Change in Control Event

A change in control event is a defined term in Treasury Regulation 1.409A-3(i)(5), the rule that lists the occasions on which nonqualified deferred compensation may be paid without violating Internal Revenue Code section 409A. The regulation sets out three things that qualify: a change in the ownership of a corporation, a change in its effective control, and a change in the ownership of a substantial portion of its assets. It then says these are "collectively referred to as a change in control event."

The definition matters because 409A does not let a plan pay out whenever the parties feel like it. Payment must track an event on a short permitted list, and a corporate sale is on that list only if it meets one of these three tests. A plan that promises money on a "change in control" defined more loosely than the regulation allows is paying on a non-permitted event, with penalties that fall on the employee rather than the company.

Be careful with the shorter phrase. "Change in control" without the word "event" is used loosely across corporate and securities practice for any meaningful shift in who runs a company, including as a disclosure trigger for current reports. That general usage is not this term. This page is about the specific regulatory test, which has numbers in it.

Limb one: a change in the ownership of a corporation. This occurs on the date one person, or more than one person acting as a group, acquires stock that, together with stock already held, constitutes more than 50 percent of the total fair market value or the total voting power of the corporation's stock. A plan may set a higher percentage than 50, provided it does so by the deadline for fixing the time and form of payment. Two limits follow from the text. Someone already over the line cannot trigger the event by buying more, and the limb applies only where stock is transferred or issued and stock remains outstanding afterwards, which is what separates it from the asset limb.

Limb two: a change in the effective control of a corporation. Two quite different things satisfy it. The first is a person or group acquiring, in one go or across the 12-month period ending on the date of the most recent acquisition, stock with 30 percent or more of the corporation's total voting power. The second is the replacement of a majority of the board of directors during any 12-month period by directors whose appointment or election was not endorsed by a majority of the board sitting before that appointment. A proxy contest that turns over the board therefore counts, with no shares changing hands and no transaction of any kind. As with the first limb, a plan may substitute a higher percentage or a larger portion of the board, and a person who already has effective control does not trigger it again by acquiring more.

Limb three: a change in the ownership of a substantial portion of the assets. This occurs when a person or group acquires, in one transaction or over the 12-month period ending on the most recent acquisition, assets with a total gross fair market value equal to at least 40 percent of the total gross fair market value of all the corporation's assets immediately before the acquisition. "Gross" is doing work: the regulation says value is determined without regard to any liabilities associated with the assets, so a heavily mortgaged division counts at its full value. There are carve-outs for transfers that keep the assets in the family: a transfer to a shareholder in exchange for its stock, to an entity the corporation owns half or more of, to a person owning half or more of the corporation, or to an entity half or more owned by such a person, is not a change in the ownership of those assets.

Which corporation has to have the event. The regulation does not accept any corporate change anywhere in the structure. The event must relate to the corporation the service provider works for, or the corporation liable for paying the deferred compensation, or a corporation that is a majority shareholder of one of those, following the chain upward. Its own worked illustration has a parent, a subsidiary and a sub-subsidiary: a change at the middle company is an event for people working at the middle or bottom, and is not an event as to the parent unless the sale is itself a change in the ownership of a substantial portion of the parent's assets.

Ownership is counted with attribution, and options count in a specific way. Section 318(a) applies to determine stock ownership for all three limbs. Stock underlying a vested option is treated as owned by the option holder; stock underlying an unvested option is not. There is one exception: where a vested option is exercisable for stock that is not substantially vested, the underlying stock is not treated as owned. The "acting as a group" test is narrower than it sounds. People are not a group merely because they bought stock at the same time or in the same public offering. They are a group if they are owners of a corporation entering into a merger, consolidation, stock purchase or similar transaction with the corporation in question.

One interaction worth flagging. Ordinarily a forfeiture condition cannot be extended in order to keep compensation deferred. The regulation makes a narrow exception where a condition would otherwise lapse because of a change in control event under the ownership or asset limb: it may be extended or modified before and in connection with that event, and it will still be treated as a substantial risk of forfeiture, provided the transaction is a bona fide arm's length deal with unrelated parties and the extended condition would itself qualify. That is what lets an unvested award keep its deferred status when a buyer re-sets the vesting condition as part of the deal.

1. Identify the right corporation. Trace from the service provider's employer, the entity liable for the payment, and any majority shareholder above either of them.

2. Work out who owns what, applying section 318(a) attribution and treating stock under vested options as owned by the holder.

3. Test the ownership limb. Has any person or group crossed more than 50 percent of total fair market value or total voting power, counting stock they already held?

4. Test the effective-control limb. Has anyone acquired 30 percent or more of voting power within a 12-month window, or has a board majority been replaced within 12 months by directors the prior board did not endorse?

5. Test the asset limb. Add up assets acquired over the 12 months ending on the latest acquisition, at gross fair market value, and compare with 40 percent of the corporation's total gross asset value immediately beforehand. Check the related-person carve-outs before concluding.

6. Confirm the event is objectively determinable, with no discretionary certification standing between the facts and the payment.

An example, with invented figures. Larkfield Systems has total assets with a gross fair market value of $50,000,000, measured without netting off the debt secured on them. In March it sells its logistics division, gross fair market value $9,000,000, to an unrelated buyer, and in the following January it sells its instruments division, gross fair market value $13,000,000, to the same buyer. The two acquisitions fall inside the 12-month period ending on the second one, so they are added: $9,000,000 + $13,000,000 = $22,000,000. Against the $50,000,000 starting figure that is 22 ÷ 50 = 44 percent, above the 40 percent floor, so a change in control event has occurred under the asset limb. Larkfield's shareholders are exactly the same people they were before, and its board has not changed. Had the second sale closed two months later, the first sale would have dropped out of the window and the running total would have been $13,000,000, or 26 percent, with no event at all.

What the definition does well

• It is objective. Three numerical tests and a board-composition test leave little room for argument about whether the event happened.
• It reaches control changes that involve no purchase, through the board-replacement limb, so an insurgent slate cannot sidestep it.
• The asset limb closes the obvious workaround of selling the business out from under the shares instead of selling the shares.
• Twelve-month aggregation stops a buyer from stepping over the line in slices.
• A plan may make the test harder to meet by specifying higher percentages, which lets an employer keep money deferred through smaller transactions.

Where it causes difficulty

• The phrase is used far more loosely everywhere else, so a plan drafted from a business definition of "change of control" can promise payment on something the regulation does not recognize.
• Getting it wrong is expensive for the wrong person: 409A's additional tax falls on the employee, not the company that drafted the document.
• The three limbs can fire at different moments in a single deal, so the payment date is not always the closing date people have in mind.
• Gross asset value ignores attached liabilities, so a division with little equity in it can still carry the transaction over 40 percent.
• Attribution and the vested-option rule mean the ownership percentages on a cap table are not the percentages this test uses.