a plan.

(2) Specification of the times when distributions can be made.

(3) Restrictions on the accelerated payment of benefits.

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d. There are severe tax consequences for failing to meet the newrequirements:

(1) Unless the participant's right to the deferred compensationis subject to a "substantial risk of forfeiture," allcompensation that has been deferred under the pan for allyears through the year in which the noncompliance occursis taxable to the participant (unless previously taxable). Forthis purpose, a substantial risk of forfeiture exists if theparticipant's rights are conditioned upon his or herperformance of substantial services.

(2) Interest will be charged at the underpayment rate, plus onepercentage point, on the underpayments that would haveoccurred had the deferrals been includable in gross incomefor the taxable year in which first deferred, or if later, thefirst taxable year in which the deferrals are not subject to asubstantial risk of forfeiture.

(3) A 20% additional income tax is charged on the amount ofthe deferral.

e. The new requirements apply to amounts deferred after December31, 2004. However, amounts deferred in taxable years beginningbefore January 1, 2005 will be also be subject to the new rules ifthe plan under which the deferral is made is "materially modified"after October 3, 2004. The Conference Report states that theaddition of a benefit, right or feature to a plan will be treated as amaterial modification. Therefore, the addition after October 3 of anew distribution right or the addition of conditions that acceleratethe time when distributions are made would generally cause theplan to be subject to the new rules. The reduction of an existingbenefit, right or feature will not be a material modification, norwill the amendment of a plan to remove a distribution provision.In addition, ministerial changes, such as a change in the plan'sadministrator, will not be material modifications.

4. ERISA Considerations

a. Deferred compensation plans typically are ERISA pension plansbecause benefits are paid upon termination of employment orretirement, or defer benefits beyond those dates. See ERISA §3(2).

b. In order to effectively defer the taxation of benefits under anonqualified deferred compensation plan, the plan generally must

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qualify as a "top-hat" plan. Top hat plans are exempt from all ofERISA's substantive requirements, except for certain reportingrequirements and ERISA's enforcement provisions. See ERISA§§ 201(2), 301(a)(3), 401(a)(1).

c. A deferred compensation plan will qualify as a top-hat plan if theplan is unfunded, and is maintained to provide deferredcompensation to a "select group of management or highlycompensated employees."

(1) A plan will generally be considered to be unfunded so longas plan participants and their beneficiaries do not have anysecured claim against any assets of the employer, and theemployer has not set aside any assets for their benefit freefrom the reach of creditors. See Belka v. Rowe FurnitureCorp., 571 F. Supp. 1249 (D. Md. 1983).

(2) The Department of Labor has never adopted final guidanceproviding standards for determining a select group ofmanagement or highly compensated employees. The courtshave recognized that the determination is fact-sensitive, andgenerally have refrained from adopting definitive standardsfor making this determination. See £g., Demery v.Extebank Deferred Compensation Plan (B). 216 F.3d 283(2Ud Cir. 2000); Gallione V. Flaherty, 70 F.3d 724 (2

nd Cr.1995); Simpson v. Ernst & Young, 879 F. Supp. 802 (S.D.Ohio 1994).

III. SPECIAL TAX PLANNING CONSIDERATIONS

A. Considerations for Employers Organized as S Corporations

1. Compliance with Qualifying Shareholder Limitations

a. S corporations can have no more than 100 shareholders. None ofthose shareholders can be nonresident aliens. An election can bemade to allow all family members to be counted as a singleshareholder. See I.R.C. § 1361(b)(1)(A), (C) (as amended by theAmerican Jobs Creation Act of 2004, effective for taxable yearsafter December 31, 2004). Violation of these limitations willgenerally cause a loss of S corporation status.

b. Options for, or outright awards of, S corporation stock must becarefully monitored to avoid violating these limits. In accordancewith general tax principles, holders of stock options generally are

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not considered to hold the underlying stock until the option isexercised.

c. Holders of restricted stock are not considered to be S corporationshareholders for as long as the stock is substantially nonvested(i.e., subject to a substantial risk of forfeiture and nontransferable).However, if the holder makes an 83(b) election the stock is treatedas outstanding and the holder will be considered a shareholder.See Treas. Reg. § 1.1361 -I(b)(3).

2. Second Class of Stock Concerns

a. S corporations may not have more than one class of stock. SeeI.R.C. § 1361(b)(1)(D).

b. Stock options issued to employees or independent contractors inconnection with the performance of services for the S corporationor for a more than 50% owned subsidiary corporation of the Scorporation will not be considered to create a second class of stockif the following conditions are met:

(1) The compensation provided by the option is not excessivein relationship to the services performed,

(2) The option is not transferable by the optionee (asdetermined under the regulations of I.R.C. § 83), and

(3) The option does not have a readily ascertainable fair marketvalue (as determined under the regulations under I.R.C. §83).

See Treas. Reg. § 1.1361-1(1)(4)(iii)(B)(2).

c. Phantom stock arrangements, SARs and deferred compensationplans generally do not create a second class of stock if they do notconfer any voting rights to employees, merely represent anunfunded promise to pay an amount in the future, are issued to anemployee or independent contractor in connection with theperformance of services, and are issued under a plan pursuant towhich the employee or independent contractor is not currentlytaxed. See Treas. Reg. § 1.1361-1(b)(4); P.L.R. 9840035; P.L.R.9040035.

d. Restricted stock will not be a second class of stock so long as it issubstantially nonvested. Shares that have become vested or forwhich an employee has made a Section 83(b) election will not

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create a second class of stock so long as the stock providesdistribution fights and liquidation rights that are identical to thoseof other shares. Differences in voting rights are generallydisregarded. See Treas. Reg. § 1.1361-1(1)(1), (3).

B. Considerations for Employers Organized as LLCs or Partnerships

I1. ISOs Are Not Available

a. ISOs may only be granted with respect to the stock a corporation.See Treas. Reg. § 1.421-1(a)(1).

b. Therefore, options to acquire LLC or partnership interests cannotqualify for ISO treatment, except in the case of an LLC that haselected to be taxed as a corporation. See Treas. Reg. §§ 1.42 1-l(i)(1), 301.7701-3(a).

c. By contrast, S corporations are treated as corporate entities andoptions on S corporation stock can qualify for ISO treatment. SeeTreas. Reg. § 1.421-1(i)(1); P.L.R. 9840035.

2. Outright Grants and Options on Membership/Partnership Interests

a. Except as described above, partnerships and LLCs generally maygrant all of the same types of equity-based incentive compensationawards that corporate employers may award. The tax treatment ofthese awards is generally dependent upon whether the underlyingequity interest is a capital interest (a right to receive a share of thebusiness's assets upon liquidation) or a profits interest (a right onlyto a share of the profits of the business).

b. Transfer of a capital interest in exchange for services is generallynot considered eligible for non-recognition treatment. See I.R.C. §721; Treas. Reg. § 1.721-1(b)(1). The amount and timing of taxrecognition is determined under the rules of Sections 61 and 83.

(1) Unrestricted Interests. The fair market value of anunrestricted capital interest (i.e. one that is fully vested atthe time of transfer) is ordinary income to the recipient onthe date of transfer, less the amount (if any) that therecipient paid for the interest. See Treas. Reg. § 1.721-I(b)(1). The LLC or corporation will be able to deduct oramortize the amount the recipient reports in income. SeeI.R.C. § 83(h), 162 and 212.

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(2) Restricted Interests. If the interest is subject to asubstantial risk of forfeiture at the time of transfer, the fairmarket value of the capital interest (less the amount paid bythe transferee, if any) will be ordinary income to thetransfer when the risk of forfeiture lapses. The LLC orpartnership will be able to deduct or amortize the paymentat the time the recipient reports the income. In addition, therecipient may elect to make an election to be taxed on thefair market value of the interest as of the date of transfer.See I.R.C. § 83(b). The recipient will immediately becomea member if the 83(b) election is made. See Treas. Reg.1.83-2(a).

c. The tax treatment of compensatory options to acquire capitalinterests is not entirely settled. However, the general view is suchoptions should be taxed within the framework of the Section 83rules (see previous discussion regarding the tax treatment ofNSOs).

d. A transfer of profits interests to a service provider in exchange forservices to the LLC/partnership will not be a taxable event foreither the recipient of the interests or for the members/partners if:

(1) The recipient is already acting in a partner capacity or theaward is in anticipation of the recipient acting in a partnercapacity,

(2) The interest does not relate to a "substantially certain andpredictable stream of income,"

(3) The partner holds the interest for at least two years afterreceipt, and

(4) The LLC/partnership is not publicly traded.

See Rev. Proc. 93-27, 1993-2 C.B. 343.

e. The IRS has clarified this position in response to concerns withwhether this treatment would apply to restricted profits interests(i.e., those subject to vesting conditions). The IRS will consider anunvested interest to have been transferred to the recipient on thedate of grant if all of the conditions of Revenue Procedure 93-27are met and:

(1) the recipient of the profits interest is treated as the owner ofthe interest from the date of grant and the recipient takes

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into account the distributive share of tax items associatedwith the interest for the entire period that the recipientholds the interest, and

(2) neither the LLC/partnership nor any of themembers/partners deduct any amount for the fair marketvalue of the profits interest when the interest is granted orwhen it becomes vested.

See Rev. Proc. 2001-43, 2001-2 C.B. 191.

f. These IRS positions create an attractive compensation planningopportunity that cannot be replicated under any of the equity-basedincentive compensation arrangements available to corporateemployers. However, certain issues should be considered beforegranting employees profits interests:

(1) If the partnership/LLC attaches a vesting schedule to theaward, recipients may still wish to make protective Section83(b) elections.

(2) Because the special rule only applies to persons who arepartners or who are expected to become partners, grants tonon-partner employees may not qualify for the rule unlessthe employee will have some attributes of a partner.Consideration should be given the employee's managementrights and other indicia of partner status. See P.L.R.9533008.

(3) In order to avoid some of the uncertainties surrounding thespecial rule, partnerships and LLCs may want to consideranother form of incentive compensation. For example, aphantom stock plan may be a more efficient and simplerarrangement to administer.

IV. FINANCIAL ACCOUNTING ASPECTS OF INCENTIVE COMPENSATION

A. Significance of Financial Accounting Rules

I1. Amounts paid to employees and consultants in exchange for their servicesmust generally be recorded as a compensation expense for balance sheetpurposes. Unlike public companies, private businesses generally are notas sensitive to the impact of compensation arrangements on their financialstatements. However, companies planning for a public offering and thosewhose financial statements are the subject of loan covenants or conditions

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imposed by outside investors may be concerned with minimizingcompensation expenses.

2. There are a number of special rules governing how much, if any,compensation expense must be recognized in connection with varioustypes of incentive-based compensation. One of the traditional attractionsof stock options is that they may, under certain circumstances, be awardedwithout generating a compensation expense under current financialaccounting standards.

B. General Accounting Principles for Stock Compensation

I1. There are two alternative methods of computing the value of stockcompensation for employees. Under current accounting standards, anemployer is required to elect and consistently use one of the methods.

a. Intrinsic Value Method. This is the most popular method becauseit often will not result in recognition of any compensation expensefor stock options. The intrinsic value method is used by the vastmajority of private companies to account for employee stockcompensation. See APB Opinion No. 25, Accounting for StockIssued to Employees ("APB 25"); FASB Interpretation No. 44,Accounting for Certain Transactions involving StockCompensation ("FIN 44").

b. Fair Market Value Method. This method requires that someexpense be recognized in connection with a compensatory stockaward. The expense is based on the fair market value of the stockaward on the date on which it was granted. Fair market value istypically computed based on a formula that considers a number offactors. See FASB Statement of Financial Accounting Standards,Accounting for Stock-Based Compensation ("FAS 123").

2. Stock awards to non-employees must be accounted for under the fairmarket value method of FAS 123. However, employers have the option tomeasure the compensation expense based on either the fair value of theincentive award or the fair value of the goods or services received fromthe non-employee, whichever is more reliably determinable.

3. There is an important exception to the requirement that awards to non-employees be accounted for under FAS 123. Non-employee directors ofcorporate entities are treated as employees and awards to them aremeasured under the intrinsic value method of accounting under APB 25.See FIN 44, 7, 8.

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4. Even though the fair market value method of accounting under FAS 123 isoptional, employers that use the intrinsic value method of APB 25 arerequired to disclose on a pro forma basis in the footnotes to their financialstatements what their earnings and earning per share would have been ifFAS 123 had been applied.

C. Basic Principles of the Intrinsic Value Method of Accounting (APB 25)

1. APB 25 requires that a compensation expense be measured and reflectedfor all stock option, purchase, award and bonus rights granted by anemployer corporation to an individual employee. However, if a stock planqualifies as a "noncompensatory plan," no compensation expense isrequired to be recognized for awards made under the plan. In order to be anoncompensatory plan, a plan must meet the following conditions:

a. Only one employer stock can be issued,

b. Substantially all full-time employees who meet limitedemployment qualifications must be eligible to participate in theplan,

c. Options or awards must be granted equally to all employees, orbased on a uniform percentage of salary,

d. The discounted purchase price of any option under the plan mustbe reasonable. A 15% discount is a safe harbor for purposes ofthese rules, and

e. The time permitted for exercise of options under the plan must bereasonable.

2. If a plan does not qualify as a noncompensatory plan, compensationexpense must be measured as of a "measurement date."

a. The determination of the measurement date is a key factor indetermining how much, if any, cost must be recognized under anaward. The measurement date is typically the first date on whichboth of the following factors are known:

(1) The number of shares the employee is entitled to receive

under the award; and

(2) The option or purchase price, if any.

b. Performance conditions that are limited solely to the employee'scontinued service are ignored for purposes of determining how

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many shares the employee will be able to acquire. As a result,applying a service-related vesting schedule to an award will notcause the measurement date to be delayed beyond the date onwhich the award was granted.

c. However, if vesting is based solely on the attainment of corporateperformance objectives, the measurement date generally will notoccur unless and until the performance criteria are met. It may bepossible to avoid this result by using a vesting schedule that merelyaccelerates vesting upon attainment of performance criteria.

See APB 25, 10

3. If both of these factors are known at the time the award is made, the awardis fixed. Under "fixed plan" accounting, the amount of compensation costis measured based on the difference between (1) value of the stock on themeasurement date, and (2) the amount the employee is required to pay toreceive the stock, if any. Therefore, options that qualify for fixed planaccounting will not give rise to any compensation expense if the exerciseprice is equal to the fair market value of the stock on the date of grant.

4. If the factors described above are not known at the time the award isgranted, the award is variable. Under "variable plan" accounting, thedifference between (1) value of the stock on the measurement date and (2)the amount the employee is required to pay to receive the stock, if any, isrecognized on the date the award was granted, and increases or decreasesin the fair market value of the stock are periodically recognized until themeasurement date occurs.

a. For example, a stock option that is subject to variable planaccounting will give rise to a compensation expense as a result offuture increases in the value of the underlying stock, even thoughthe exercise price of the option was equal to the after market valueof the stock on the date it was granted.

b. Two types of awards that are always subject to variable planaccounting are SARs and phantom stock plans. Variable planaccounting for SARs often make them a less desirablecompensation vehicle than stock options and restricted stock,which can qualify for fixed plan accounting. See FASBInterpretation No. 28, Accounting for Stock Appreciation Rightsand Other Variable Stock Option or Award Plans.

5. There are a number of rules governing the period over which an expensemust be recognized.

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a. For awards subject to fixed plan accounting, compensationexpense under the award must be recognized "using a systematicand rational method" over the employee's total service period.Companies generally elect to recognize the expense on a straight-line basis over the vesting period of the award.

b. For awards subject to variable plan accounting, compensationexpense must also be recognized over the employee's serviceperiod. However, this expense must be periodically adjusted toreflect changes in the value of the employer's stock.

See APB 25, 12-15.

D. Proposed New Accounting Standards (Share-Based Payment Standards)

1 . In response to criticism over the intrinsic value method of accounting,FASB has issued an exposure draft with entirely new standards ofaccounting for stock compensation. Based largely on the FAS 123 fairvalue standards, the exposure draft would eliminate intrinsic valueaccounting.

2. Under the proposed new standards, a company would be required torecognize an expense for stock-based awards according to the fair marketvalue of the awards on the date of payment. Awards that are designed tobe settled in stock, such as a stock option, would be subject to fixedaccounting. The company granting the option would be required todetermine the fair market value of the option as of the date on which itwas granted, and then recognize this fixed compensation cost over theoption's "requisite service period" (which is typically the vesting period).

3. The exposure draft has been subject to intense review since it was issuedin April, 2004. Particular attention has been focused on the appropriatemethod for valuing options and other "equity instruments."

4. The new standards are proposed to take effect for non-public companiesfor years beginning after December 15, 2005. However, there have beenreports that FASB is considering delaying the effective date of the newrules. A new draft of the standards is expected to be released later thisyear or early next year.

E. Deferred Compensation and Other Cash Compensation

I1. General Rules

a. The liability that accrues under a cash-based deferredcompensation plan is required to be recognized as an expense. As

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a general matter, expense from the plan is required to berecognized over the employee's required service period. See APB12, Omnibus Opinion - 1967; FAS 87, Employers' Accounting forPensions.

b. The aggregate amount that is accrued over the service periodshould equal the present value of the benefits that ultimately areexpected to be paid. If the amount to be paid is not known withcertainty due to an unknown variable (such as how long theemployee will continue to work), the accrual is made based on bestavailable estimates.

c. If corporate owned life insurance is purchased to informally fundthe expected future liability under the deferred compensation plan,increases in the cash surrender value of the policy can generally byrecorded as a an asset that offsets the cost of the benefit accruingunder the plan. See FASB Technical Bulletin 85-4, Accounting forPurchases of Life Insurance

V. SECURITIES LAW ASPECTS OF INCENTIVE COMPENSATION

A. Types of Compensation Plans Affected by Securities Laws

I1. Stock-Based Plans

a. These plans include traditional stock option and SARarrangements.

b. For securities purposes, there are two potentially registrablesecurities under these plans. One security is the actual stock that isissuable under the plan. The other security is a derivative security,such as a stock option. Generally, it is not necessary to separatelyregister or exempt from registration a derivative security if theunderlying stock issuable under the plan is registered or exemptfrom registration.

2. Deferred Compensation Plans

a. An employee's deferrals into a deferred compensation plan areoften credited with a hypothetical or deemed investment return.The employee's account is adjusted up or down based on theperformance of the target investment.

b- As explained in more detail below, the SEC staff has said that it is"not prepared to disregard" the argument that deferred

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compensation obligations are analogous to investment notes, whichtypically are viewed as securities.

3. Bonus Plans Involving Stock and Phantom Stock Plans

a. From the SEC's perspective, a bonus plan is a plan that does notrequire any payment by an employee to receive either the stock ora cash benefit based on the value of employer stock. For thispurpose, an employee's performance of future services are nottreated as payment for receipt of such stock or cash.

b. For broad-based bonus plans, the SEC position is that there is no"sale" involved. If there is no sale, the stock issued under the plandoes not have to be registered or exempted from registration. SeeEcolab, Inc., SEC No-Action Letter (February 11, 1991).

c. For individually negotiated arrangements, there may be a "sale" ofthe bonus stock which would require registration or exemptionfrom registration. See Pacific Telesis Group, SEC No-ActionLetter (June 30, 1992).

B. Securities Laws that Apply to Compensation Arrangements

1. Securities Act of 1933

a. The Securities Act of 1933 ("1933 Act") is the primary controllingstatute for securities offerings. The 1933 Act controls all offers orsales of securities. All offers and sales of covered securities mustbe registered unless an exemption applies.

b. The basic remedy for a registration violation is a right of recission.Under recission, a purchaser of a security is allowed to rescind thetransaction and recover the consideration paid for the security, plusinterest. See Section 12(a), 1933 Act.

2. Securities Exchange Act of 1934

a. The Securities Exchange Act of 1934 ("1934 Act") provides for theregistration of companies traded on an exchange or that have morethan $1 million in assets and 500 or more shareholders. SeeSection 12, 1934 Act.

b. The principal provisions of the 1934 Act affecting executivecompensation are the Section 16 rules on reporting of holdings andshort swing profit recovery, as well as a prohibition on employerloans to executive officers. See Sections 16 and 13k, 1934 Act.

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3. State Blue Sky Laws

a. States and the federal government share responsibility for theregulation of securities. In most cases where a federal registrationissue arises, there is a parallel state law issue. The state laws thatregulate securities are commonly referred to as "blue sky" laws. Acompany does not have to be conducting business in the state for astock award to be subject to a state's securities regulations.

b. Federal law preempts state blue sky law in certain circumstances.For example, offers of securities that are listed on an establishedexchange are generally not subject to state blue sky laws.However, transactions involving most private companies aresubject to state blue sky laws.

c. Many states exempt employee benefit plan transactions fromregistration, or exempt transactions that involve only a smallnumber shares or a small number of offerees in the state.However, some states, notably California, have a developedsystem of regulating private company stock option plans.Attention should be paid to these rules when developing plans thatwill provide for grants in such states. See Cal. Code Regs. tit. 10,§ 260.140.41.

C. Why Register or Exempt Compensation Plans?

I1. Plans Involving Sales of Securities. The sale of an unregistered securitymakes the seller subject to liability. Therefore, registration orqualification for an exemption is necessary to avoid this potential liability.

a. Stock options involve a sale of a security by the issuer company tothe optionee. The exercise of an option involves the payment ofthe exercise price in exchange for the issuance of stock.Registration or exemption of the underlying shares, rather than theoptions themselves, is required.

b. The option generally is considered a derivative security. Becausethe option generally is given to the optionee, the option is treatedas a bonus that does not involve a sale (see Section V.A.3 above).

2. Plans that Defer Compensation

a. Following the Supreme Court decision in InternationalBrotherhood of Teamsters v. Daniel (439 U.S. 551, 1979), the SECissued two releases designed to clarify the application of the 1933Act to compensation arrangements. The releases conclude that two

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elements are required to make an employee compensation plansubject to the 1933 Act: (1) voluntary participation, and (2)contributions by participants. Plans that are not both voluntary andcontributory generally are not considered to involve any potentialsale of securities. The releases focus on tax-qualified plans andplans involving sales and purchases of employer stock. SeeEmployee Benefit Plans, Release No. 33-6 188 (February 1, 1980);Employee Benefit Plans, Release No. 33-6281 (January 15, 1981).

b. In the two releases, the SEC relied on the test in SEC v. W.I.Howey Co., 328 U.S. 293 (1946) to determine the existence of aninvestment contract. Under Howey, a financial interest must havefour elements to be a security: (A) investment of money, (B) in acommon enterprise, (C) with an expectation of profits, (D) fromthe efforts of others.

c. Before 1991, the SEC issued a series of no-action letters involvingregistration of interests in deferred compensation plans. Theseletters typically involved one of two scenarios.

(1) First, the SEC staff took a no-action position on the failureto register interests in deferred compensation when theyield was measured other than by employer stock price.See McKesson Corp., SEC No-Action Letter (Jan. 9. 1990)(compensation committee sets rate); Shearson LehmanHutton, Inc., SEC No-Action Letter (May 29, 1986)(Treasury bill rate).

(2) Second, in circumstances where employer stock was usedas a means of measuring benefits, the no-action letters thatdid not require registration dealt with plans that benefitedonly a few highly compensated employees and the planswere "mirror" arrangements for qualified plans that wereregistered. See St. Paul Companies, Inc., SEC No-ActionLetter (Feb. 25, 1988).

d. In 1997, the SEC staff changed its position. It announced that itwould cease to issue no-action letters for any non-qualifieddeferred compensation plans, including interest-only plans,because "it was not prepared to disregard the argument that thedebt owed to plan participant is analogous to investment notes,which typically are viewed as debt securities." See SEC Div. ofCorp. Fin., Current Issues and Rulemaking Projects, pp. 56-57(November 14, 2000).

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3. Consequences of Not Registering or Exempting Sales under the Plan

a. As discussed above, the purchaser of the security has the right torescind the sale. The purchaser can sue for a period of up to oneyear for recovery of the amount paid for the security, plus interest.See Section 12(a), 1933 Act.

b. In addition, violations of the registration rules can result in adversepublicity and could negatively impact plans to go public. SeeGoogle Discloses Possible Violations, Associated Press article(Aug. 5, 2004)

D. Federal Registration Exemptions for Privately-Held Companies

1. Rule 701. Rule 701 is the primary exemption for offerings of securitiesunder employee benefit and other compensatory plans. Some of itsconditions are similar to those that apply to the short form of registrationavailable to public companies for registering their plans with the SEC.

a. Rule 701 applies to any issuer that is not subject to the reportingrequirements of Section 13 or 15(d) of the 1934 Act. The ruleapplies to securities issued while a company is private, even if thecompany later becomes a public reporting company. See 17 C.F.R.§ 230.701(b).

b. Rule 701 covers "compensatory benefit plans" which are purchase,savings, option, bonus, stock appreciation, profit sharing, thrift,incentive, deferred compensation, pension or similar plans orcontracts. See 17 C.F.R. § 230.701(c)(2). The issuer, its parent ormajority-owned subsidiaries of it or its parent can establish theplan. See 17 C.F.R. § 230.701(c).

c. The eligible participants are employees, directors, general partners,trustees of business trusts, officers, consultants or advisors. See 17C.F.R. § 230.701(c). Consultants or advisors can only participateif they are natural persons, provide bona fide services to theregistrant and the services are not in connection with a sale ofsecurities in a capital-raising transaction. See 17 C.F.R. §230.701(c)(1).

d. In addition, Rule 701 applies to an employee's family memberthrough the exercise of a transferable option that was transferredthrough a gift or domestic relations order. A family member is achild, stepchild, grandchild, parent stepparent, grandparent, spouse,

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former spouse, sibling, niece, nephew, certain in-laws, a trust inwhich these persons have more than 50 percent interest and similarfoundations or other entities. See 17 C.F.R. § 230.701(c)(3).

e. Rule 701 has no limits on the amount of securities than can beoffered under the exemption. It does impose a maximum limit onthe amount of securities that can be sold in any 12-month period.The limit is the greatest of(A) $1 million, (B) 15% of the totalassets of the issuer, or (C) 15% of the outstanding securities of theclass being offered. See 17 C.F.R. § 230.701(d)(2). For purposesof this limit, the grant of a stock option is treated as a sale (withoutregard to when the option will become exercisable). The sale priceis the exercise price of the option. See 17 C.F.R. § 230.701(d)(3).

f. There are explicit disclosure requirements for offerings under therule. In all cases, the issuer must deliver a copy of thecompensatory benefit plan or contract to the reward recipient. Inaddition, if the aggregate sale price of securities sold in any 12-month period exceeds $5 million, the issuer must provide (A)information about the risks associated with the investment, (B) itsfinancial statements, and (C) a summary of the terms of the planSee 17 C.F.R. § 230.701(e).

g. Unlike some other exemptions, the use of Rule 701 does notdisqualify the company from other exemptions and the securitiesissued under Rule 701 are not integrated with other offerings. See17 C.F.R. § 230.701(d)(3)(iv), (f).

h. All securities issued under Rule 701 are restricted securities forpurposes of Rule 144. See 17 C.F.R. § 230.701(g).

2. Regulation D. Under Regulation D of the 1933 Act, there are severalpossible exemptions from registration for limited offerings. For smallgroups of executives, many of these exemptions may be available. Theseexemptions may be most applicable to officers of a company since thoseofficers are likely to have information about the financial and businesssituation of the issuer.

a. Under Rule 505 of the 1933 Act, an issuer can offer up to $5million in securities within a 12-month period. There can be nomore than 35 purchasers under a Rule 505 offering. See 17 C.F.RI§ 230.505(b)(2). The issuer must provide financial and otherinformation to the purchaser. See 17 C.F.R. § 230.502 (b).

b. Under Rule 506, any amount of securities can be offered to nomore than 35 purchasers. See 17 C.F.R. § 230.506(b). Each

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purchaser must be an accredited investor or have the knowledgeand experience to evaluate the merits and risks of the investment.See 17 C.F.R. § 230.506(b)(2)(ii).

c. In addition, Rule 504 applies to offerings that are less than $1million in a 12-month period. See 17 C.F.R. § 230.504(b)(2). Theissuer generally must provide financial and other information tothe purchaser. See 17 C.F.R. § 230.502(b).

3. Rule 147. Section 3(a)(1 1) of the 1933 Act exempts sales of securitiesthat are conducted entirely within a single state. There are a number ofconditions for this exemption which limit its usefulness, such as therequirement that all offerees and purchasers have their principal residencein the state. See 17 C.F.R. § 147(d).

VI. EMPLOYMENT AND LABOR LAW ASPECTS OF INCENTIVE COMPENSATION

A. Federal Hourly Wage Laws

I Fair Labor Standards Act of 1938 (FLSA)

a. The FLSA regulates the manner in which pay is computed foremployees who are not otherwise exempt from the act (i.e., "non-exempt employees"). There have been questions for a number ofyears as to whether grants of stock options and other forms ofstock based-compensation to non-exempt employees must be takeninto account in computing wages under the FLSA.

b. In 1999, the U.S. Department of Labor issued an opinion letter inwhich it concluded that stock options did not fall within anyrecognized exemption from the FLSA. See Department of Labor,Wage and Hour Division Op. Let., Feb. 12, 1999.

2. Worker Economic Opportunity Act of 2000 (WEOA)

a. The uncertainty created by the Department of Labor's FLSA rulingled to enactment of legislation which creates a limited safe harborfrom the FLSA for certain types of stock awards. The WEOAprovides that grants of stock options and SARs, and rights toacquire stock under a stock purchase plan, will be excluded fromcalculating an employee's regular pay under the FLSA if certainconditions are met. See 29 U.S.C. § 207(e)(8).

b. The safe harbor provided by the WEOA does not cover restrictedstock awards.

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c. The general conditions for the exemption are:

(1) In the case of stock options and SARs, there must be atleast a six month period between the date of grant and thedate on which the option or SAR is first exercisable. Inaddition, the exercise price for the stock option or SARmust be at least 85% of the FMV of the underlying stock onthe date the award is granted.

(2) Employees must be informed of the material terms andconditions of the plan and their rights under it either at thebeginning of their participation or at the time they aregranted an award (e.g., the expiration of the award, exerciseprice, exercise period, etc.)

(3) The employee's right to exercise the award under the planmust be voluntary. However, employers are permitted toautomatically exercise an award at the time it would expireso long as the employee had not previously notified theemployer that he or she did not want the employer toexercise the award on their behalf

(4) Additional requirements apply if the award is performance

based, or if the plan is an employee stock purchase plan.

B. Employment Law Issues

1. Recent Litigation Involving Stock Options and Other Awards

a. There have been number cases brought by employees in recentyears concerning rights under options and other stock awards.Some of the areas of dispute that typically arise involve:

(1) Whether termination of an employee's employment wasinitiated to prevent the employee from vesting in his or herunvested incentive awards.

(2) Whether alleged oral promises made concerning fitureincentive awards or the terms of existing awards areenforceable against the employer.

(3) Proper interpretation of ambiguous terms in incentiveawards.

b. Although employers generally cannot fully insulate themselvesfrom these types of claims, they can take steps to minimize the risk

IMcGUIREWOODS

that employees or former employers could succeed on such claims.Some helpful practices include:

(1) Careful drafting of incentive awards to eliminate anylanguage that would appear to provide employees withvesting rights beyond those that the employer intends toapply. For example, plans and grants should clearly statethat unvested awards are granted in consideration of futureservices and that the award is not an employment contract.

(2) Companies should consider monthly vesting formulas(instead of the standard yearly formula), and should notgrant awards with significant future vesting terms to poorlyperforming employees.

(3) Termination, vesting, and exercise provisions should beclearly set forth in plans and individual award agreements.

(4) All incentive awards should evidenced by writtenagreements.

2. Use of Noncompetition Agreements in Stock Awards

a. The traditional means for employers to enforce non-competeagreements has been to seek a judicial injunction. This is oftencostly, and courts are typically hostile to non-competitionagreements that are not specifically tailored to address theemployer's particular business concerns. In addition, some courtswill not enforce non-competes unless the employee was providedsome specific economic benefit (other than mere continuedemployment) in exchange for the non-compete. See, e.g., Youngv. Mastrom, Inc. 99 N.C. App. 120, 392 S.E. 2d 446 (N.C. 1990)

b. In recent years, employers have been adding non-competeprovisions to stock option awards. A common approach is torequire that the award be cancelled if the employee breaches thenon-compete, and that the employee disgorge any gains that he orshe received under the award as a result of any exercise thatoccurred within a specified time prior to the breach.

c. The courts that have reviewed these agreements have generallyheld them to be enforceable. See IBM v. Bajorek 191 F.3d 1033(9 th Cir. 1999); IBM Corp. v. Martson, 37 F. Supp. 2d 613

(S.D.N.Y. 1999).

IMcGUIREWOODS

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Executive Compensation Planning for Privately-Held …€¦ · · 2016-08-09Executive Compensation Planning for Privately- ... EXECUTIVE COMPENSATION PLANNING FOR PRIVATELY-HELD