Top 10 Compensation Concerns of Executives
Presentation to:
Presented by:
NASPP, Austin Chapter
July 22, 2014
Anthony J. Eppert, Winstead PC
AEppert@Winstead.com
713.650.2721
© 2014 Winstead PC
© 2013 Winstead PC
About Anthony ("Tony") Eppert

Tony is a Shareholder in Winstead's Compensation & Benefits
practice group. His legal practice focuses on executive compensation
and employee benefit arrangements in the United States and abroad

Before entering private practice, Tony:
– Served as a judicial clerk to the Honorable Richard F. Suhrheinrich of the
United States Court of Appeals for the Sixth Circuit
– Obtained his LL.M. (Taxation) from New York University
– Obtained his J.D., cum laude (Tax Concentration) from Michigan State
University College of Law
 Editor-in-Chief, Journal of Medicine and Law
 President, Tax and Estate Planning Society
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Purpose of Presentation

The purpose of this presentation is to discuss various compensation
concerns of executive officers and key employees

To that end, this presentation is limited to the top 10 compensation
concerns (presented in no particular order):
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1
Point of hire compensation;
Pushing for incentive stock options or restricted stock;
Maximizing capital gains through partnership profits interests;
Achieving favorable vesting provisions;
Proactively addressing insider trading issues;
Minimizing 280G exposure;
Separation pay and termination triggers;
Six-month wait issues under Section 409A;
Limiting restrictive covenants and clawbacks; and
Ensuring proper indemnification coverage
© 2014 Winstead PC
Point of Hire Compensation

Base salary
– The amount is negotiated
– Flexibility is typically afforded in the executive contract as to “how often”
the amount will be negotiated

Bonus
– Contracts generally provide executives with a bonus, even though the
timing and the amount of any bonus is subject to the sole discretion of the
board of directors
– It is also common to set a target bonus equal to a % of the executive’s
base salary
– Be sure any provisions addressing the timing of a bonus payout comply
with Section 409A

Signing bonus
– Signing bonuses are typically provided in the form of cash or equity
– Typically the executive has to negotiate the issue of whether any signing
bonus should be forfeited or subject to clawback if the executive
terminates employment within a certain period of time or attempts to
violate any provision of the contract
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Point of Hire Compensation (cont.)

Equity grants
– To avoid sloppy grant practices and potential allegations of back-dating,
consider specifically indicating when the grant is to occur
– Is it to occur in the future when the board of directors acts? Or is it to
occur on the “effective date” of the executive contract?
– If the latter, be sure that the board of directors approves the contract
because, absent a valid delegation of authority from the board of directors
to another individual or committee, only the board of directors would have
the authority to grant equity
– Consider whether key terms of the equity grant should be included within
the executive contract, such as number of shares, strike price (if any),
vesting schedule, any restrictive covenants, etc.
 Alternatively, attach the award as an exhibit to the executive contract and
incorporate the exhibit into the executive

Expense reimbursement
– Typically, reimbursement will be subject to the employer’s reimbursement
policies and procedures
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Point of Hire Compensation (cont.)

Fringe benefits
– From the executive’s perspective, it is best to list as many fringe benefits
within the executive contract as possible (e.g., gym membership, golf, etc.)

Car allowance
– Providing a dollar allowance is the cleanest
– However, if instead a lease is to be provided, then consider who is
responsible for the lease if the executive terminates employment prior to
the end of the lease term. Who has the first opportunity to purchase the
car from the lease?

Relocation assistance
– Reasonable costs of relocation are often covered. What does this mean?
Does it cover sale of the prior home, a house hunting trip, broker
fees/commissions, the whole family, the number of trips, etc.?
– The foregoing is usually an issue if the verbiage is vague and the employer
does not otherwise have policies and procedures covering relocations

Legal fees
– Depending on the position, it is customary to cover legal fees incurred by
the executive in conjunction with the review and negotiation of the
executive contract
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Options v. Stock Grants: ISOs
•
An incentive stock option (an “ISO”) is a stock option granted to an
employee to purchase stock of the employer corporation, its parent or
its subsidiary
– Numerous tax rules must be satisfied for an option to qualify as an ISO
•
Generally, ISOs are preferred by optionees (compared to nonstatutory
stock options, a.k.a., “NSOs”) because of their favorable tax treatment
– No taxable income is triggered to the optionee at the time of grant
– No taxable income is triggered to the optionee at the time of exercise
o However, the spread between the fair market value of the underlying stock and
the exercise price would be an item of adjustment for purposes of calculating
any alternative minimum tax
– If the stock is held for at least 2 years from the date of grant AND at least 1
year from the date of exercise (the “Holding Period”), then any gain
realized on a subsequent sale of the underlying shares would be taxed at
capital gains rates
•
5
Neither the grant nor the exercise of an ISO provides the employer
with any compensation deduction
© 2014 Winstead PC
Options v. Stock Grants: ISOs (cont.)
•
A “Disqualifying Disposition” occurs when the Holding Period (prior
slide) is not satisfied. In such instances:
– The optionee would recognize ordinary taxable income (and the employer
would have a corresponding compensation deduction) equal to the excess
(if any) of the fair market value of the stock as of the date of exercise over
the exercise price
– Such compensation income would be added to the stock’s basis to
determine any capital gain that must be recognized on the Disqualified
Disposition
•
To qualify as an ISO, the option must comply with all of the following
tax rules:
– Rule 1: The plan providing for the grant of ISOs must be approved by the
employer’s shareholders within 12 months before or after the plan is
adopted
– Rule 2: The plan must specify the aggregate number of shares of
employer stock that are available for issuance under the plan AND the
number of shares subject to ISO treatment
– Rule 3: The plan must specify the employees or class of employees
eligible to participate
– Rule 4: The option must be granted within 10 years from the date the plan
is adopted or approved, and must be exercised (if at all) within 10 years
from the date of grant of the option
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Options v. Stock Grants: ISOs (cont.)
•
To qualify as an ISO, the option must comply with all of the following
tax rules (continued from prior slide):
– Rule 5: The optionee must be an “employee” of the granting corporation,
its parent or its subsidiary (or an employee of an entity that has assumed
the options pursuant to a reorganization)
– Rule 6: The optionee must remain an employee from the time the ISO is
granted until three months before it is exercised, extended to one year if
termination of employment is due to disability, and no time limit if
termination of employment is due to death (also known as the “posttermination exercise period”)
o The terms of the plan may specify a shorter period
– Rule 7: The exercise price must be equal to or greater than the FMV of the
underlying stock at the time the ISO is granted
o However, for optionees owning 10% or more of the employer’s voting power or
all classes of stock, the exercise price must be at least 110% of the fair market
value of the underlying stock at the time the ISO is granted
– Rule 8: There is a $100,000 limit on the aggregate fair market value
(valued at the time the option is granted) of employer stock that can be
exercised under an ISO for the first time by an employee during any
calendar year
o Any options exceeding this limit are treated as NSOs
– Rule 9: An ISO cannot be transferable (except at death), and during the
employee’s lifetime, must be exercisable only by the employee
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© 2014 Winstead PC
Options v. Stock Grants: ISO Modifications
•
Generally, modifications, extensions and renewals of an ISO and NSO
would be deemed a new grant. If no other changes are made to the
exercise price, then:
– The ISO would lose favorable ISO treatment and be deemed an NSO
(because it did not comply with Rule 7 (see Slide 4))
– The NSO would likely violate Section 409A and therefore would likely be
subject to adverse tax consequences under Section 409A. Such adverse
tax consequences include:
o An earlier inclusion of ordinary taxable income,
o An additional tax equal to 20% of the amount that that is required to be included
as ordinary taxable income, and
o Interest, fines and penalties
•
Avoid modifications by addressing provisions on the front end!
– Whenever an amendment to an existing option is being considered
(whether an ISO or NSO), be sure to determine whether the amendment
would be considered a “modification,” “extension” or “renewal” of the
option under ISO rules (if applicable) and Section 409A
– For example, adding a "net exercise" feature after-the-fact IS a
modification for ISO purposes but is NOT a modification for 409A purposes
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Options v. Stock Grants: Immediately Exercisable ISOs
9

Immediately exercisable ISOs are prevalent in tech companies

The concept of an immediately exercisable ISO is that an optionee
may exercise unvested stock options and, upon such an exercise,
he/she will receive a restricted stock award subject to the same
vesting schedule

The question is whether to make an 83(b) election at the time of an
early exercise? Questions often arise as to why even make the
election given that the ISO already protects any positive spread as
capital gains (assuming the Holding Period is satisfied)

Remember AMT applies to the spread of an ISO on the date of
exercise

Tax law provides that the determination of the spread for AMT
purposes will occur at vesting UNLESS the optionee makes an 83(b)
election (for AMT purposes) at the time of exercising the ISO and
receiving the restricted stock award

Thus, assuming the stock price is on the rise at the time of exercise,
the goal is to capture AMT at a lower fair market value (as opposed to
capturing AMT at a higher fair market value when the underlying stock
later vests)
© 2014 Winstead PC
Options v. Stock Grants: Net Exercise of an ISO
10

The question is whether a net exercise of an ISO will destroy ISO
eligibility as to the whole ISO? Or will ISO eligibility be lost only as to
the portion that was netted?

The law is not settled on this issue (the law is silent or unclear)

A conservative position is to treat the whole option as having lost ISO
status

However, the Code is a law of restraint, and since there is no direct
tax law that would require the whole option to lose ISO treatments, a
position could be taken that ISO treatment is not lost as to the stock
that was not netted in the net exercise
© 2014 Winstead PC
Options v. Stock Grants: Restricted Stock
•
Generally, the grant of restricted shares would constitute a corporate
transfer but not a tax transfer
– A corporate transfer means the executive is entitled to voting and dividend
rights even if the award is subject to forfeiture
– If the award is subject to forfeiture, then the tax transfer typically coincides
with vesting
•
Tax treatment to the executive assuming no 83(b) election was timely
filed:
– Unless an 83(b) election is timely filed, the executive would generally
recognize ordinary taxable income equal to the fair market value of the
award (less any amount paid) as of the earlier of: (i) the date the shares
become transferable, or (ii) the date the forfeiture restrictions lapse (i.e.,
the date of vesting)
– Until such time, any dividends received by the executive on account of the
restricted stock grant would be treated as compensation, not dividends
– After such time, any sale of the underlying stock would be treated as
capital gain or loss equal to the difference between the sale price and the
tax basis
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Options v. Stock Grants: Restricted Stock (cont.)
•
Tax treatment to the executive assuming an 83(b) election was timely
filed:
– The executive could attempt to capture as much of the anticipated future
appreciation of the underlying stock at capital gains rates by making an
“83(b) election” within 30 days from the date of grant
o The purpose of an 83(b) election is to limit the ordinary taxable income element
to the value of the stock on the date of grant (which can be much lower than the
amount of ordinary taxable income the executive would otherwise recognize at
the time of vesting)
o This means the executive would be taxed at the time of the initial transfer (at a
time when the fair market value of the stock may be low)
o Thereafter, any increase in the fair market value of the stock subject to the 83(b)
election would typically be taxed at capital gains rates when the executive sells
the stock
•
Tax treatment to the employer:
– If the executive is an employee, the employer would have a withholding
obligation and employment taxes at the time the executive recognizes
ordinary income
– Additionally, the employer would have a corresponding compensation
deduction at that time
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Options v. Stock Grants: A Comparison
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Options v. Stock Grants: A Comparison (cont.)
EVENT
Date of
Exercise
(Employee)
ISO
No federal income tax consequence
to the optionee or the company
However, the “spread” under an ISO –
i.e., the difference between the FMV
of the shares at exercise and the
exercise price – would be classified
as an item of adjustment in the year
of exercise for purposes of AMT. In
order to avoid the application of AMT,
the optionee would have to sell the
shares within the same calendar year
in which the ISOs were exercised.
However, such a sale within the same
calendar year would constitute a
“disqualifying disposition” (see next
slide)
The company would have no
withholding obligation and would not
be entitled to any deduction
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© 2014 Winstead PC
NSO
Optionee would have
compensation income (taxed at
ordinary rates) equal to the
difference between the option’s
exercise price and the FMV of the
underlying shares on the date of
exercise
The company would have a
corresponding withholding
obligation
The company would generally be
entitled to a compensation
deduction equal to the amount the
optionee included as ordinary
income
Restricted Stock
Not applicable
Options v. Stock Grants: A Comparison (cont.)
EVENT
ISO
NSO
Date of Sale
(Employee)
The tax consequences depend on whether the sale is
a “disqualifying disposition” (i.e., no disqualifying
disposition if the stock is held for at least: (i) 2 years
from the date of grant AND (ii) 1 year from the date of
exercise)
Any gain or loss
would be short- or
long-term capital
gain or loss,
depending on
whether the
shares were held
for one year
following exercise
If the sale is not a disqualifying disposition, then the
optionee would recognize long-term capital gain (or
loss) equal to the difference between the sale price of
the shares and the exercise price. The company
would be entitled to no corresponding deduction
If instead the sale is a disqualifying disposition, the
optionee generally would have compensation income
(taxed at ordinary rates) equal to the difference
between the exercise price and the FMV of the
underlying stock at the time of exercise (the company
would be entitled to a corresponding deduction).
Such compensation income would be added to the
stock’s basis to determine any capital gain that would
have to be recognized on the disqualifying disposition
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© 2014 Winstead PC
The company
would not receive
a compensation
deduction for any
such gain or loss
Restricted Stock
Same as NSOs
Options v. Stock Grants: Stock Grant Example
•
The following example compares the tax consequences of receiving
restricted stock with and without an 83(b) election
•
Assume the following facts:
– An executive received 10,000 shares of restricted stock on February 1,
2014, when the fair market value per share was $10
– The award vests 100% on the two year anniversary of the date of grant
(no interim vesting)
– When 10,000 shares vest on January 31, 2016, the fair market value per
share is $30
– The executive then sells the shares for $400,000 in May 2016, when the
fair market value per share is $40
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Options v. Stock Grant: Stock Grant Example (cont.)
•
•
•
17
If an 83(b) election IS timely filed upon receipt of the award:
Ordinary income upon grant 2/1/14:
Ordinary income tax 2/1/14 (40% x 100,000):
Ordinary income upon vesting 1/31/16:
Capital gain at sale 5/16 ($400,000 - $100,000):
Capital gains tax 5/16 (23.8% x $300,000):
$100,000
40,000
------300,000
71,400
Aggregate Tax on Award:
$ 111,400
If an 83(b) election IS NOT filed:
Ordinary income upon grant 2/1/14:
Ordinary income upon vesting 1/31/16:
Ordinary income tax 1/31/16 (40% x $300,000):
Capital gain at sale 5/16 ($400,000 - $300,000):
Capital gains tax 5/16 (23.8% x $100,000):
$ ------300,000
120,000
100,000
23,800
Aggregate Tax on Award:
$143,800
In this example, the tax cost to the executive for failing to make an
83(b) election is $32,400 ($143,800 less $111,400)
© 2014 Winstead PC
Options v. Stock Grant: Stock Grant Example (cont.)
•
The greater the increase in the value of the shares during the vesting
schedule, the greater the tax cost to the executive for failing to make
an 83(b) election
•
When determining whether or not to make an 83(b) election, the
executive generally must carefully consider the risk that the executive
may terminate employment prior to full vesting of the award
– Under Example 2, if the executive files an 83(b) election but terminates
employment prior to any vesting, the executive will forfeit all the shares
and will have paid $32,400 in tax for which he/she generally cannot claim a
refund
– Whereas if the executive had NOT filed an 83(b) election and terminated
employment prior to any vesting, he/she would have forfeited all of the
shares but would not have paid any tax
•
Worth noting is that some employers negate the above economic risk
by providing the executive with a gross-up at the time an 83(b)
election is made. Such a formula could be:
Total Gross Up = FMV of Stock on Date of Grant
1 Minus Applicable Tax Rate
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© 2014 Winstead PC
Partnership Profits Interests

Compensatory partnership interests offer a unique ability for the
executive to recognize all tax on an equity award at capital gains rates

A "capital interest" is generally defined as "an interest that would
provide the service provider a share of the proceeds if the
partnership's assets were sold at fair market value and then the
proceeds were distributed in complete liquidation of the partnership"
– Such can take the form of restricted interests, options to acquire interests,
conditional promises to be settled in equity (i.e., RSUs, SARs and
performance units)
– A benefit of a capital interest is that it provides the service provider with
enterprise value in the partnership as of the date of grant
– A drawback of a capital interest is the tax consequence

The tax consequences to granting a capital interest include:
– To the extent it is vested or an 83(b) election is timely made, the service
provider would recognize ordinary taxable income equal to the fair market
value of the capital interest, minus any monies paid for such interest
– Under Section 83, the partnership would be entitled to a compensatory
deduction at the time and in the amount that the service provider
recognized as ordinary taxable income
 As a planning note, ensure that the partnership agreement allocates any
compensatory deductions to only those partners that existed immediately prior to
the grant
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© 2014 Winstead PC
Partnership Profits Interests (cont.)

A “profits interest” is generally defined as an interest other than a
capital interest. It provides the service provider with a share of future
partnership profits and no interest in partnership capital prior to the
date of grant
– It is intended to provide an incentive for the service provider to pursue
enterprise growth
– Benefits of receiving a profits interest include: (i) tax consequences, (ii)
represents actual equity in the partnership, (iii) service provider generally
recognizes capital gains treatment upon a sale of the partnership to a third
party, and (iv) the character of income at the partnership level is generally
retained when distributed to the service provider

Tax consequences to the service provider in receiving a profits
interest
– Under Rev. Proc. 93-27 and Notice 2001-43, and Section 83 and Notice
2005-43 (with a protective 83(b) election), the service provider would not
recognize any taxable income on the date of grant
– Instead, the service provider would have taxable income on the sale of the
compensatory interest and such income would be taxed at capital gains
rates
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Favorable Vesting Provisions: CIC

Consider whether the applicable arrangements should require full or
partial accelerated vesting upon a CIC. Alternatives include:
– No acceleration
– Discretionary acceleration
– If an equity award, single trigger acceleration unless such equity is
assumed or replaced
– Double trigger acceleration (e.g, 6 to 18 months)
– If an equity award, single trigger acceleration even if equity is assumed or
replaced
 Generally not advisable

Some tax considerations include:
– Section 280G (later Slides)
– Accelerating vesting is permissible under Section 409A
– ISO status of stock options would be lost to the extent the aggregate value
of the underlying shares with respect to which the stock option became
exercisable for the first time by any individual during a calendar year
exceeded $100,000
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Favorable Vesting Provisions: CIC (cont.)

For public companies it is important to note that ISS highly disfavors
single-trigger vesting provisions

With that said, the following is a reason why some public companies
continue to use single trigger vesting provisions (as reported in some
proxy filings):
– Interest alignment between employees and target shareholders is
strengthened
– Equitable treatment to target shareholders, especially in instances where
unexercised options are in-the-money prior to closing but underwater after
closing due to inept management at acquiror level
– Possibly more effective to retaining management through closing (though
acquiror would prefer double trigger for post-closing retention purposes)
– Post-closing disputes over constructive termination is higher in the doubletrigger context than in the single trigger context
– Awards with significant value at time of closing would otherwise encourage
employees to be among those terminated
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Favorable Vesting Provisions: Retirement

There are two types of award agreements that are at issue when a
"retirement" provision within the award would accelerate vesting:
– Those with performance-based vesting provisions, and
– Those with time-based vesting provisions

For agreements with performance-based vesting provisions that
contain retirement provisions:
– The deferred compensation provisions of Section 409A generally do not
apply to the extent Section 83 of the Code applies;
– The continuation of performance-based metrics within the award
agreement should act as a substantial risk of forfeiture under Section 83 of
the Code. Such is the answer even though the employee has a
“contractual” right to benefits (to the extent the performance condition is
satisfied) due to his or her attaining retirement age;
– For the above reasons, there is no taxation upon the employee attaining
retirement age. This means no withholding obligation and no FICA/FUTA
is triggered at retirement age or upon a termination of employment on or
after attaining retirement age. Instead, taxation (both withholding and
FICA/FUTA) would be triggered when the performance condition becomes
satisfied
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Favorable Vesting Provisions: Retirement (cont.)

For agreements with only time-based vesting provisions that contain
retirement provisions:
– With time-based awards, the substantial risk of forfeiture under Section 83
is eliminated upon the employee attaining retirement age. Thus, a Section
409A issue arises whenever an employee attains retirement age but does
NOT then have a separation from service
– Whether Section 409A will apply depends upon “when” within the life cycle
of the award the employee attains retirement age. The following are
possible factual variations where the employee does not have a separation
from service upon reaching retirement age:
 The employee has attained retirement age as of the date of grant,
 The employee attains retirement age shortly after the date of grant,
 The employee attains retirement age within the calendar year of the regularly
scheduled vesting date, and
 The employee attains retirement age after the regularly scheduled vesting date
– Assuming the employee does not have a separation from service upon
attaining retirement age, the compensation in question is considered
“deferred” until his/her separation from service
– Due to the above, FICA and FUTA is triggered upon the employee
attaining retirement age. Wage withholding will then be triggered upon the
employee incurring a separation from service
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Favorable Vesting Provisions: 162(m) & Rev. Rul. 2008-13

The performance-based exception to the $1mm deductible
compensation limit under Section 162(m) does not apply if the
compensation is paid without regard to whether the stated
performance goal is satisfied

Revenue Ruling 2008-13 clarified that a payment would not qualify as
performance-based if under the terms of the executive contract (or
other agreement) it is payable (without regard to satisfying the
performance objectives) upon a termination of employment:
– By the company without Cause,
– By the employee with Good Reason, or
– Upon the employee’s retirement

However, notwithstanding this Slide to the contrary, satisfaction of the
objective performance goals may be waived upon:
– The employee’s death,
– The employee’s disability or
– A change in control of the company
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Favorable Vesting Provisions: 162(m) & Rev. Rul. 2008-13

The point of the prior slide is that the Executive could negotiate for the
bonus to be paid upon a termination without Cause, for Good Reason
or upon his or her retirement

This can be accomplished by, upon the above trigger, the executive
waiving rights to the performance pay and instead being paid some
other compensation, such as the greater of:
– A multiple of the executive’s base salary, and
– The average of the executive’s performance bonus paid to him/her over
the past three years
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Favorable Vesting Provisions: Other

Other provisions to be used to accelerate vesting include:
– A termination of the executive by the employer for other than Cause, and
– A termination by the executive for Good Reason (i.e., a constructive
discharge scenario)

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These concepts are addressed on a later slide
© 2014 Winstead PC
Insider Trading Solutions

Absent an applicable exception, insiders are generally prohibited from
purchasing or selling a security on the basis of material non-public
information
– A purpose of Section 10(b) and Rule 10b-5 is to prevent those with
material non-public information from gaining a competitive market
advantage over those who do not have access to the same information

Generally, the above rule is not violated if the insider has material
non-public information and only (though some insider trading policies
are not tightly written and could preclude an exercise or net exercise):
– Exercises and holds the shares,
– Initiates a net exercise to pay the exercise price or a net withholding to pay
withholding taxes, and
– Exercises and sells pursuant to a 10b5-1 trading plan

And in instances where a net withholding would be desired, but the
company lacks the cash flow to effectuate the IRS remittance, the
market could pay the withholding dollars if:
– The award agreement provided for such a sale in the market pursuant to a
formula that otherwise satisfied the rules for a 10b5-1 trading plan
– Such could be contained within the tax withholding section of the award
agreement
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Minimizing 280G

Golden parachute payments are governed by Sections 280G and
4999 of the Code. If applicable, these Code provisions generally:
– Impose a 20% excise tax on disqualified individuals for their receipt of an
excess parachute payment, and
– Deny a corporate deduction for the same

Only “excess” “parachute payments” that are “contingent” on a
“change in control” are subject to adverse tax consequences under
Section 280G
– Negate any of these 4 elements and Section 280G would not apply to that
particular payment
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
Payment is excessive if the aggregate present value of all payments
to a disqualified individual that would otherwise be a parachute
payment equals or exceeds 3x the disqualified individual’s “base
amount”

However, once triggered the tax applies to parachute payments that
exceed 1x base amount
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Minimizing 280G (cont.)

Alternative 1 – Do nothing
– Deduction would be disallowed and disqualified individual would be subject
to an excise tax

Alternative 2 – Allow the payment but provide the disqualified
individual with protection through a full or partial gross-up
– This alternative can cause shareholder relation issues
– Institutional shareholder advisory services such as ISS are opposed to
gross-ups

Alternative 3 – Implement a cutback so that the parachute payment
would not exceed 2.99x base amount (i.e., threshold test is never
satisfied)
– May not be ideal for a disqualified individual who could be financially better
off paying the excise tax (instance where payment would otherwise equal,
for example, 7x base amount)
– Conversely, a cutback could be financially advantageous to a disqualified
individual if the payment exceeding 2.99x base amount would otherwise
be less than the amount of the excise tax (instance where payment would
otherwise equal, for example, 3x base amount)
 Remember, the excise tax applies to amounts exceeding 1x base amount
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Minimizing 280G (cont.)

Alternative 4 – Implement a hybrid cutback whereby a disqualified
individual would be entitled to receive the greater of a 2.99x cutback
or payment of the excess parachute payment (with the 20% excise
tax)

Alternative 5 – Implement a hybrid cutback whereby an excess
parachute payment would not exceed a certain dollar amount

Alternative 6 – Implement a shareholder vote exception (private
corporations only), which generally means:
– Payment must be approved in a separate vote,
– Payment must be approved by more than 75% of the outstanding voting
power (excepting disqualified individuals),
– Adequate disclosure must be made of all material facts, and
– Vote must establish right of disqualified individual to receive payment
(means such individual must first disclaim all rights to such payments)
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
Alternative 7 – Same as Alternative 6 but provide a gross-up if the
corporation fails to SEEK shareholder approval (however, this
alternative could not apply to the condition of “gaining” shareholder
approval due to the above disclaimer requirement)

Alternative 8 – Allow employee the opportunity to rebut presumption
with a tax opinion
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Minimizing 280G (cont.)

Alternative 9 – Structure the payment to be reasonable compensation
paid for services rendered before the CIC
– Burden of proof is clear and convincing evidence
– If burden is satisfied, the amount of the reasonable compensation reduces
the excess parachute payment
– In determining reasonable compensation, relevant factors include:
 Nature of the services to be rendered,
 Individual’s historic compensation for such services, and
 Compensation for those performing similar services where payment is not
contingent on a CIC
– Reasonable compensation INCLUDES compensation for refraining from
personal services (e.g., for a covenant not to compete)
 What is the value of a covenant not to compete? Generally, it is the difference
between the enterprise value of the company with and without the non-compete
 Thus, the value of the 280G reduction could be more than the severance pay
that is otherwise directly associated with the non-compete
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© 2014 Winstead PC
Minimizing 280G (cont.)

Alternative 10 – Structure payment to represent payment for future
services (thereby negating the “contingent” element)
– Burden of proof is clear and convincing evidence
– If burden is satisfied, the amount of the reasonable compensation reduces
the excess parachute payment
– Similar to prior Slide, payments for covenants not to compete can
represent payment for future services if there is a reasonable likelihood
that the agreement would be enforced against the individual
– Additionally, payments for breach of contract can be structured to apply for
future services if:
 The contract was not entered into (or amended) in contemplation of the CIC;
 The compensation is otherwise reasonable under Section 162 of the Code;
 Damages do not exceed the present value (determined on date of receipt) of the
compensation the disqualified individual would have received had he or she
remained employed until the end of the contract term;
 The disqualified individual offered personal services, but such were rejected by
the company; and
 The damages are reduced by mitigation (e.g., the individual’s attempt to find a
job)
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© 2014 Winstead PC
Minimizing 280G (cont.)

Alternative 11 – In the year preceding the year of the CIC, increase
the disqualified individual’s base amount in order to increase his or her
5-year average. For example:
– The disqualified individual could exercise stock options
– The company could payout deferred compensation
– The company could Increase and payout the disqualified individual’s
bonus
– The company could payout LTIP awards
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© 2014 Winstead PC
Separation Pay: Post-Termination Exercise Period

Consider whether to extend the post-termination exercise period for
stock options
– Such is permissible under Section 409A if the option term is not extended
beyond its original term (i.e., typically stock options contain a term of 10
years from the date of grant)
– However, ISO status would be lost if the stock option is not exercised
within 3 months from the optionee’s termination of employment
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© 2014 Winstead PC
Separation Pay: Performance Awards

Performance-based awards have unique circumstances to consider,
including:
– Should the award be paid in full or pro rata upon a CIC
– How should the level of performance be measured
– How should the time period for performance be measured

36
If the employer is a public company and the executive is otherwise
subject to Section 162(m), then keep in mind Rev. Ruling 2008-13
(addressed on a prior slide)
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Separation Pay: Triggers
•
Absent extenuating circumstances, severance pay is generally
provided only if the executive terminates employment for “good
reason” or the employer terminates the executive “without cause”
– Sometimes an employer will provide severance upon an executive’s
disability, but such provisions are not too common
•
Thus, a termination by the executive without good reason or a
termination of the executive by the employer for cause would
generally not trigger any severance pay
•
Consider that severance pay should be “bridge pay”
– Keep in mind that severance pay packages should be designed to act as a
“bridge” between jobs
– Consider whether it makes sense to offset the amount of any future
severance pay by the amount of any income the executive earns from
his/her new employer, if applicable
– REMEMBER: ISS has thoughts on this issue. Too much severance pay
could trigger a no vote on the employer’s next say-on-pay, or if egregious
enough when combined with other poor pay practices, a no vote on the reelection of the members of the Compensation Committee of the Board
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© 2014 Winstead PC
Separation Pay: Triggers
•
A typical definition of “cause” includes:
– A material breach by executive of his/her obligations under the agreement;
– A willful or continued failure to follow orders or perform;
– A conviction or plea of nolo contendere to any felony or a crime involving
dishonesty or moral turpitude or which could reflect poorly on the
Employer;
– Executive engaging in misconduct, negligence, etc. that is injurious to the
Employer;
– A material breach by executive of a written policy of the employer; and
– Any other misconduct by executive that is injurious to the financial
condition of the employer and/or its reputation
•
Consider defining the term “cause” to include a substantial underperformance (e.g., failure to achieve minimum financial goals for two
consecutive fiscal years)
– Consider further that such a provision is not typical and would subject
executive to elements that could be outside his/her control
•
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Consider the Board’s use of after-acquired evidence to determine whether
Executive terminated employment for “cause.” Otherwise, evidence supporting
a termination for cause that is found after executive’s termination could not
likely be used to retroactively recharacterize executive’s termination (thus, a
payout of severance benefits would likely continue)
© 2014 Winstead PC
Separation Pay: Triggers (cont.)
•
A typical definition of “good reason” includes:
– A decrease in executive’s base salary or a failure by the employer to pay
material compensation when due;
– A diminution of the responsibilities, positions or title of executive;
– A requirement that executive move more than [__] miles from [_____]
•
It is favorable to the employer to require both a notice and cure period
before “good reason” can be triggered
– Consider that if a notice and cure period is used in good reason, is it fair to
also apply a mirror provision to the definition of “cause”
•
Should there also be a claims run out period, such that if good reason
exists, executive must provide notice within [___] days of such trigger,
otherwise, the claim giving rise to good reason is considered waived
by executive
– Such would prevent executive from “saving” the good reason trigger for a
rainy day 6 months or a year after-the-fact
– Consider whether “cause” should contain a mirror provision
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© 2014 Winstead PC
Separation Pay: Triggers (cont.)
•
[Good Reason continued from the prior slide]
•
Consider adding a “good reason” definition that includes:
– “. . . a material breach of any provision of this Agreement . . . ” AND
– A provision later in the agreement that provides something to the effect: “. .
. failure of the Company to obtain a written agreement from any successor
or assign of the Company to assume the obligations of the Company
under this Agreement upon a Change in Control shall constitute and be
deemed a material breach of this Agreement.”
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•
The above should comply with the Section 409A safe harbor definition
of “good reason”
•
But more important, the above could provide executive with
substantial negotiating power if the acquiror wants to retain executive
after consummation of the transaction (i.e., any deviation from the
agreement could give rise to good reason) and the existing
employment agreement is otherwise too “rich” for the acquiror to
continue
© 2014 Winstead PC
Section 409A 6-Month Wait
•
Generally, a "separation from service" is a permitted payout event
under Section 409A; however, any payout to a "specified employee"
generally must be delayed at least six months after separation from
service
– A specified employee is generally defined to include the following:
 Employees owning more than 5% of the Company's stock,
 Employees owning more than 1% of the Company's stock and who have
compensation from the Company in excess of $150,000, and
 Officers of the Company with compensation in excess of $170,000. Whether an
individual is an officer is based on the nature of the individual's duties (not his
job title)
– Whether a specified employee had a separation from service is based
upon the facts and circumstances
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© 2014 Winstead PC
Section 409A 6-Month Wait (cont.)
•
An issue does arise if the specified employee will provide independent
contractor services immediately after his/her termination of
employment
– The specified employee has incurred a separation from service if the time
commitment under the consultant agreement is no greater than 20% of the
time the specified employee spent performing services for the employer
during the 36-month period immediately preceding his termination of
employment
– Other rules apply if the time commitment is greater than 20% but less than
50%, and another set of rules apply if the time commitment is at or greater
than 50%
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© 2014 Winstead PC
Section 409A 6-Month Wait (cont.)
•
There are a number of payments that would be EXEMPT from Section
409A; therefore, the 6-month wait addressed above should not apply
to such exempt payments:
– Such exemptions could be used in combination and cumulatively, thereby
producing a larger exemption than any one exemption would otherwise
provide by itself
•
The most notable of the exemptions would be the two times, two year
rule, under which the following could be exempt:
– An amount not exceeding the lesser of (i) two times the executive's annual
compensation for the year prior to the year of termination (e.g., 2013
compensation) or (ii) two times the annually adjusted Section 401(a)(17)
limit (i.e., 2x would be $520,000 for 2014), AND such severance is paid to
the executive by the end of the second calendar year following the year
the executive separated from service
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© 2014 Winstead PC
Restrictive Covenants: Non-Compete
•
Consider tolling the non-compete provision for any period of time the
executive violates the restrictive covenant
– Some states do not allow equitable tolling and therefore would not
otherwise toll the non-compete beyond the terms of the contract
– Absent equitable tolling or a contractual tolling provision, it may be difficult
for an employer to enforce, for example, a six-month non-compete
provision (i.e., it could take more than six months to get to court)
•
Consider using non-compete provisions to avoid the use of a 280G
gross-up provision
– As background, tax gross-ups are generally preferred by executives and
disfavored by shareholders
– Implementing a non-compete can act to reduce an otherwise golden
parachute payment subject to the 280G excise tax
– Such reduction is generally not on a dollar-for-dollar basis, but rather, the
reduction is generally based on the difference between the enterprise
value of the company with and without the non-compete
– Thus, the value of the 280G reduction could be more than the severance
pay directly associated with the non-compete
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© 2014 Winstead PC
Restrictive Covenants: Clawbacks
•
Consider whether to implement robust clawback provisions
•
Clawback provisions currently exist under Section 304 of SarbanesOxley Act and the Dodd-Frank Act
•
Additionally, consider the use of other clawback provisions, such as:
•
•
45
A clawback for any breach of post-employment restrictive covenants (e.g.,
violation of a non-compete clause)
A clause that if the non-compete provision is ever judicially or
administratively ruled to be unenforceable, then Executive must forfeit
certain portions of his/her severance pay (including a return of any gains
on equity awards that the executive sold after his/her termination of
employment)
© 2014 Winstead PC
Indemnification
•
Generally, indemnification of executive officers and members of the
board of directors is addressed in the articles of incorporation and
bylaws of the employer
– Therefore, it is preferable from the employer’s perspective to NOT include
such a provision within the employment agreement
– But to the extent such a provision is provided in the employment
agreement, care needs to be taken to ensure such a provision is not
outside the scope of the indemnification within the articles of incorporation
and bylaws
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•
Same issue is applies in the context of an errors and omissions policy
•
Do not overlook this issue, care should be taken. Consider the
following two slides as an example that applied to a director, but could
apply to executives too
© 2014 Winstead PC
Indemnification (cont.)
•
Schoon v. Troy Corp, court upheld retroactive amendments to the
corporation’s bylaws that negated a former director’s right to receive
advancement of expenses for law suits filed after such director left the
board
– Court found any contractual right to advancement of expenses under the
bylaws would have vested upon being named as a defendant, and
because such naming did not occur until after amendment of bylaws,
former director was not able to receive advancement of attorney fees
•
Effective August 1, 2009, the outcome in Schoon was legislatively
reversed due to an amendment to Section 145(f) the DGCL, which
provides:
– “A right to indemnification or to advancement of expenses arising under a
provision of the certificate of incorporation or a bylaw shall not be
eliminated or impaired by an amendment to such provision after the
occurrence of the act or omission that is the subject of the . . . [action] . . .
for which indemnification or advancement of expenses is sought, unless
the provision in effect at the time of such act or omission explicitly
authorizes such elimination or impairment after such action or omission
has occurred”
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© 2014 Winstead PC
Indemnification (cont.)
•
Though DGCL amendment limited the application of the Schoon
decision, it still stands as a “lesson learned” under other states’ laws.
Thus, as applied to negotiations with Executives, consider:
– Charter or bylaw provisions should expressly provide that rights to
indemnification and advancement of costs vest by virtue of the
directors/officers services at the time the facts giving rise to the claim
occurred
 Subject to any limits under exculpation provisions and indemnification provisions
– Applicable charter or bylaw provisions should state that such provisions
may not be amended without consent of the affected director/officer
– Determine whether to treat indemnification and advancement differently
– Consider using separate indemnification agreements that cannot be
amended without mutual consent, especially where it is impracticable to
amend charter or bylaws




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Fewer enforceability issues
Protects against unilateral amendment
Provides ability to address rights in more detail
Provides a greater degree of comfort to covered directors/officers
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