To lure and retain valuable executive talent, employers – especially emerging companies and start-ups – often feel compelled to issue restricted stock as part of the compensation package.

Those key employees are generally reluctant to pay full price for the stock. They also want to defer income recognition on its receipt. And they want any income recognized to be taxed as capital gains rather than ordinary income. Why not? If you don’t ask, you don’t get!

One way companies can answer those concerns is via employer-financed restricted stock sales. But they can also create uncertainty about how and when the employees are taxed. There may, however, be a better solution if the tax problem is faced head-on.

Employees aren’t normally taxed on the grant of restricted stock; instead, they are taxed at ordinary income-tax rates when the stock vests. The taxation is based on the fair-market value of the stock at the time of vesting less any amount paid for the stock.

On a later sale of the stock, after its restrictions have lapsed and ordinary income has been recognized, employees incur a capital gain or loss. But the holding period for determining whether any gain is a long-term capital gain doesn’t start until the restrictions lapse.

Employees, however, can make a Section 83(b) election, which would enable them to accelerate the taxable event to the time the stock is transferred, rather than the time the stock vests. In that way, they can obtain capital-gain treatment, rather than ordinary income-tax treatment, on the appreciation of the stock from and after the date of transfer and during the period the stock restrictions are in effect.

Still, employees will be taxed in the year of transfer at ordinary rates on the difference between the fair-market value of the stock at the time of transfer (determined without regard to the restrictions) and any amount paid for the stock. Any appreciation thereafter would be a capital gain on a later sale, with the holding period starting at the time of transfer.

Most employees are unwilling or unable to pay fair-market value for their restricted stock. Many also dislike the ordinary income-tax hit resulting from appreciation in the stock between the time of transfer and that of vesting. Even the Section 83(b) election proves unsatisfactory to employees who still must pay ordinary income tax at the time of transfer if (and to the extent that) they haven’t paid full value for the stock.

To solve this dilemma for the employees and to serve as a better recruitment tool, companies can lend them cash to finance the purchase price of the stock. Understandably, the employees may be wary of the personal liability associated with a recourse loan collateral. However, if the stock is paid for through the issuance of a nonrecourse loan to the employer secured solely by the restricted stock, the transaction will be treated as the grant of an option to acquire the restricted stock, rather than a “transfer” of the stock.

Without a “transfer” of stock, the Section 83(b) election is unavailable. Thus, the compensation element of the grant remains open, resulting in ordinary income to the employees on the appreciation of the underlying stock until the option is exercised. Capital-gains treatment would then only be available after the option has been exercised. When the “option” is considered exercised (and thus the stock transferred) in this context is far from clear. A large down payment makes it more likely that the stock would be treated as transferred. But there is a significant uncertainty about what amount would be considered enough, thus exposing the employees to a potentially big tax liability. While making the loan partially recourse could solve the problem, the question is still: How much of the loan has to be recourse?

Not to worry. An alternative approach, implicitly sanctioned by the Internal Revenue Service in a series of private letter rulings in 2009, involves the avoidance of this issue altogether. Instead of having the employer finance the employees’ purchase of the stock, the employer finances the employees’ tax liability.

Here is how it works: The employer transfers the stock to the employees at no cost, and the employees make the Section 83(b) election to accelerate the taxable event to the date of transfer. That requires the employees to recognize ordinary income in an amount equal to the value of the stock and enables the employer to report an ordinary noncash deduction equal to the same amount.

The employer then finances the employees’ income-tax liability with a nonrecourse loan to the employees (at today’s low interest rates) secured by the restricted stock. Since this doesn’t involve the financing of the employees’ purchase price of the stock, the restricted stock grant would be considered a “transfer” of the stock, thus closing the compensation element of the transaction upon transfer because the Section 83(b) election is made. This avoids the tax uncertainty created by financing the actual stock acquisition with a nonrecourse loan and the requirement of a substantial cash down payment by the employees or, alternatively, a substantial portion of the acquisition note’s being recourse.

Although employees must still pay the ordinary income tax incurred on the date of grant, they have deferred the payment of the tax by means of the employer’s nonrecourse loan. The employer is permitted a noncash deduction in the same amount and at the same time, while the employees are required to include the compensation element of the restricted stock grant in income.

If the employer has enough taxable income, the resulting tax benefit can be used to finance the nonrecourse loan made to the employees. Thus, the use of a nonrecourse loan to finance the employees’ tax liability associated with the restricted stock grant is a win-win solution for both the employer and the employees. Other than interest payments, neither incurs an out-of-pocket cost on the equity grant to the employees. Of course, the employer still has a decision to make: is the economic cost of the equity granted to the employees a worthwhile cost to incur in gaining key employees’ services?

Mr. Lieb received his Juris Doctor degree from the University of Michigan Law School, Ann Arbor, and his Bachelor of Arts degree from Emory University, Atlanta.  For additional information, please click here.

Alan Bergman is Of Counsel to ECJ’s Real Estate Department.  Mr. Bergman’s practice specializes in multi-residential and commercial real estate together with all related business and real estate transactional matters.

QUESTION: I know this has come up before, but whose tax identification number do I use to report income earned by the receivership estate?

ANSWER: If you were appointed receiver for a tax reporting entity — a corporation, a partnership, a limited liability company or a limited liability partnership — or have been appointed receiver for assets belonging to such an entity, you should use that entity’s tax identification number. If the entity in receivership will not provide you with its tax identification number and you cannot locate it from review of tax returns or other documents, you should submit an IRS Form SS-4 (Application for Employer Identification Number) and obtain and use a new tax identification number. Similarly, if you are receiver for assets belonging to an individual, you should report any income on that individual’s social security number. Never use your own social security number or the tax identification of your property management company or any other entity helping you administer the estate.

There’s plenty of equity money in the marketplace seeking operating companies to buy. Such buyers are the usual suspects — wealthy individuals, established companies, and private equity funds. Some may be very motivated because the time period for them to draw upon their investors’ capital commitments may be near expiration.

The sellers who want to sell to those buyers, however, may not want to sell – especially if the price is based on operating performance they believe is only temporarily depressed in the wake of the financial meltdown. Or they may be hesitant to sell based solely on historical performance when their businesses are in high-growth industries.

Buyers, however, want to buy on proven performance and not speculative future performance. This presents a classic situation: a buyer wanting to buy for less negotiating with a seller wanting to sell for more. When buyers and sellers cannot agree on the valuation, a way to bridge this gap is through an earnout.

An earnout is a contingent pricing mechanism. In an earnout, a portion of the purchase price is calculated by using the performance of the selling company over a period of time after the closing of the sales transaction. It rewards the seller only if the future performance actually matches the current projections of future performance.

Further, it allows a seller to exit its current investment without forfeiting the ability to share in its future growth. It also protects the buyer from overpaying if a seller’s projections are overly optimistic. In many ways, the earnout aligns the financial incentives of both the buyer and the seller.

The contingency of the earnout can be measured using any number of factors, such as achieving certain sales volumes, EBITDA levels, or other operating benchmarks. It could even be measured according to transaction-specific milestones, like the target company obtaining a large contract.

The parties can also decide that the additional purchase price is earned only if the targeted performance levels are achieved. Or they can decide that it can be earned in part based on a sliding scale of operations relative to a target level. The parties must determine over what period of time performance is measured and when the additional payments are made. They also need to consider such “what if” scenarios as a later sale by the buyer of the newly purchased business – or even a sale of the buyer itself.

The use of an earnout may always be well-intended. Still, there are many instances in which the deployment of an earnout creates friction between the buyer and seller. A buyer doesn’t want any limitations placed on its ability to integrate the newly purchased business and achieve the economies of scale and other synergies that motivated its purchase. For its part, the seller wants to maintain separate and distinct operations to make achievement of the performance targets more likely. Operating control and capital funding issues must be dealt with to make sure that each party’s expectations are met.

Taxing Issues

The tax treatment of the earnout to the seller requires sharp analysis. Is the earnout contingent upon the seller’s continued employment by the buyer? If so, is the earnout really additional purchase price (capital gain) or another way of providing incentive compensation (ordinary income)?

The timing of the recognition of gain on the sale is also affected by the earnout. The installment method of reporting the gain on the sale, in which the tax liability is deferred until cash is received, is allowed. But that gain will necessarily be accelerated, either because all contingent future payments of the earnout are included in the gain calculation or because the basis of the shares sold is allocated ratably over the earnout period.

If the operating results are not achieved so that additional earnout payments are not made, the capital loss then generated may be of limited utility to the seller. Moreover, the gain recognized is subject to the tax rates in effect in the year of recognition.

If, as many believe, tax rates will be higher in the future, your post-closing earnout payments will come with a higher tax cost. Finally, some part of the earnout payments will be treated as ordinary interest income.

To solve or lessen the impact of these problems, many sellers have opted to opt out of the installment method of reporting the gain on the sale. To do so, however, sellers must report and pay tax on the present value of the earnout payments. The seller’s valuation for tax purposes should be compared with the buyer’s valuation of the earnout which the buyer must undertake in order to properly account for the purchase.

Earnouts can bridge the valuation gap in the negotiation between buyers and sellers. However, they create their own unique problems and carry their own costs. It takes a significant amount of time to negotiate an earnout and have it properly analyzed and documented.

That additional time translates into additional professional costs. Moreover, an earnout keeps the seller involved in the business even though, in many instances, the seller is moving on to other priorities.

From the buyer’s perspective, the seller is looking over the buyer’s shoulder to make sure the business is being operated in order to maximize the earnout payment and not necessarily what is good in the long-term for the buyer.

Notwithstanding these shortcomings, earnouts do ensure that the competing objectives of the buyer and seller are met – the buyers pays for actual performance and not speculative conjecture, while the sellers get paid for the value they always knew was there.

The legislation was proposed in an effort to ensure that pregnant working women are not forced out of jobs unnecessarily or denied reasonable modifications to their position that would allow them to continue working.

Pregnant women are currently protected by the federal Pregnancy Discrimination Act, but protection against discrimination does not require accommodation. The Pregnant Workers Fairness  Act would require businesses to make reasonable accommodations for workers who are currently pregnant and prevent employers from forcing women out on leave when they could be reasonably accommodated by the company.

The law would also prevent employers from denying job opportunities to women based on them being pregnant or requiring accommodations that are related to childbirth, pregnancy or related medical conditions.

Several examples of workers being denied accommodations or being prevented from performing certain actions were presented to highlight the need for the law, including personal experiences from several lawmakers.

"Women are not disposable workers who can be cast off if, and when, they are pregnant," said Congresswoman Speier. "Welcoming women in the workforce also means women who are pregnant. They deserve the same treatment as any other employee who is in need of a temporary accommodation. I served in the California State Assembly during both of my pregnancies and understand the challenges that working women are confronted with during those nine months."

These legislative protections could help women keep their jobs and acquire accommodations for their pregnancy across the nation, however, California employers should have no trouble adjusting to the Pregnant Workers Fairness Act for the simple reason that California led the way in protecting pregnant workers by enacting similar law 20 years ago.

What this blog is not:  A mere reporting of new developments in statutory or case law.  There are many on-line services that can provide that information to you.  Nor is it a “brag” about our department’s successes, though there are certainly many of those.

What this blog is:  A series of takes by seasoned litigators on issues of strategy, fees and litigation economics, legal ethics, and other litigation-related matters which we hope you will find of interest and value.

And finally:  At the end of each post, we will recommend a wine for your enjoyment—after all, doesn’t everyone need a drink after dealing with lawyers?.  They will all be wines which we have personally experienced and liked.  Of course, we welcome your palate’s feedback!

Today’s Take:  Be Wary of Arbitration

Arbitration is sold as a quicker and cheaper way to resolve disputes than traditional litigation.  In the business and commercial context—it ain’t necessarily so!  First of all, in addition to paying your lawyer, you’ll be paying your share of the arbitrator’s hourly fees, whereas your tax dollars already pay your court’s judges.  And here’s the deal:  Cynically speaking an arbitrator’s interests are best served by being very accommodating to both sides’ lawyers in scheduling matters or letting proceedings stretch on and on; after all, this (a) results in more fees to the arbitrator and (b) avoids offending the lawyers on whom the arbitrator relies to get future work.  And even not being cynical, arbitrators in large business and commercial cases usually feel it necessary and appropriate, given the large amount or other issues at stake, to allow the parties the time and discovery necessary to adequately prepare their respective cases.  As a result, arbitrators frequently let the parties do almost everything they could do in a normal litigation, so the time and cost savings are minimal.

Besides, most arbitrations are “binding”, meaning that the arbitrator’s award is generally non-appealable and can only be overturned in very limited circumstances.  Also, arbitrators generally need not strictly follow the rules of evidence, and many arbitrations are conducted without a court reporter being present, as that would be an additional expense.  As a result, the outcome is significantly less predictable, and losing litigants are left much more frustrated, than is the case with a court trial.  And if you need provisional relief such as a preliminary injunction or an attachment, courts are usually much more familiar with their requirements and are used to dealing with such requests, especially on very short (“ex parte”) notice; arbitrators are not.

So if you have a choice as to whether to include a mandatory arbitration clause in an agreement, or whether to accept an offer to arbitrate, be wary of arbitrating business and commercial disputes, especially major ones which do not occur on a regular basis.  Instead, have your attorney work with you to establish a monthly budget for the litigation and let the litigation process take its course.

Allan Cooper, Head of ECJ’s Litigation Department

Today’s Wine:  As an inaugural wine for an inaugural post, my partner Howard Camhi recommends a village Meursault by Matrot.  These wines are a pure example of the smoky mineral characteristics of Meursault, are food-friendly, and won’t force you to break your piggy bank ($30-40 per bottle).  They are a terrific introduction to white burgundy wines.

QUESTION: I am a receiver appointed by the Orange County Superior Court in a contentious case. One of creditors has threatened to sue me in Nevada where he is located. How can this creditor sue me? I am a receiver appointed by the Court!

ANSWER: Welcome to the gritty world of receiverships. While you are a court appointed receiver, and may personally have quasi-judicial immunity, you can still be sued. Your question is unclear as to why the creditor wants to sue you and whether he intends to sue you in your official capacity as receiver or individually. Generally, receivers do have quasi-judicial immunity for any actions brought against them in their individual capacity, unless their activities exceeded the scope of their order of appointment (the distinction between personal liability and official liability will not be discussed here). Assuming the creditor wants to sue you in your official capacity, the creditor needs to first obtain permission to do so from the court which appointed you. McCarthy v. Poulsen, 173 Cal. App. 3rd 1212, 1219 (1985); Ostrowski v. Miller, 226 Cal App. 2d 79, 83 (1964). C.C.P. §568 used to provide that a receiver cannot be sued without the permission of the receivership court. The statute was amended in 1982 and the express prohibition was deleted. However, the courts have subsequently held that this deletion did not affect the rule requiring court permission to sue a receiver. Vitug v. Griffin, 214 Cal. App. 3rd 488, 493 (1989). It has been repeatedly stated that the purpose of the rule is to promote judicial economy by prohibiting the receiver and the receivership estate from a multiplicity of lawsuits and because, in most cases, claimants can obtain appropriate relief within the receivership case. If you are sued without permission being obtained, you need to raise that at the first opportunity, either by demurrer or motion to dismiss; otherwise this requirement can be deemed waived. Vitug supra. A creditor cannot evade the permission requirement by suing outside the receivership court. Merryweather v. U.S., 12 F. 2d 407, 408 (9th Cir. 1926) [“The court which holds the estate and administers must decide whether it will determine for itself all claims against the receiver, or will permit suits to be brought and determined in other courts. And as said by Justice Gray in Porter v. Sabin, supra. * * * No suit, unless authorized by statute, can be brought against the receiver without the permission of the court which appointed him.”]. Some courts require an evidentiary showing that the claims have merit before permission will be granted. See, for example, Federal Deposit Insurance Corp. v. J.D.L. Assoc., 866 F. Supp. 76 (D. Conn. 1994). Other courts, however, merely require allegations. Although you can never stop someone from suing you, you may be able to convince the court that any action brought against you should be litigated in the receivership court, before the judge who appointed you, who is most familiar with the receivership proceeding.

Employers in the state could be affected by Senate Bill 459, which appears as Sections 226.8 and 2753 of the California Labor Code.

This legislation dramatically increases the penalties for companies who are found to have intentionally misclassified employees as independent contractors. For each violation of this law, an employer could face a penalty of at least $5,000 and up to $15,000.

If a court in the state is able to determine that the employer continues to engage in a "pattern or practice" of violations, the monetary penalty is adjusted upward to a minimum of $10,000 and a maximum of $25,000 for each transgression.

The issue revolves around the intent of the employer, as certain companies – especially firms with limited resources that lack small business legal help – may simply misclassify employees without intending to deceive the state's labor board.

However, others have intentionally misclassified workers in the state in order to avoid tax implications in the form of federal income tax, social security, Medicare and unemployment taxes.

Regardless of the intent of the company, proving that an employer willfully misclassified an employee could lead to fines for businesses that do not have the resources to pursue the matter. In the meantime, it could take several years for the court to establish a precedent for what qualifies as a willful misclassification under the new law.

The EEOC recently ruled 4-to-1 that employers should no longer use a criminal background check, or a job applicant's criminal record, when making an employment decision. This shift by the EEOC could impact businesses that rely on full examinations of potential employees.

The federal agency noted that the new "enforcement guidance" would prevent employers from maintaining a hiring policy that excludes all applicants with a criminal record, stressing that only crimes relating to the field that they are working in should be considered.

The guidance was put forth as a way to ensure that companies don't hire employees of one race over those of another, as the EEOC noted that the use of an individual’s criminal history has a "disparate impact on racial and ethnic minorities, who have higher arrest and conviction rates than whites."

The EEOC guidelines, which often influence court decisions, could mean that many employers who use these background checks as a way to eliminate potentially poor workers will no longer be able to do so. This would leave businesses with one less tool with which to judge job applicants, leaving open the possibility for a bad hire that could cost a company money.

The commission made the argument that this guidance is necessary due to the fact that many online recordkeeping companies fail to update their database to include changes to criminal records. Nevertheless, this guidance could provide a legal headache for an employer who is worried about turning away a candidate for a job based on past criminal activities.