United States: Layoffs & Severance Pay Can Trigger Serious Tax Issues

by Taci Darnell

Layoffs may be as inevitable as death and taxes, but how a company structures its workforce reduction can make a big difference to its bottom line. Did you know that

the Worker Adjustment and Retraining Notification (WARN) Act requires employers with at least 100 full-time employees to provide 60 days notice in the event of a plant closing or mass layoff?

To side step the 60-day notice rule, some companies provide workers with severance payments in lieu of notice. Other companies give employees severance in exchange for waivers on discrimination claims.

If your company is forced to layoff employees and does not have the cash to pay severance compensation, consider one of two stock-based severance options that could give relief from the WARN notice period. Companies that use stock options as an important form of compensation can satisfy their legal obligations by the acceleration of options or extention of the exercise period in exchange for a waiver of the notice period. There are complex tax and accounting rules that apply to Non-Qualified Stock Options and Incentive Stock Options, so be sure to consult a tax advisor and your accountant.

Accelerating options could be an attractive course of action for your company. That’s because the acceleration of the vesting schedule on options does not trigger income to the employee, nor does it result in an additional deduction for your company. There are potential traps, however. For example, when the value of accelerated options exceeds $100,000 (determined as of t the date of grant), they may lose their ISO status, regardless of the spread on the options. This results from a tax law stating that no more than $100,000 worth of ISOs may vest in any given year.

With Non-qualified Stock Options, from a tax perspective, neither your company nor its employees will be impacted by an extension of time to exercise options. However, problems may arise if the options are ISOs. The federal tax code mandates that in order to achieve the favorable tax treatment of and option as and ISO, the ISO must be exercised within three months of termination of employment. If the time to exercise ISOs extends beyond this three-month limit, the options will automatically be converted to Non-qualified Stock Options. A terminated worker being paid severance may maintain employee status through the severance period, even though services are not being performed for the company. Keep in mind that the three-month period begins only when the employee is no longer on the payroll.

Be careful. Extending the time for exercising a stock option can often trigger an accounting charge, so check with your accountants before implementing this strategy.

Given the financial impacts, what option is best for your company? When making your decision, remember that tax treatments of Non-qualified and Incentive Stock Options differ significantly. When Non-qualified Stock Options are exercised, your employee will have ordinary income based on the difference between the fair market value at the time of exercise and the exercise price. This ordinary income is subject to Social Security and income tax withholdings. Your company will receive a tax deduction equal to the amount of ordinary income reported to the individual. Later, when these shares are sold, capital gains tax may be imposed. The amount of capital gain recognized by the employee is the difference between the price at which the shares were sold and the fair market value as of the exercise date.

Exercising Incentive Stock Options, however, does not create ordinary income. Consequently, your firm will not receive a deduction. However, the difference between the fair market value of the stock and the exercise price will be an Alternative Minimum Tax (AMT) preference item that could generate an AMT tax. Therefore, projecting income tax is important to do prior to exercising options. Stock held for at least two years from the Incentive Stock Option grant and at least one year from the date exercised will result in capital gains tax for the difference between the sale price and the exercise price; no ordinary income is recognized by the employee at any time.

Ultimately, your company must take a long look at tax laws before deciding which course of action to pursue. Conducting a layoff is painful enough. Don’t make matters worse by choosing a severance deal that hurts your company’s bottom line. Stock-based severance deals can provide you with some real advantages in the event of a layoff.