Broad definition of for “cause” termination could have significant tax implications
Under the Internal Revenue Code (IRC) section 83 regulations, compensation that is forfeitable if an employee voluntarily terminates employment is subject to a substantial risk of forfeiture and is unvested for tax purposes, while compensation that is forfeitable only if an employee is terminated for “Cause” is not subject to a substantial risk of forfeiture and is vested for tax purposes. A December 2013 decision of the U.S. Tax Court, Austin v Commissioner of Internal Revenue, 141 TC 18 (2013), makes clear that the meaning assigned to the term “Cause” by the parties in an employment or other agreement is not necessarily the same meaning the term has for tax purposes.
In Austin, the Tax Court held that the term “Cause,” as used in the section 83 regulations, is intended to have a narrow meaning, limited to very serious acts of employee misconduct (analogous to committing a crime) that are very unlikely to occur. In the Austin case, two employees received stock that was forfeitable only if the employer terminated their employment for “Cause,” which term was defined to include failure to “faithfully and diligently perform[ ] the usual duties of his employment.” The Tax Court held that the risk of a termination and forfeiture for such conduct was substantial and that the stock was unvested for tax purposes.
The Tax Court decision in Austin could have significant implications where an employee has worked long enough so that a voluntary termination will not result in forfeiture of compensation, but forfeiture will result if the employee is terminated for “Cause” (broadly defined as in Austin). These implications include, without limitation, the following:
- Under section 83, in the absence of a section 83(b) election, (i) restricted stock is taxable to the employee as ordinary income (and deductible by the employer) when the stock becomes vested in an amount equal to the then value of the stock, (ii) the long term capital gain holding period for the stock begins on the vesting date, and (iii) post-vesting appreciation in value of the stock is capital gain. If the stock remains forfeitable if the employee is terminated for broadly defined “Cause,” vesting and income recognition (and employer deduction) may not occur until the stock is sold, and the entire proceeds on sale may be ordinary income to the employee (and deductible by the employer). Whether or not the employee should make an 83(b) election could become an even more involved decision.
- In the absence of an 83(b) election, restricted stock is treated as not being outstanding and owned by the employee prior to vesting, which may not occur until sale of the stock if it is forfeitable for broadly defined “Cause.” In the Austin case, the two employee taxpayers received stock in an S corporation which, as noted above, was forfeitable upon termination of their employment for broadly defined “Cause.” Because their stock was held to be subject to a substantial risk of forfeiture and unvested, they were not taxable on their share of the undistributed S corporation income (which was instead allocated to the only other shareholder, a non-taxable ESOP).
- If stock options, stock appreciation rights or restricted stock vest independently of and prior to a change in control transaction, the items are not treated as parachute payments for purposes of IRC section 280G. However, if such items remain forfeitable upon a termination of the employee for broadly defined “Cause,” the items may not vest for tax purposes until exercise or settlement at the time of the change in control, in which case the items will be parachute payments.
- Compensation arrangements that are subject to but not in compliance with IRC section 409A may be corrected at any time prior to vesting (or prior to the year of vesting). If such a compensation arrangement were forfeitable upon termination of the employee for broadly defined “Cause,” it would not be vested for tax purposes until paid, thereby permitting the arrangement to be amended to comply with 409A at any time prior to payment (or prior to the year of payment).
- Under an exemption for short term deferrals, section 409A does not apply to a compensation arrangement if the compensation is paid on or before March 15 of the year following the year in which the compensation becomes vested. Compensation that is forfeitable upon termination of an employee for broadly defined “Cause,” if it is not vested until paid, would by definition qualify for the short term deferral exemption from, and never be subject to, 409A.
Negotiations over for “Cause” termination provisions of employment and other agreements should, as a result of the Tax Court’s December 2013 decision in Austin, also take into account the tax implications, and employers, employees and their advisors should understand and be prepared to deal with the tax consequences of broad “Cause” definitions outlined above.
If you have questions about this or any other Tax matter, please contact one of Honigman's Tax attorneys.