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Determining compensation deductions in M&A transactions

By Karen Field, J.D., Washington, D.C.; Michelle Borman, J.D., Chicago; and Chloe Webb, J.D., LL.M., Kansas City, Mo.

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Editor: Mo Bell-Jacobs, J.D.

Compensation deductions in mergers and acquisitions (M&As) are complicated. Deductions can end up with multiple parties over several tax years. Companies may assume that deductions for compensation related to the transaction will go to the target. However, there are many considerations when determining who gets the deduction (e.g., type of compensation, accounting methods, and buyer’s fiscal year).

This item explores three types of compensation paid to employees of the target. The target receives one deduction, but the other deductions fall into two tax years of the buyer. In this scenario, Public1 (Buyer) acquired Public2 (Target) on June 30, 2022 (the change-in-control (CIC) date), in a merger treated as a stock acquisition for federal income tax purposes. The salient facts are as follows:

  • Target has a Dec. 31 tax year end and will file a short-period tax return ending on the CIC date, joining the consolidated group of Buyer on July 1, 2022.
  • Buyer has a Sept. 30 tax year end.
  • The compensation payments included transaction bonuses, restricted stock units (RSUs), and restricted stock awards.
  • Vesting for all awards accelerated on the CIC date and were paid within a week afterward.
  • No Sec. 83(b) elections were made for the restricted stock awards.
  • Target has historically deducted cash bonus payments in the year of accrual, when the bonuses were fixed and determinable at year end and paid within 2½ months of year end.
  • Target historically took deductions related to RSUs in the year the shares were transferred.

The treatment of compensation is described in a summary format for each of the relevant tax years below.

Tax year 1: CIC on June 30, 2022

Sec. 404(a)(5) governs the deduction timing of nonqualified deferred compensation, that is, compensation that is earned and vests in one year and is paid in a subsequent year. However, if the compensation payment is made within 2½ months after the end of the employer’s tax year in which the services creating the right to such compensation are performed, it may not have to be treated as deferred compensation. Instead, Temp. Regs. Sec. 1.404(b)-1T provides that the employer’s method of accounting may apply to determine the deduction timing of the short-term deferral payment.

Here, the transaction bonuses vested and were fixed and determinable on the CIC date and were paid within one week following the CIC; therefore, under the short-term deferral rule, Target’s method of accounting can be applied to determine the deduction timing of the payment.

Target routinely deducted bonus payments in the year of accrual, when such amounts were fixed and determinable at year end and paid within 2½ months after the end of the employer’s tax year in which the services creating the right to such compensation were performed. Therefore, the transaction bonuses can be deducted on Target’s June 30, 2022, return.

Tax year 2: Year end Sept. 30, 2022

RSUs represent a promise to pay a share or cash in the future. RSUs can be designed to comply with the Sec. 409A requirements or to be exempt from Sec. 409A under the short-term deferral exception discussed above. If the plan is under the short-term deferral rule, the employer’s method of accounting applies to determine the deduction timing.

In a stock transaction, the target’s tax attributes are generally retained. Here, vesting accelerated for the RSUs on the CIC date, and the shares were transferred within a few days of the CIC date. Target historically deducted RSU payments in the year the shares were transferred, due to the volatile nature of the stock’s value. Therefore, the RSUs can be deducted on Buyer’s Sept. 30, 2022, return.

Tax year 3: Year end Sept. 30, 2023

Restricted stock awards transfer shares to employees that are subject to vesting conditions. Sec. 83 governs the deduction timing of restricted stock, which depends upon whether the property is vested or unvested at the time of the grant. If an employee makes a Sec. 83(b) election at the time of the grant, the company can take a deduction at the time of the grant. If a Sec. 83(b) election is not made, then, under Regs. Sec. 1.83-6(a)(1), an employer can take the compensation deduction at vesting for the shares included in the employee’s compensation in the employer’s tax year in which or with which ends the employee’s tax year in which the amount was reported as compensation.

Here, vesting accelerated for the restricted stock on the CIC date, and the stock was transferred within a few days of the CIC date. No Sec. 83(b) elections were made at grant. Therefore, the restricted stock can be deducted on Buyer’s Sept. 30, 2023, return (the employer’s tax year covering Dec. 31, 2022, and the end of the employee’s tax year in which the shares were included in the employee’s income).

The table “Summary of Transaction Payments,” below, shows these three types of compensation and the timing of their deductibility for either party to the M&A under the facts given.

summary-of-transaction-payments

Other limits and factors to consider for public companies

When considering the deduction of compensation payments in a public company transaction, tax advisers must acknowledge possible additional limits on the compensation deductions that are outside of the scope of this item but are noted briefly below.

Sec. 280G limits employer compensation deductions for compensation paid to an individual in connection with a CIC transaction. The limitation applies when a disqualified individual — an officer, 1% shareholder, or highly compensated individual — receives such payments that exceed three times the disqualified individual’s average base compensation for the five years preceding the year of the CIC transaction. (Private companies can take advantage of a shareholder vote process that would eliminate these negative tax impacts, but such a “cleansing” vote is unavailable to public companies.)

In addition, Sec. 162(m) limits employer tax deductions on certain excessive employee remuneration (compensation over $1 million per covered employee per tax year).

Editor Notes

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP. Contributors are members of or associated with RSM US LLP. For additional information about this item, contact Karen Field, J.D. (Karen.Field@rsmus.com), Washington, D.C.; Michelle Borman, J.D. (Michelle.Borman@rsmus.com), Chicago; and Chloe Webb, J.D., LL.M. (Chloe.Webb@rsmus.com), Kansas City, Mo.