M&A: Tax Reporting and Payments to Employees

In many transactions, employees and directors share in the proceeds of the merger and escrow. For simplicity, we will just refer to employees below, but a similar analysis may apply to other individuals, including board members. Most paying agents will not process payments that are treated as employee compensation. They are not set up to handle employee withholding, payroll tax payments and W-2 tax reporting. As a result, paying employees their share of sale proceeds in a merger can be confusing. When distributions are made at closing (or later on due to escrow releases or earnouts), some employees receive their payments through the escrow/paying agent while others receive payments from the buyer or a payments administrator that has the capability to process such payments, and still others receive payments from both. To add to the confusion, some employees get 1099-Bs while others receive W-2 tax forms, even after they leave the selling or buying company.

Why?

It depends on how the employee received his or her shares or if the payment is from some form of bonus program. If an employee is a shareholder who either purchased shares or received shares and executed a Section 83b election, then any merger-related payout generally is considered an “investment.” Those employees usually receive payments through the paying/escrow agent, and the proceeds are reported on 1099-B tax forms.

In contrast, if an employee received restricted stock and did not make an 83b election, or exercised vested options (or net-exercised) at closing, then any receipt of funds is usually considered “compensation”. As is true of other employee compensation, it generally is paid via payroll and reported on the W-2 tax form, even if the individual is no longer an employee of the company when the payment is made. Finally, in some transactions, employee options are cancelled at closing in exchange for a right to receive cash or may participate in a management incentive bonus plan. In both of these cases, the payments are also considered compensation.

Because of this distinction, shareholder representatives and company buyers need to be aware of the proper tax treatment for each employee participating in escrows (and other deferred payments of merger consideration), and ensure that the routing of funds in the merger and escrow agreements is correct and reported on the appropriate tax forms. Typically the proceeds needing to be treated as employee compensation will be routed back to the surviving corporation or to a specialized employee payments administrator for payment, while all other payments can be made by the escrow or paying agent.

The parties should also consider the economic implications of the classification of the payment to the merged company. As a general rule, compensation is subject to employer payroll taxes, while capital gains or losses are not.¹ The parties to the merger should be cognizant of the appropriate tax treatment because it could be more expensive for a buyer to pay the purchase price if a portion of it is to be treated as wages. In that case, the parties should ensure that this is properly contemplated in the agreements. SRS Acquiom has seen transactions in which the buyer submitted an indemnification claim for its employer payroll tax obligations, alleging that it constituted an undisclosed liability. Some claims for employer payroll taxes will be submitted even when no such obligation exists because it was assumed that such payment must be treated as compensation. To avoid these problems, the parties should carefully consider who is being paid in the merger, determine how to classify those payments prior to closing, and negotiate the economic deal regarding any related tax payment obligations prior to closing.

¹SRS Acquiom notes, however, that compensation related to a disqualifying disposition of options might not be considered wages for the purposes of federal tax withholding and employer payroll taxes.