Stock options are a popular form of compensation, but they can be tricky. Dan Morgan of Blank Rome LLP takes a look at a recently filed lawsuit that focuses on the tax problems that can result from the timing and restrictions of shares.
It is common for executives to be compensated by giving them the right to receive employer stock. This right can take different forms, including direct stock grants, stock options, and restricted stock units. Equity awards often are subject to vesting conditions that require either the executive to remain employed for a stated period of time or the company or the executive to satisfy specified performance criteria.
An executive who has been awarded restricted stock units—RSUs—receives, as the RSUs vest, shares of the employer’s stock equal to the number of vested RSUs or an equivalent amount of cash, with the value of the stock or the cash being taxed as compensation income. A recently filed lawsuit against CV Sciences, Inc. by its former CEO and president, Michael J. Mona, Jr., calls attention to what can happen when someone who has been awarded RSUs receives shares of stock that they are unable to sell.
According to the complaint filed in Mona, Jr. v. CV Sciences, Inc., Mona agreed to resign as the company’s CEO and president in connection with the company’s settlement of litigation brought by the Securities and Exchange Commission alleging fraud on the part of the company. In exchange for his resignation, he and the company signed an employment agreement that granted him RSUs entitling him to receive 2,950,000 shares of company stock in accordance with a vesting schedule. Mona subsequently agreed to retire from the company entirely and entered into a settlement agreement with the company that recognized that Mona’s RSUs had immediately vested upon his retirement, which resulted in a taxable distribution to him of the 2,950,000 shares of company stock promised by the RSU award.
Mona’s complaint states that, on the day Mona received the 2,950,000 shares of stock, the stock was trading over the counter at a price of $4.66 per share. Mona, however, was an insider, and the federal securities laws prevented him from selling the stock for six months and limited the number of shares he could sell thereafter. During the restriction period, the stock price dropped to around $0.50 a share. The upshot is that Mona only received approximately $1,484,845—before commissions and fees—for the stock when he was able to sell it. Per the complaint, this compares to a value for the shares of approximately $13,747,000 on the date that the shares were distributed, and a combined federal and state income tax liability slightly north of $5,281,000.
The company did not withhold the income taxes that were due upon Mona’s receipt of the shares. Mona asserts that this contravened the terms of his employment agreement, which stated that the company “shall withhold from any payroll or other amounts payable to [Mona] pursuant to this Agreement [all taxes] and other contributions as are required pursuant to any law or other government regulation or ruling...”
It does not appear from the complaint that Mona was being paid cash compensation when he got the stock. He argues that the company should have withheld from his stock distribution a sufficient number of shares to cover the tax liability. Mona’s position is that the company’s failure to pay income withholding taxes breached the employment agreement and entitles him to damages.
Possible Prior Precedent
In Davidson v. Henkel Corp., a federal district court judge sided with a group of employees who had brought a class-action lawsuit alleging that their employer did not follow the so-called “special timing rule” that treats certain forms of deferred compensation as taxable FICA wages at the time that the compensation vests.
The effect of not adhering to the special timing rule was that the employees’ deferred compensation was taxable at the time it was paid. Had the employer followed the special timing rule, the deferred compensation would have had more favorable tax treatment because, at the time of vesting, the employees’ other compensation would likely have been above the Old Age, Survivors, and Disability Income 6.2% FICA tax annual dollar limit and, therefore, the deferred compensation would only have been subject to the Hospital Insurance 1.45% FICA tax rate. When the employees received the deferred compensation, they were no longer getting salary payments, which meant that the deferred compensation was taxed at the combined 7.65% FICA tax rate. In addition, the employees had to pay FICA taxes on their post-vesting deferred compensation earnings, which application of the special timing rule would have avoided.
In holding for the employees, the court pointed to the following provision of the deferred compensation plan, which the court said required the employer to abide by the special timing rule:
“Taxes. For each Plan Year in which a Deferral is being withheld or a Match is credited to a Participant’s Account, the company shall ratably withhold from that portion of the Participant’s compensation that is not being deferred the Participant’s share of all applicable Federal, state or local taxes. If necessary, the Committee may reduce a Participant’s Deferral in order to comply with this Section.”
The court concluded that the increase in the employees’ FICA taxes that resulted from the employer not satisfying the special timing rule reduced the employees’ deferred compensation plan benefits, which the employer had to make up.
Does Henkel Help?
To date, it appears that Henkel is the only case that has considered the implications of an employer’s failure to withhold taxes on compensation in the face of a contractual agreement to do so.
Mona’s complaint—which references a couple of court decisions—does not mention the Henkel case. However, given the absence of other precedent, it is worth noting a key difference between the facts in Henkel and the facts laid out in Mona’s complaint.
In Henkel, the employer’s failure to withhold FICA taxes resulted in the payment of additional FICA taxes by the plaintiffs that could have been avoided. Mona, on the other hand, is arguing that by not withholding income taxes on his stock distribution, the company forced him to wait out the period restricting his ability to sell shares, causing him to sell shares at a price that was much lower than the stock price at the time he was taxed on the shares. Not withholding income taxes did not increase the amount of taxes Mona owed when he got his share of stock. He owed those taxes without regard to the company’s actions.
Some Thoughts on the Issues
Mona’s complaint indicates that the IRS is looking only to him for the unpaid taxes. The IRS has the right to collect the taxes from both Mona and the company. This alternative collection structure points up an anomaly in the tax law. Generally, employees are entitled to a credit on their income tax return for taxes withheld by their employer. However, where the IRS collects the taxes that were not withheld from the employer in a later year, the employee does not get this credit and is still on the hook for the taxes. By comparison, a specific provision in the Internal Revenue Code allows an employer to avoid liability for taxes that the employer did not withhold if the employee pays those taxes.
As discussed above, Mona’s tax problems are attributable to the confluence of a restriction on selling stock and a rapidly declining stock price. The complaint does not say whether he asked the company to withhold shares that could be sold to pay income taxes. Given the short period of time in which the company would have been required to deposit income withholding taxes, and the number of shares that would had to have been sold to generate the funds to pay those taxes, agreeing to such a request might have had a negative impact on the company’s stock price.
Mona’s quandary would have been that much starker if the company’s stock was not publicly traded. In that instance, there would have been no mechanism to translate the value of the shares into cash that could be used to pay taxes. This problem is not unique to stock-settled RSUs, but can arise in any instance where an executive is compensated in employer stock. What this means is that private companies tend to look to stock options—the granting of which is not a taxable event—as the vehicle for equity compensation, the idea being that executives will not exercise the options—and trigger taxation—except in connection with a liquidity event such as an acquisition. Although private companies will sometimes couple a stock option with a right to sell shares acquired through the exercise of the option back to the company, for a number of reasons—including, importantly, concerns related to cash flow—there is a reluctance by private companies to obligate themselves to buy back stock.
As a final note, outright grants of stock in a private company that is a start-up can avoid the potentially draconian result of the stock being taxed at its value at the time it vests by making a section 83(b) election when the stock is received, at which time the stock presumably has little value.
“Recent Lawsuit Highlights a Potential Equity Compensation Trap,” by Daniel L. Morgan was published in Bloomberg Tax on January 11, 2022. Reprinted with permission.