Common Questions & Answers Regarding Coronavirus-Related Layoffs and Furloughs and the Impact on Stock Options and Deferred Compensation

BOSTON — In reaction to the dramatic change in business conditions relating to the COVID-19 pandemic, many businesses are conducting layoffs and furloughs of employees. Meanwhile, the recently enacted Families First Coronavirus Response Act has expanded sick leave and FMLA leave. Here are some common questions (and answers) surrounding how these events impact incentive stock options (ISOs), nonqualified stock options (NSOs) and deferred compensation governed by Section 409A of the Internal Revenue Code.

As always, this Q&A is provided for informational purposes only and is not legal or tax advice. Always consult a professional tax advisor for advice in light of the taxpayer’s particular circumstances.

Q: How would options and deferred compensation be impacted by layoffs and furloughs?

A: Generally, most option and deferred compensation plans include a concept of “continuous service” (or similar term). If continuous service terminates, the holder or participant typically forfeits any unvested awards and has a prescribed period (commonly three months) to exercise any vested options or else they expire. Further, a layoff or furlough could be a “separation from service” under Section 409A of the Internal Revenue Code, triggering a cash or in-kind payment under a deferred compensation plan. That said, subject to federal, state, and local labor laws, the terms of option and deferred compensation plans may vary widely as to the definition and consequences of continuous service, vesting, post-termination exercise of options, timing of payment, and the power of the employer to amend or interpret the plan itself. Before reading further, consult the text of the option or deferred compensation plan, together with any relevant award agreements, grant notices, etc., to determine the impact of layoffs and furloughs.

Q: What happens if an option holder is laid off?

A: “Layoff” is not technically defined but generally means the option holder is being terminated indefinitely. Most stock options (both ISOs and NSOs) provide that, once an option holder’s continuous service for the corporation terminates, the option holder forfeits any unvested options and has a prescribed amount of time to exercise any vested options (commonly three months). Subject to the discussion below regarding certain types of leave, a layoff will typically trigger these post-termination provisions – forfeiture of unvested options and commencement of a defined period to exercise vested options.

Q: What happens if an option holder is furloughed?

A: “Furlough” is another term that isn’t technically defined, but it generally means the option holder is placed on is mandatory leave with limited or no pay, with the expectation that the option holder will return to work once regular business resumes. Importantly, furlough generally doesn’t mean an employee is terminated, but rather remains an (at-will) employee even though he or she isn’t working. Unless otherwise specified in an option plan or related agreement, a furlough would not disrupt an employee’s continuous service for vesting purposes. That said, the plan or agreement may pause, or give the employer the power to pause, vesting during a furlough. Although a furlough would not usually commence a post-termination period to exercise NSOs, the result for ISOs may be very different. Under the tax regulations, an ISO loses its tax status if it is not exercised within three months after termination of employment. For this purpose, an employee on a voluntary or involuntary leave (like a furlough), excluding any leave after which re-employment is provided for by law or contract, is only considered employed for three months. If the employee does not return for work after three months, his or her employment is deemed terminated for ISO purposes and his or her ISOs will lose their tax status if not exercised within an additional three months (i.e., six months after starting the leave).

Q: What happens if an option holder takes sick leave or FMLA leave?

A: The COVID-19 pandemic has brought renewed focus on sick leave and FMLA leave, the availability of which has been temporarily expanded by the Families First Coronavirus Response Act. The consequences of sick leave or FMLA leave to an option holder are similar to those for furloughs described above, except that FMLA leave is, and sick leave usually is, the kind of leave after which re-employment is provided for by law. An ISO holder on such leave is treated as employed for the duration of the leave rather than for only three months.

Q: What happens if an option holder transitions from full-time to part-time?

A: Under most option plans, a reduction in hours does not constitute a termination of continuous services, including for purposes of the three-month post-termination exercise period for ISOs.

Q: If an employee is terminated, can the post-termination exercise period of an option be extended?

A: Yes, but subject to limitations and potential tax implications. The post-termination exercise period of a stock option generally can be extended until the earlier of (1) the latest date the option could have expired by its original terms, and (2) the 10th anniversary of the grant of the option. However, extending the post-termination exercise period for an ISO that is “in the money” will cause the option to immediately become a NSO. And although an ISO that is “underwater” or “at the money” on the date of an extension amendment will remain an ISO (assuming the option otherwise meets all the ISO requirements on the amendment date), the “one year from grant” holding period for ISO tax benefits will restart.

Q: Will a layoff or furlough be a “separation from service” under a deferred compensation plan?

A: Under the notorious Section 409A, deferred compensation can and must be paid on the occurrence of certain permissible events, one of the most common of which is a “separation from service.” A layoff typically will constitute a “separation from service” under Section 409A, but with respect to a furlough, the employment relationship will be treated as continuing intact for up to six months, provided that there is a reasonable expectation that the employee will return to work. But if the employee retains a right to reemployment by contract or under an applicable statute (like FMLA), then the employee is treated as employed for the duration of the leave rather than for only six months. However, keep in mind that reduced hours may have a lasting impact because Section 409A measures a “separation from service” by reference to the average level of services performed by an employee over the 36-month period immediately preceding the purported termination of employment.

Q: What’s your advice to companies with stock options?

A: Now would be a good time to review the applicable provisions in stock option award agreements and plan documents that may be implicated when an option holder takes a leave of absence, transitions from full-time to part-time employment status, or is furloughed or laid off. Private companies looking to award stock options soon (or thinking about repricing existing options) should consider getting a new 409A valuation that takes into account the recent market volatility surrounding the COVID-19 pandemic. And companies concerned about granting underwater stock options could consider granting “full value” awards, such as restricted stock units.

For further information regarding stock options, deferred compensation plans, or other types of executive compensation and incentives, please contact:

Christopher Bird
(617) 918-7086
CBird@BlaisTaxLaw.com

Travis Blais
(617) 918-7081
TBlais@BlaisTaxLaw.com