Earn Out After Noncompliant CIC Event?

[EBECatty]

I see a few prior threads answering some portion of these questions, but wanted to solicit thoughts on an issue I've had come up several times.

A small, privately held company wants to grant a key employee a portion of the proceeds of any major transaction. No equity will be involved; it will simply require the company to make a cash payment to the employee of, say, 10% of the total transaction value. They also want the payout to follow the same schedule of payments made to the company/shareholders for the purchase. So if the company is paid $1M at closing, then is paid contingent payments depending on earnings over the next 3 years, the key employee will get 10% of the first $1M and 10% of each contingent payment.

Most likely, any transaction will be a 409A-compliant change in control. In that case, 1.409A-3(i)(5)(iv)(A) should apply and allow payments for up to five years based on the same terms as the company or shareholders receive payments from the buyer.

If we don't use a 409A-compliant CIC definition, we can use the short-term deferral exception for any payments made before March 15 of the year following closing, e.g., entire amount paid within 30 days of closing. No further payments based on company's contingent payments. No problem there as we don't need a 409A CIC to use the short-term deferral exception.

I see a noncompliant CIC definition being useful here. Say the shareholders sell 60% of the stock to a buyer, creating a change in control, in 2015. Then in 2016 they sell the remaining 40% of their stock to the same buyer. In that case, the employee is only entitled to payment on the first 60% if we're using a 409A-compliant definition because the acquisition of additional control is not considered a change in control.

Now combine the two. If we have a noncompliant CIC definition, the first payment within 30 days of closing will be fine, but I'm concerned with the three additional contingent payments. Assume the hurdles for contingent payments are "substantially" at risk, i.e., there's a substantial risk the company may not meet the targets. Can we use the short-term deferral for the three years' worth of contingent payments to the employee? In other words, because there remains a substantial risk the company will not receive the contingent payments, there's a substantial risk the key employee won't receive anything.

Here's my concern: The preamble to the final regs says "one commentator suggested that any right to a payment be treated as subject to a substantial risk of forfeiture until the amount of the payment is readily determinable, at least where the payment could be zero. The Treasury Department and the IRS do not believe that this standard is appropriate."

I think there's no question the key employee here would have a legally binding right to the contingent payments if the company receives them. The preamble seems to say that the contingent payments are not subject to a risk of forfeiture simply because the amount is not determinable (and may be zero). Am I reading this too broadly?

This seems to leave two possibilities: (1) use only a 409A-compliant CIC definition and allow contingent payments to the employee under the five-year rule; or (2) use a noncompliant CIC definition and require all payments within the short-term deferral period.

Any other suggestions on how to combine the two permissibly?

[Blackbirch]

Another route would be set up discrete agreements each time there's a transaction that you think warrants it.

In other words, today, there's either no agreement in place, or one that uses only a compliant CIC definition (triggering on the first 60% transaction in your example). At this point, the employee is entitled to nothing with respect to any subsequent transaction.

Later, upon the 40% transaction, the employer decides if it want's to make an additional award to the employee based on this subsequent transaction. At that time, the distribution event is a 409A-compliant stated date rather than a non-409A-compliant CIC event.

The challenge is not establishing a right to the 2nd benefit in advance of the transaction. Any written policy to that effect may be viewed as creating such a right and, thus, non-compliant deferred comp.