Executive loan programs have become a popular strategic response to complex executive compensation demands in a competitive talent market. The use of loan programs in conjunction with incentive equity awards has also seen an increase in popularity in a slower market, when companies and executives are looking for new solutions as sponsor exits and liquidity events have been extended beyond their initial planned timing. A well-structured executive loan program can help executives optimize tax planning while aligning the management team’s interest with the company’s success.
While they carry extensive potential benefits, it is critical that these programs are carefully designed and administered, so as not to run afoul of the Internal Revenue Code. We note that some financial institutions implement different loan programs for new hires or revenue generators and those programs carry considerations that are potentially different from or in addition to those discussed below.
What Executive Equity Loan Programs Do
Executive loan programs can be designed to work in tandem with a company’s equity incentive program to provide executives the cash needed to purchase restricted share awards or to exercise an option award and purchase the underlying shares.
How Executive Loan Programs are Documented
To evidence the loan, an executive enters into a promissory note with the company whereby the company loans the executive money that will be used to purchase shares of company stock.
The promissory note is commonly entered into concurrently with a stock purchase agreement (or, if the shares are being purchased on exercise of an option, an exercise and stock purchase agreement).
If the shares being purchased are fully or partially unvested (either because they represent a new grant or were underlying an option that was fully or partially unvested at the time of exercise), the executive will be purchasing restricted shares and the stock purchase agreement will provide the vesting schedule applicable to such restricted shares (including, where applicable, incorporating the vesting schedule that was applicable to the corresponding portion of the unvested option).
The stock purchase agreement also typically includes repurchase mechanics so that the shares can be repurchased by the company in the event that the executive’s employment ends.
How Effective Executive Loan Programs Can Be Structured
If an executive loan program is structured improperly, the loan can be deemed disguised compensation by the Internal Revenue Service (IRS) and subject to taxation as income, resulting in a heavy tax burden for the executive. To avoid this, a loan must be structured as a “bona fide loan” and be treated as such by the company. The following are some of the key indicia of a bona fide loan:
- A bona fide loan charges interest at a rate no less than the IRS applicable federal rate (AFR) compounded semi-annually.
- The promissory note should have a specified term for the loan and a maturity date. The term of the loan (determined by the maturity date) will determine whether the AFR used should be the short-, mid-, or long-term AFR. A loan term is commonly seven to nine years.
- Even when contemplated, it is prudent that neither the promissory note nor any other documentation provide for, or expressly reference, loan forgiveness, even in the event of the executive’s death or disability. Loan forgiveness weighs against there being a real obligation for loan repayment, which can result in a determination that the loan is not a bona fide loan.
- The promissory note should be personally recourse to the executive even if secured by the shares the loan is used to purchase. A common approach is that the full value of the shares secures the loan and the applicable executive is at least 50% personally liable for the loan.
- The promissory note should require that some or all of the loan will be immediately due upon certain events, such as the end of the executive’s employment or a change in control of the company, and if the executive sells a portion of the shares the loan was used to purchase or receives distributions on those shares, a corresponding portion of the loan should become immediately due. Note that employment laws in some states, like California, restrict an employer’s ability to provide for loan acceleration in connection with termination of employment, and for loan arrangements in those states, careful consideration needs to be given to applicable state laws.
In addition to ensuring that the promissory note and loan documentation has the foregoing terms indicating a bona fide loan, an issuing company would be well advised to also take the following steps to ensure it is continuing to appropriately treat the loans as bona fide loans:
- The company should have practices in place to collect loans.
- The company should have procedures in place to enforce the loan and collect the unpaid principal and interest in the event the executive’s employment with the company ends or the executive defaults on the loan. Any uncollected or forgiven loan amount, whether principal or accrued but unpaid interest, should be reported as taxable income for the executive and subject to applicable withholding for taxes.
How an Executive’s Income Tax Bill Is Impacted
The impact on an executive’s income tax differs based on the timing of the option grant in relation to when the option is being exercised. The loan is issued at the time the option is exercised.
If the option is exercised immediately following grant, then the per-share exercise price of the option will be equal to the per-share fair market value at the time of exercise. Upon an immediate exercise, where the aggregate exercise price is equal to the principal of the loan, there should be no immediate income tax event because the executive is purchasing the shares at fair market value.
Alternatively, if the loan is used to exercise options that were granted prior to when the loan was issued and the shares underlying the option have increased in value above the applicable exercise price, then the exercise of the options will trigger an income tax event with respect to the excess of the fair market value of the shares on the date of exercise over the exercise price of the options.
In any event, the executive can file an 83(b) election at the time the option is exercised for any unvested restricted shares that are purchased so that those restricted shares are not taxed at the time that they vest and are instead taxed at the time of purchase. Filing an 83(b) election locks in taxation of unvested shares at their current value instead of their value at the time they vest, heading off a higher tax bill in the event the share value increases prior to vesting.
How We Can Help
Our team is available to help companies plan, structure and implement executive loan programs and complex equity-based executive compensation arrangements.
Keeping best practices and potential tax implications in mind is critical in designing an executive loan program that meets the needs of the company and its executive team while avoiding the pitfalls that can result in burdensome tax consequences. If done right, an executive loan program is an innovative solution to the obstacles that limit an executive’s participation in company equity.
Please contact the authors of this article or your Morgan Lewis contacts with any questions or if we can assist in helping develop such a program.