Understanding Stock Option Deductions in M&A

Understanding Stock Option Deductions in M&A

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Tax professionals often encounter many of the same tax questions and issues in corporate acquisitions, but one issue generally requires me to think through the basic rules each time to reach the correct answer: In which tax period is the target entitled to deduct an amount paid to cash-out stock options? That is because the answer can vary depending on the method of accounting used by a target (e.g., cash method or accrual method), the type of a target entity (e.g., C corporation or S corporation), as well as the type of an acquiring entity, the type of acquisition (e.g., asset purchase or stock purchase), and the timing of payments. Also, the amounts involved are usually significant enough to warrant some caution.

Incentive compensation in the form of stock options has been one of the dominant forms of long-term equity-based compensation for a number of U.S. corporations since the 1950s, although the use of stock options has lessened compared to other forms of incentives.1 A stock option is a right to buy a company's stock in the future at a specified “exercise price” (generally the fair market value of the share on the date the option is granted). The hope is that the exercise price is lower than the stock price at the time of exercise where a company's stock price increases over time. Stock options usually vest over time and can thus be incentives for an employee to stay with a company for a long term.

In this article, we go over the basic rules with regard to the deduction for a cash-out of stock options in an acquisition context. Due to the complexity of the rules, our discussions in this article are limited to a cash-out of nonstatutory stock options (that are not subject to §409A2 ) in a taxable acquisition context (i.e., statutory stock options, nonqualified deferred compensation and cancellation of stock options in a tax-free acquisition context are excluded from the scope of this article). Also, we do not address any issue arising under §280G in this article.

Income taxation of stock options in general

§83 governs taxation of stock options for any "service provider," which includes both an employee and an independent contractor (although this article references employees, the rules are the same for other service providers). §83 also governs the deduction and deduction timing rules for the employer. If an employee is granted an option in connection with the performance of services and if such option has "a readily ascertainable fair market value" (as narrowly defined in the regulations) at the time the option is granted, the employee is required to include the value of the option as compensation income at the time of grant3  (very rarely do options meet the "readily ascertainable" rules). Typically, an employee is granted an option without a "readily ascertainable fair market value" and thus the employee is required to report the "spread" as employee compensation at the time of exercise, or disposition of the option. The "spread" is the amount of the fair market value at the time of the exercise (or the disposition) over the exercise price paid by the employee.4

An employer is generally allowed a tax deduction equal to the "spread."However, the timing of the deduction can be unexpected in an acquisition.5

§83 deduction timing

If an employer grants restricted shares to an employee (transferring the shares into an employee's name on the date of grant, but subjecting the shares to a substantial risk of forfeiture, usually based on continued service with the employer), the general §83 deduction rule provides that the employer can only take the deduction for the taxable year of the employer in which or with which the employee's taxable year of income inclusion ends.6

Example: Employee vests in restricted shares on February 20, 2015. Employee includes the fair market value of the vested shares as taxable compensation in the employee's taxable year, the calendar year ending December 31, 2015. An employer with a March 31 fiscal year can only deduct the compensation amount in its taxable year ending March 31, 2016 (because the employee's December 31, 2015 year ends during the employer's tax year ending March 31, 2016). Under this rule, there may be a deferral of a deduction for a fiscal year taxpayer.

However, §83 also provides an exception to the §83 deferred deduction timing rule for certain types of equity compensation. This exception can be especially useful in relation to an exercise or a cash-out of stock options upon acquisition.

The exception applies only if the property received by an employee is substantially vested upon transfer. This rule generally applies for options because on exercise, most employees receive fully vested shares. However, if the employee exercises options and receives unvested shares, the exception is not available. Under the exception, the deduction is allowed to the employer in accordance with its method of accounting (rather than the year in which or with which the employee's taxable year including the income ends).7 A deduction is allowed under an accrual method of accounting when all events to establish a liability have occurred, the amount of a liability can be determined with reasonable accuracy, and the economic performance has occurred with respect to the liability.8 This means that the liability with respect to a cash-out of stock options for a target company using an accrual method of accounting is generally fixed when the optionee/employee becomes entitled to the payment under the agreement, which generally occurs on closing, assuming the payment is made within 2.5 months after the year-end. Thus, under the exception, the employer can generally take the deduction in the employer's year in which the employee exercises an option, or in which the option is cancelled for cash (so long as the cash is paid to the employee within 2.5 months after the year-end).9

Often, a target company has outstanding stock options that are either vested or unvested. To the extent the options vest because of the transaction, such outstanding stock options are often cancelled, and instead, the employee receives cash equal to the "spread" at the date of the transaction (however, sometimes a portion of the "spread" may be paid later under escrow or earn-out terms).

IRS's positions on a deduction of a cash-out of stock options

The IRS addressed its positions on the deduction timing for a cash-out of stock options in 2003 and 2012.

In 2003, the IRS provided in Revenue Ruling 2003-98 guidance on an employer’s deduction of nonstatutory stock options in four situations involving an acquisition, addressing which entity is entitled to a deduction and in which tax year.10 The facts in Situation 3 of Revenue Ruling 2003-98 are depicted as follows, to the extent relevant to this article:

On January 1, 2003, Employee begins employment with Company M with a September 30 year-end and is granted a nonstatutory option (which has no readily ascertainable fair market value upon grant and is not exercisable until January 1, 2006) to purchase a number of shares of the Company M common stock. On November 15, 2006, Company N with a September 30 year-end acquires all of the outstanding shares of Company M for cash (without a §338 election). The options are outstanding until January 15, 2007, when pursuant to the terms of an agreement, Company N cancels the options in exchange for cash.

The IRS ruled that because the consideration received on a cancellation of the option upon the disposition of the Company M option is fully vested cash, the exception under Treas. Reg. §1.83-6(a)(3) to the general timing rule for deductions in §83(h) applies, and thus to the extent that the compensation is otherwise deductible, Company M, and only Company M, is entitled to deduct the cash actually paid using its method of accounting for its taxable year ending September 30, 2007.11  This guidance is very helpful in that it confirmed that the service recipient (i.e., Company M) is entitled to a deduction and that the exception under Treas. Reg. §1.83-6(a)(3) should apply to a cash-out of stock options. However, it did not address a deduction timing issue involving a consolidated return (i.e., where a target’s tax year ends upon acquisition because the target leaves a seller’s consolidated group or joins an acquiring’s consolidated group, there is a question of whether the deduction is allowed in a pre-closing tax year or in a post-closing tax year of the target).12

In 2012, the IRS addressed this question in GLAM 2012-010 by providing its view on how the "next-day rule" in the consolidated return regulations should be applied to a deduction of nonstatutory stock option expenses (and certain other expenses) in an acquisition context.13  The next-day rule generally provides that when a transaction occurs on the day of the subsidiary member's change of status that is properly allocable to the portion of the day after the transaction, the subsidiary and all persons related to it immediately after the transaction must treat the transaction as occurring at the next day.14

The facts relating to a deduction of the stock option expenses in GLAM 2012-010 are provided as follows:

A subsidiary of Acquiring (a calendar year, common parent of a consolidated group) merges with and into Target (a calendar-year, accrual-basis C corporation) and Target's shareholders exchange their Target stock for cash (without a §338 election). Target thus becomes a member of the Acquiring’s consolidated group at the end of November 30, 20XX (pursuant to which two short tax years are created for Target: a pre-closing short tax year for January 1, 20XX through November 30, 20XX and a post-closing short tax year for December 1, 20XX through December 31, 20XX).

At the time of the acquisition, Target has outstanding nonqualified stock options (without readily ascertainable fair market value at grant) issued to certain of its employees for which Target is obligated to pay certain amounts for and in cancellation of their stock options in the event of a change in control. Under the terms of its agreements with its employees, within several days after the acquisition, Target pays its employees (using its own funds or funds received from Acquiring) the amounts required under the terms of the option agreements. Target becomes entitled to a deduction on November 30, 20XX.

In the GLAM, the IRS concluded that the next-day rule is inapplicable by its terms, and it is neither proper nor reasonable to allocate deductions from the liabilities to the post-closing portion of the acquisition date. Consequently, the IRS further concluded these deductions are governed by the end-of-the-day rule15  and are properly reported on Target's short-year return for the taxable year ending November 30, 20XX (i.e., pre-closing short tax year). The IRS provided three main reasons for its conclusion: (i) Target's obligation to pay and the amount of its liability become fixed and determinable upon closing; (ii) the liability relates to the performance of services for Target by employees (i.e., transactions) before the acquisition; and (iii) the corresponding deductions are not attributable to any "transaction" on the acquisition date other than the acquisition itself.

This conclusion has been the matter of some debate, as many practitioners do not agree with the analysis provided by the IRS in the GLAM.16 Tax practitioners argue that: (i) the IRS observation that the services often were performed historically fails to acknowledge that most items eligible for next-day treatment similarly reflect the recognition of items (such as gain or loss) that economically arose before the change date; (ii) the fact that there is no transaction triggering the deduction other than the change of control itself is also true of other circumstances that are explicitly eligible for next-day treatment under the existing regulations; and (iii) next day treatment is appropriate in cases where, without the acquisition transaction, there would not have been a change-of-control which triggered the cash-out of the stock options. Moreover, the GLAM ignores the fact that the next-day rule regulations specifically provide that a determination as to whether a transaction is properly allocable to the portion of the target's day after the event resulting in the target's change in status will be respected if it is reasonable and consistently applied by all affected persons.17  In addition, tax practitioners point out that not applying the next-day rule to the cash-out of stock options in this instance would cause a double detriment to the buyer where the target is a loss corporation and the acquisition causes a section 382 limitation18  and thus would not be correct from a tax policy perspective.

Although allocating the deduction for the stock option expense to the preacquisition tax period (as advocated in the GLAM) may be a "reasonable" approach, many tax practitioners generally view applying the next-day rule to allocate the stock option expense to the post-acquisition tax period as equally reasonable, and that applying the next-day rule in this instance would be sustained at the more-likely-than-not level.19  There are other approaches that may permit the buyer in a transaction to take the stock option deduction. The following examples apply the above rules to a number of situations where a corporation acquires a domestic target corporation or its business similar to those in which a foreign corporation, such as a Japanese corporation, or its U.S. subsidiary acquires a domestic target corporation to illustrate the typical results.

Examples

We assumed in all situations that (i) Target and Acquiring both use an accrual method of accounting unless otherwise stated; (ii) Target uses a calendar year-end and Acquiring uses a March 31 year-end; (iii) Target has outstanding stock options (vested or unvested) for certain employees; (iv) Acquiring acquires the outstanding stock of Target on June 30, 2015 (Closing Date); (v) all unvested stock options become vested upon closing and all options are cancelled for cash upon closing under the terms of stock option agreements; (vi) the actual cash payment for the options is made within a few days after the closing date. However, different facts may provide different results. Always check with a tax adviser familiar with the §83 rules and other compensation rules before taking a deduction with regard to equity compensation.

Situation A: The stock of a U.S. target company (Target), a C corporation owned by noncorporate shareholders (e.g., partnerships and/or individuals), is directly acquired by a foreign corporation (Acquiring). The Target remains in existence and a §338 election is not made. In this case, Target’s tax year does not end on the closing and thus it files only one tax return for its calendar year unless it changes its tax year-end.

As Target does not close its year-end at closing, Target would claim the deduction, with regard to the cash actually paid for the cancelled options, for its tax year ending December 31, 2015. Often, the buyer and the seller agree to use a “closing of the books” method to allocate tax liability between hypothetical pre- and post-closing periods. To avoid any conflict, we generally suggest that the parties agree on which period the deduction will be allocated for purpose of determining tax liability between the seller and the buyer.

Situation B: Same as Situation A except that Target is acquired by a member of a U.S. consolidated group (Acquiring Group), the parent of which is owned by a foreign corporation. In this case, Target’s tax year ends on the closing (i.e., June 30, 2015) and Target has two short tax years: a pre-closing tax year from January 1, 2015 through June 30, 2015 (which is reported on the Target’s separate company tax return and a post-closing tax year from July 1, 2015 to March 31, 2016 (which becomes part of the Acquiring Group’s consolidated return).20

If we use the conclusions in GLAM 2012-010, a deduction would be claimed for the short tax year ending on the closing date (i.e., June 30, 2015). From the Acquiring Group’s perspective, this result may not be favorable especially if the Acquiring Group assumes the liability and/or if the Target’s pre-closing short year generates an NOL that would be subject to an annual limitation under §382 (because of the ownership change triggered due to the acquisition). On the other hand, if, contrary to GLAM 2012-010, we apply the next-day rule, a deduction would be claimed for the post-closing tax year.

Situation C: Same as A except that the U.S. target company (Target) is an S corporation which is owned by one individual (Seller). A §338 election is not made. In this case, Target’s tax year as an S corporation terminates at the end of the day before the closing (i.e., June 29, 2015) and its tax year as a C corporation starts at the beginning of the closing date (i.e., June 30, 2015).21

A deduction would be claimed for the C corporation tax year starting on the closing date as Target becomes entitled to the deduction on the closing date (i.e., June 30, 2015). This result would likely be favorable to Acquiring, but we generally suggest that the seller and the buyer agree on the timing of the deduction prior to the closing to avoid any inconsistent treatment among the parties. This would also be the result if Target were acquired by Acquiring Group (as in Situation B).22

Situation D: Same as B except that Target uses a cash method of accounting. After Target joins the Acquiring Group’s consolidated group, Target uses an accrual method of accounting. As in B, Target’s tax year ends on the closing (i.e., June 30, 2015) and Target has two short tax years: a pre-closing tax year from January 1, 2015 to June 30, 2015 (which is reported on the Target’s separate company return) and a post-closing tax year from July 1, 2015 to March 31, 2016 (which becomes part of the Acquiring Group’s consolidated return).

As Target changes its overall method of accounting from a cash method to an accrual method in its post-closing tax year, Target would be required to compute the impact from the change (i.e., a section 481(a) adjustment) as of the beginning of the post-closing tax year and include such impact in gross income of the post-closing tax year.23 The deduction from the stock options should be included as part of the section 481(a) adjustment, which Target would recognize in the post-closing tax year(s).24 Accordingly, Target would take the deduction into account in one or more post-closing tax years and, if the section 481(a) adjustment is negative, is entitled to a deduction on the post-closing tax year from July 1, 2015 to March 31, 2016. On the other hand, if Target makes the payment on the closing date, Target would likely be entitled to a deduction in the short year ending on the closing, but the rule is unclear as the next-day rule may apply to treat the payment as occurring at the beginning of the next day after the closing if it is properly allocable to the post-closing period.25

Situation E: Same as B except that substantially all assets of a U.S. target corporation are purchased and certain liabilities including the stock option liability are assumed by a member of the Acquiring Group. In this case, Target’s tax year does not end as of the closing, but rather continues until it potentially liquidates with and into its owner(s). The purchaser has only purchased assets and assumed the liability, and thus, the Webb case26 generally suggests that the asset buyer cannot take a tax deduction for the compensation, because the compensation liability is considered to be assumed by the asset buyer as part of the acquisition, and therefore would be added to the basis of the acquired assets. Thus, under this arrangement, if the amounts are not fully paid by the date of the change in control, the buyer would likely amortize the liability as part of the purchase price (assuming it is capitalized to an amortizable asset, such as goodwill).

Situation F: Same as C except that a §338(h)(10) election is made. A section 338(h)(10) election makes a stock acquisition a deemed asset acquisition for federal income tax purposes. In a deemed asset transaction, the old target is treated as if it sold all its assets and transferred all liabilities to an unrelated party (the new target) as of the end of the closing date27 and immediately liquidated. In this case, the old target’s tax year as an S corporation terminates at the end of the closing date (i.e., June 30, 2015) and the new target’s tax year as a C corporation starts at the beginning of the following date (i.e., July 1, 2015).

In a deemed asset transaction, the new target assumes the old target’s liability for a cash-out of stock options. Following the Webb case,28 the new target would likely have to amortize the liability for the stock options as part of the purchase price (as discussed above in Situation E).

As seen in the above, each of the situations above may produce a different result. Careful attention and planning will help both the acquirers and the sellers obtain supportable tax positions.


*****

For more information, please contact:

Hiroko Kitayama | +1 312 665 8804 |hkitayama@kpmg.com

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  1. Joseph E. Bachelder III, "What has happened to stock options?" McCarter & English, LLP (October 2, 2014)
  2. §409A generally provides that unless specified requirements are satisfied, all amounts deferred under the plan are currently includable in gross income as soon as they "vest" (under these rules, vesting specifically means that the promised amounts are no longer subject to a "substantial risk of forfeiture"). Unless otherwise stated, all references to the "§" or "Section" are to the Internal Revenue Code of 1986, as amended, and all references to the "Regulations" or to "Treas. Reg." are to the Treasury Regulations promulgated thereunder.
  3. §83(a); Treas. Reg. § 1.83-7.
  4. Id.
  5. We note that although a taxpayer may not deduct certain costs it incurs to facilitate a transaction, Treas. Reg. § 1.263(a)-5(d)(1) states employee compensation is an amount that does not facilitate a transaction.
  6. §83(h); Treas. Reg. § 1.83-6(a).
  7. Treas. Reg. § 1.83-6(a)(3).
  8. Treas. Reg. § 1.461-1(a)(2).
  9. Note, however, compensation paid for services could be categorized as a "deferred compensation" if the payment is made after 2.5 months after the year-end of the employer. As an example, if some of the option spread will be paid later, out of escrow or only on reaching an earn-out, this later payment must be designed to satisfy the §409A deferred compensation rules. According to Treas. Reg. § 1.404(b)-1T(c), a plan, or method or arrangement, shall not be considered as deferring the receipt of compensation or benefits for more than a brief period of time after the end of the employer's taxable year to the extent that compensation or benefits are received by the employee on or before the end of the applicable 2.5-month period. Thus, for example, salary under an employment contract or a bonus under a year-end bonus declaration is not considered paid under a plan, or method or arrangement, deferring the receipt of compensation to the extent that such salary or bonus is received by the employee on or before the end of the applicable 2.5-month period.
  10. Rev. Rul. 2003-98, 2003-2 C.B. 378.
  11. Id.
  12. In general, under the "end-of-the-day rule" in Treas. Reg. § 1.1502-76(b)(1)(ii)(A), if a corporation (S) becomes or ceases to be a member of a consolidated group, it becomes or ceases to be a member at the end of the day on which its status as a member changes, and its tax year ends for all Federal income tax purposes at the end of that day. Unless the "next-day rule" applies, the member allocates its items of income or loss through the end of the day on the acquisition date to the pre-closing tax year.
  13. GLAM 2012-010 (11/30/2012). Note that a GLAM should not be used or cited as precedent. See also Proposed Reg. § 1.1502-76(b)(2)(ii)(C)(9) (addressing some of the concerns articulated by commentators, but reaffirming the position taken in the GLAM).
  14. Treas. Reg. § 1.1502-76(b)(1)(ii)(B). If, on the day of S's change in status, a transaction occurs that is properly allocable to the portion of S's day after the event resulting in the change, then S (and all persons related to S under §267(b) immediately after the event) must treat the transaction for all Federal income tax purposes as occurring at the beginning of the following day. A determination as to whether a transaction is properly allocable to the portion of S's day after the event resulting in S's change in status will be respected if it is reasonable and consistently applied by all affected persons.
  15. See note 12.
  16. See, for example, Deanna Walton Harris, Mark Hoffenberg, and Jeff Vogel, "Questioning the IRS's Application of the Next-Day Rule," Tax Notes (10/13/2014) and Anne Batter and Christine Sloan, "IRS Addresses Controversial Option Deduction Issue in GLAM 2012-010," Journal of Corporate Taxation (Jul/Aug 2013).
  17. Note that the regulations provide factors to consider in determining whether an allocation is reasonable, such as consistency with other Code or regulation provisions or facts indicating a transaction is not properly allocable to the post-acquisition period.
  18. The position would cause a double detriment to the acquirer in that first, the deduction would be subject to a section 382 limitation, and second, would increase Net Unrealized Built-in Loss or NUBIL, which would become part of the loss subject to a limitation (or decrease Net Unrealized Built-in Gain or NUBIG, which would increase the amount of a section 382 limitation).
  19. This view will likely change once the proposed next-day regulations become final.
  20. Note that following the acquisition, Treas. Reg. §1.1502-76(a) requires Target to change its accounting period to adopt the consolidated group's annual accounting period (i.e., a March 31 tax year end).
  21. §1362(e)(1); Treas. Reg. § 1.1362-3(a).
  22. Note, however, that if Target is acquired by a member of a U.S. consolidated group (or if Target and a U.S. Acquiring corporation elect to file a consolidated return), Prop. Reg. § 1.1502-76(b)(1)(ii)(B)(2), when it is finalized, would change this result. Under the new "previous-day rule," the deduction would be required to be allocated to the S corporation tax year. According to the Preamble to the proposed regulation, the proposed regulations added this "previous-day rule," which requires extraordinary items (such as compensation-related deductions) resulting from transactions that occur on the termination date (but before or simultaneously with the event causing the target's status as an S corporation to terminate) to be allocated to the target's tax return for the short period that ends on the previous day (that is, the day preceding the termination date).
  23. §481(a).
  24. Rev. Proc. 2011-14, 2011-4 I.R.B. 330. If the net adjustment is positive (unfavorable), the adjustment is recognized over four years and if the net adjustment is negative (favorable), the adjustment is recognized in one year.
  25. Treas. Reg. § 1.1502-76(b)(1)(ii)(A).
  26. David R. Webb Co., Inc. v. Commissioner, 52 AFTR 2d 83-5104 (1983).
  27. §338(a)(1) provides that if a purchasing corporation makes an election under this section, then, in the case of any qualified stock purchase, the target corporation shall be treated as having sold all of its assets at the close of the acquisition date at fair market value in a single transaction.
  28. See supra note 15.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and do not necessarily represent the views or professional advice of KPMG.

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