Discount Payments and Other Issues

We have a long term incentive plan where participants vest after 3 years.  On vesting, they receive shares of Common Stock which they can't sell.  If there is a Liquidity Event everyone get's paid for their shares.  If they terminate before the Liquidity Event, they get paid 65% of the value of the shares (this reflects that there is no liquidity or marketability for the shares at that time).  

I think the discount in the event they terminate before the liquidity event is ok, but is there any guidance as to what an appropriate discount would be?  Is 65% normal?

The Company also wants the option at termination to either (1) pay for the shares in a lump sum, or (2) pay for the shares installments up to 5 years at their discretion.  I think this violates 409A's time/form of payment rules -- do you agree?

18 hours ago, ERISA-Bubs said:

The Company also wants the option at termination to either (1) pay for the shares in a lump sum, or (2) pay for the shares installments up to 5 years at their discretion.  I think this violates 409A's time/form of payment rules -- do you agree?

Agreed

409A may not be applicable here.  Consider the exclusion in the regulations for property subject to IRC Section 83.

I don't know of any rule of thumb on marketability discount, but 35% seems in the ballpark. You just don't want it to be so large that the IRS could question whether there was a transfer of property to begin with. See Treas. reg. 1.83-3(a)(5). There are nontax issues regarding valuation, I guess, in theory, but if this is papered from the outset as a call option on part of company at time of grant to pay that price, seems bullet-proof.

409A may apply, but I'm not sure of your facts. The provision in 409A regs regarding 83 (1.409A-1(b)(6)) says in (a) that you don't have a deferral merely because an 83 property transfer is not includable at transfer because not vested, but then in (b) says that if you don't have an immediate transfer, but rather a promise to transfer, you have deferred comp.

If the idea is that on a liquidity event everyone vests and includes 65% of 100% of the value of the shares (i.e., after taking the 35% marketability discount) in income, but then company buys the shares back over 5 years, then 409A does not apply, but rather you have an installment sale or a call option or put, however it's papered, and the payments will be nontaxable return of basis except for interest amount. How you paper it (installment sale, vs. call/put) may affect whether exec gets short-term or long-term cap gain. If the idea is rather something like, in the event of a liquidity event the stock never gets transferred and instead you pay cash equal to 65% of 20% of value of shares in each of next 5 years, and only report the payments as made on W-2, then you've turned an 83 arrangement into a 409A arrangement, and violated 409A at same time.

On 12/6/2018 at 3:59 PM, ERISA-Bubs said:

I think the discount in the event they terminate before the liquidity event is ok, but is there any guidance as to what an appropriate discount would be?  Is 65% normal?

If you know someone who does ESOP stock appraisals you might want to hit them up for a favor to see what they think.  Since most ESOPs are not publicly traded this comes up in just about all stock appraisals.  I have seen some as large as 35% but I have seen plenty smaller.   I know not very insightful was that last sentence.  I am not sure what goes into the determination by the appraisal firms. 

The use of the term "vesting" is confusing. After 3 years individuals are entitled to received restricted stock (not stock units) according to some formula. Since there is nothing in the description suggesting that the stock is subject to a substantial risk of forfeiture, it should be taxable upon receipt. That obviates any concern with either 83 or 409A. Unless one could argue that 65% of the stock Is fully vested on delivery and 35% (if that is proper discount - beyond my pay grade) is subject to substantial risk of forfeiture and therefor Sec. 83. But I don't see how 409A would apply under any analysis and therefore don't see any issue with the company having limited discretion over redemption terms.