The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 3, October 2000, Panel Publishers, New York, NY.

EXCHANGING VESTED OPTIONS: IS THERE A GOLDEN PARACHUTE PAYMENT?

By Robert W. Wood

In this heyday of high-tech (and dot.com) mergers and acquisitions, there has probably been no greater time for preeminence of the stock option, whether qualified or non qualified. The presence of stock options has truly revolutionized the economy. In many cases, the question comes up whether a rich option deal will result in a triggering of the golden parachute payment rules, thus spelling nondeductibility to the payor, and even an excise tax.

Recently, the IRS ruled in Letter Ruling 200032017, Tax Analysts Doc. No. 2000-21137, 2000 TNT 158-5, that the exchange of vested, nonqualified stock options in an acquiring company for vested options in a target company is not a parachute payment under Section 280G. The Service also ruled that for non qualified options that become vested as a result of the merger of the target into the acquiring company, the parachute is determined under Proposed Regulation Section 1.280G-1, Q&A 24(c).

The acquiring company in the deal merged with the target and, as part of the merger, nonqualified stock options held by target employees were converted into nonqualified options in the acquiring company. The differential between the value of the target's options and the acquirer's options was based on the exchange ratio for the merger (and that was arrived at in an arms'-length negotiation between the companies and their respective advisors). The only outstanding target options that were not fully vested became fully vested when the target shareholders voted to approve a merger.

Under these circumstances the IRS concluded that the payments made for vested non-qualified options were not parachute payments because they were not in the nature of compensation under Section 280G. The payments in the nature of compensation for the vested options occurred when the options vested (which was before the merger and not contingent on the change in control).

As far as the unvested options were concerned, options that became vested as a result of the ownership change, these were payments in the nature of compensation when they became substantially vested. Thus, these payments were contingent on the change in control because the payments were accelerated. A contingent portion, however, according to the IRS maybe reduced under Proposed Regulation Section 1.280G-1, Q&A 24(c), because it was substantially certain at the time of the ownership change that the options would have vested if the employees had continued to perform services.

One big question is what happens when options are not exchanged (as they were in Letter Ruling 200032017), but rather accelerated as a result of a change in ownership or control. The proposed regulations under the golden parachute rules expressly deal with this situation. These rules provide that where a payment is accelerated by a change in ownership or control, and that payment was substantially certain at the time of the change to have been made without regard to the change, the portion of the payment that is treated as contingent on the change in ownership for control is the lesser of:

This formula may sound a bit threatening, particularly the latter part. In fact, though, it is designed, at least in somewhat simplified terms, so that only the accelerated portion of the payment is treated as a golden parachute payment. Although this example is somewhat complex, it is worth running through at least one example contained in the proposed regulations regarding the treatment of stock options:

Example 7: (i) on January 15, 1996, a corporation grants to a disqualified individual nonqualified stock options to purchase 30,000 shares of the corporation's stock. The options do not have a readily ascertainable fair market value at the time of grant. The options will be forfeited by the individual if he fails to perform personal services for the corporation until January 15, 1999. The options will, however, substantially vest in the individual at an earlier date if there is a change in ownership or control of the corporation. On January 16, 1998, a change in the ownership of the corporation occurs and the options become substantially vested in the individual. On January 16, 1998, the options have an ascertainable fair market value of $600,000.

(ii) At the time of the change, it is substantially certain that the payment of the options to purchase 30,000 shares would have been made in the absence of the change if the individual had continued to perform services for the corporation until January 15, 1999. Therefore, only a portion of the payment is treated as contingent on the change. The portion of the payment that is treated as contingent on the change is the amount by which the amount of the accelerated payment on January 16, 1998 ($600,000) exceeds the present value on January 16, 1998, of the payment that was expected to have been made on January 15, 1999, absent the acceleration, plus an amount reflecting the lapse of the obligation to continue to perform services. Assuming that, at the time of the change, it cannot be reasonably ascertained what the value of the options would have been on January 15, 1999, the value of such options on January 16, 1998, is deemed to be $600,000, the amount of the accelerated payment. The present value on January 16, 1998, of a $600,000 payment to be made on January 15, 1999, is $549,964.13. Thus, the portion of the payment treated as contingent on the change is $50,035.87 ($600,000 — $549,964.13), plus an amount reflecting the lapse of the obligation to continue to perform services. Such amount will depend on all the facts and circumstances but in no event will such amount be less than $66,000 (1% x 11 months x $600,000). (Prop. Reg. §1.280G-1(c), Example (7).

Watch Out

With options, or any other consideration, beware of payments contingent on a change in ownership or control.

Exchanging Vested Options: Is There a Golden Parachute Payment?, Vol. 9, No. 3, The M&A Tax Report (October 2000), p. 1.