Employees generally must recognize income upon the receipt of employer stock to the extent that the fair market value of the stock received is greater than the amount, if any, paid by the employee for the stock.IRS If the employee is taxed on receipt of the stock, that could be a real problem, as he or she may not have the cash on hand to pay the income tax due if the stock is not readily tradeable on an established market.  The problem is particularly acute when the valuation of the stock has increased dramatically between the option grant date and the exercise date.  The result very often is that employees simply allow their options to expire and thus forfeit a major component of their compensation and the upside potential it represents.

Last year, the U.S. House of Representatives passed the Empowering Employees Through Stock Ownership Act (the “Bill”). The Bill never received a vote in the Senate.  The Bill sought to alleviate the income tax burden of employees of non-publicly traded companies who exercise options or receive stock in settlement of restricted stock units (“RSUs”).  Empowering Employees Through Stock Ownership ActCompanies, particularly start-up companies, often prefer to compensate their employees with equity awards (such as options or RSUs) in order to conserve cash and attract, retain and incentivize employees by providing them with a stake in the success of the venture.

The Bill

The Bill would permit certain “qualified employees” to elect to defer, for income tax purposes, the inclusion in income of the amount of income attributable to a qualified employee’s receipt of “qualified stock” from an “eligible corporation.”

Qualified Employees

Qualified employees would generally include any employee who has not previously been a one percent stockholder, CEO, CFO, a family member of any of the foregoing or a highly compensated officer.

Qualified Stock

Qualified stock would be any stock of a corporation if (1) an employee receives the stock in connection with the exercise of an option or in settlement of an RSU, and (2) the option or RSU was provided by the corporation to the employee in connection with the performance of services and in a year in which the corporation was an “eligible corporation” (as described below). However, qualified stock does not include stock if an employee may, at the time the employee’s right to the stock becomes substantially vested, sell the stock to, or otherwise receive cash in lieu of stock from, the corporation.

Eligible Corporation

A corporation is deemed eligible with respect to a calendar year if (1) no stock of the corporation is readily tradable on an established securities market during the calendar year or any preceding calendar year, and (2) the corporation has a written plan under which, for the calendar year, not less than 80% of the corporation’s employees are permitted to receive stock options or RSUs with the same rights and privileges to receive qualified stock. In applying the requirement that 80% of employees receive stock options or RSUs, excluded employees and part-time employees are not taken into account.  Employees would not fail to be treated as having the same rights and privileges to receive qualified stock solely because the number of shares available to all employees is not equal in amount.


If an employee were to elect to defer income inclusion, the deferral would end and the income would be included for the taxable year that includes the earliest of (1) the date the qualified stock is sold, exchanged or otherwise disposed of; (2) the date the employee first becomes an excluded employee; (3) the first date on which any stock of the employer becomes readily tradable on an established securities market; (4) seven years after the employee’s right to the stock becomes substantially vested; and (5) the date the employee elects to include the amount in income. The amount included in income is the same amount that, but for the election, would have been included in income for the taxable year in which the employee’s right to the stock became substantially vested.


The Bill appears to be a step in the right direction to remedy the issue of illiquid option exercise and/or stock settled RSUs. However, the deferral does not apply to employment taxes or state and local taxes, which can result in a substantial tax payment despite the federal income tax deferral (as much as 20% for a New York City resident).  In addition, the deferral period is limited to seven years, which may not be a long enough period to induce employees of certain small pre-IPO companies to exercise their options.  Finally, it is not clear how impactful the Bill would really be given the trend toward phantom equity arrangements.  It will be interesting to see how this issue may be incorporated into the tax reform proposals being crafted in the new Congress.

Your startup was launched only a few months ago and your co-founder has just informed you that he’s leaving.  It hits you that your co-founder just walked out the door with 50% of the equity in the company.  Oops.

Founder breakups are not uncommon, but what happens to the exiting founder’s stock will depend on whether or not the founders had agreed in advance on a vesting arrangement.  Essentially, vesting of stock means that all or a portion of it effectively gets “earned” either over time or upon achieving milestones or a combination of both.  The purpose is to align incentives: encourage founders to remain with the company and avoid the unfairness inherent in walking away with unearned equity.  The arrangement is typically effectuated with the right of the company to repurchase the individual’s unvested shares, usually at some nominal price.


So if the company could be given the right to repurchase unvested shares for a nominal amount, why not just issue the shares at each vesting interval instead of issuing them all at the outset and then repurchasing shares that haven’t vested?  The answer is that issuing shares subject to vesting creates a significant tax planning opportunity for the shareholder.  Shareholders are typically better off being taxed when shares are least valuable, i.e., at or within a short period following formation.  Although shares issued under a vesting schedule are subject to a substantial risk of forfeiture and would therefore generally be taxed as they vest, shareholders can choose to be taxed at the time of issuance, i.e., when the shares are valued low, by filing a simple Section 83(b) election with the IRS.

Another reason for founders to agree to subject their shares to vesting is that VCs will typically insist on it at the time of their investment in order to incentivize founders to stay, and VCs are more likely to agree to preexisting vesting arrangements if they are reasonable.

Vesting arrangements involve several variables, each of which should be considered based upon the unique facts and circumstances of each case.  The three main variables are vesting schedules, repurchase price and acceleration.

Vesting Schedules

 Vesting schedules can be either time based, milestone based or a combination of both.  Careful consideration should be given to immediate vesting of a portion of the shares allocated to a founder to the extent that founder has made any significant pre-issuance contributions to the startup.  Vesting schedules should also be driven by founders’ expectations of their respective efforts going forward.  The most common arrangement is four-year vesting with a one-year cliff, meaning that 25% of the individual’s total share allocation vests after one year, with 1/48th of the total shares vesting every month for the next 36 months.  Of course any significant pre-issuance contribution by a founder might justify vesting a certain percentage right away.  Milestone-based vesting (e.g., some percentage of shares vest upon the development of a prototype) might be appropriate for a founder who is being relied upon to focus on development of the company’s technology.

Repurchase Price

Under any vesting arrangement, the company has the right to repurchase any shares that have not yet vested at the time of termination of employment.  The repurchase price in most vesting arrangements is some nominal amount per share (e.g., $0.0001 per share), which is intended to be the amount paid by the founder, regardless of the nature of departure.  Arguably, upon terminations by the company without “cause” or by the founder for “good reason”, the vesting agreement should provide for repurchase at fair market value at the time of repurchase as determined by the board of directors in good faith or as otherwise determined by the parties.


Founders usually negotiate for accelerated vesting upon an acquisition or change of control of the company.  Investors resist this on the theory that it would make the company a less attractive acquisition candidate inasmuch as a buyer will want to know that key employees will continue to be incentivized to remain with the company at least through some transition period.  A compromise here would be something called double trigger acceleration: unvested shares would vest automatically if the founder is terminated (typically without cause) within some period of time, usually six months to one year, following a change of control.  Most acceleration provisions call for vesting of 100% of unvested shares upon the triggering event.  A better approach might be to equate the percentage of acceleration with severance.  If the individual is entitled to severance of 50% of base salary upon a termination following a change of control, perhaps the vesting of 50% of unvested shares should be accelerated.

Sun Capital Partners was dealt a harsh blow by the United States Court of Appeals for the First Circuit in a recent decision where the court found that this private equity fund could be held liable for the pension withdrawal liability of its portfolio companies.    The court essentially espoused the view of the Pension Benefit Guaranty Corporation (PBGC), holding the fund jointly and severally liable for the unfunded pension obligations of its portfolio company based on the theory that the fund is engaged in a “trade or business.”[1]  On its face, the instant case is relevant only with respect to pension liability issues, and the approximately $4.5 million liability in question, while not insignificant, is not enough to put a major PE fund out of business.  There are, however, other potentially more far-reaching consequences for PE funds.

What is Withdrawal Liability?

Under the Employee Retirement Income Security Act of 1974 (“ERISA”), pension plan withdrawal liability arises when a contributing employer to a multiemployer pension plan stops making contributions to an underfunded pension plan in which it participates.   The liability is equal to that employer’s proportionate share of the vested but unfunded benefits.  Entities which comprise members of such a defaulting contributor’s “controlled group” (i.e., 80% common ownership) may become jointly and severally liable for this liability if such an entity is engaged in a “trade or business.”

The Sun Capital Cases

When Sun Capital’s portfolio company, Scott Brass, Inc., filed for bankruptcy and defaulted on its withdrawal obligations to a multiemployer pension plan, the plan asserted that the Sun Capital funds holding the investment were jointly and severally liable for these pension withdrawal obligations under the theory that they were engaged in a trade or business and were part of Scott Brass, Inc.’s ERISA controlled group.  The District Court for the District of Massachusetts disagreed with the plan, holding that Sun Capital’s investment funds were not “trades or businesses” but, rather, passive investment vehicles, created to pool and receive investment income.

The First Circuit disagreed. While the District Court concluded that the management and consulting activities of the funds’ management company (the General Partner of the funds) were not attributable to the funds themselves and that the funds’ appointment of directors to Scott Brass, Inc.’s board of directors was an action taken in each fund’s role as a passive investor and shareholder of the company, the Circuit Court took the view that an otherwise passive investment may rise to the level of a “trade or business” when combined with other, more active management activities, rights and responsibilities, including, in this case:

  • exercising oversight of and participating in management and operations of a portfolio company;
  • participating in development of restructuring and operating plans for the company with the intent of implementing operating improvements;
  • appointing its affiliates to serve on the Scott Brass, Inc. board; and
  • receiving management fees in exchange for business services.

The Bad News for PE Funds

The Sun Capital case involved defaulted multiemployer plan withdrawal obligations, but joint and several liability also applies to a single employer pension plan when a company with its own pension plan becomes insolvent and the PBGC steps in.   The implications of this case, therefore, go beyond those instances where a multiemployer pension plan is in place.  And because the Circuit Court held that no single factor related to the passive vs. active determination was dispositive, concluding that “the sum of all of these factors” resulted in their holding, private equity funds are left with little guidance as to what types of activities are closely-related enough to the passive activity of investment, rather than active management of a business, to keep them outside of the “trade or business” paradigm.

Broader Implications for the Carried Interest Debate

The characterization of private equity as a passive investment activity is crucial to defenders of the current taxation of carried interest; the capital gains tax treatment of carried interest is largely based on the idea that these funds are not engaged in an active trade or business.  While this ruling is limited to ERISA concepts, and the law of pension plans specifically, it is reasonably foreseeable that advocates of carried interest taxation reform will point to this decision as further evidence for their position that carried interest really is ultimately compensation paid for management services and should be taxed accordingly.

How Can a PE Fund Protect Itself?

1.         Diligence.       PE funds should conduct a thorough diligence review of the pension liabilities of their potential investments and consider avoiding any portfolio company with significant underfunded pension liabilities or, at the very least, incorporate this liability into their pricing and negotiations with the seller(s).

2.         Draw Clear Lines and Make a Record.         PE fund management should keep their eye on their level of active participation in their portfolio companies and should try to build an evidentiary record of the decision-making process and the distinctions among parties;  fund materials may describe analysis and input as to the businesses of their investments but board minutes (or other similar records) should clearly reflect that the final decision-making authority, particularly with respect to day-to-day matters and routine operations, rests with the portfolio company’s executive officers and directors.

3.         Divide and ConquerBecause portfolio companies by their nature are generally engaged in trades or businesses, those that are 80% or more owned by a common PE fund may also be part of a single ERISA controlled group.  As a result, fund managers should exercise caution when structuring the upper tiers of their investment vehicles so as not to saddle a healthy investment with a significant liability of a faltering company.

[1] Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312 (1st Cir. July 24, 2013).