What Happens to Equity Awards in a Furlough?

In a volatile business climate, it’s not uncommon for employers to bridge the gap of uncertainty by placing employees on a furlough, rather than permanently terminating the employment relationship. A furlough can be viewed as a temporary layoff, where the employer intends to have the employee return to work after a short period of time.

When it comes to equity plans, most have clear termination provisions that address the scenario where an employee ceases to work for the company. It seems to me that most of the termination terms in equity plans are drafted with a permanent separation in mind. What about when the layoff is only intended to be short term, and the employer anticipates having the employee return to work? The following are things to know about furloughs and your equity plans:
 

Review Your Equity Plan’s Termination and Leave of Absence Terms

Will a furlough be considered a termination of employment? Or, is it a leave of absence? A termination classification would necessitate following the termination outcomes defined by the plan, which often includes cancellation of unvested options/awards.

A leave of absence designation may allow the employee’s awards to remain outstanding. If the plan does allow for leaves of absence, be sure to understand any limitations – such as a maximum duration and whether vesting continues or is suspended during a leave.  

Obtain Proper Approval for Plan Administrator Decisions

In the event the plan’s terms don’t clearly address a furlough, the plan administrator (the board, a board committee, or a designated executive of the company) will likely need to decide how classify the furlough. It is important to ensure that any decisions involving an interpretation of the plan be formally approved by the plan administrator.

 
Be Aware of Impact of Changing Circumstances

In the event a furlough is treated as a leave of absence, the company still must continue to evaluate the furlough status to ensure compliance with 409A and, in the case of ISOs, employment and qualified status under Section 422 of the Internal Revenue Code.

409A Impacts

A Shearman and Sterling article ("Employee Furlough Considerations") reminds us that:
“Under Section 409A, an employee furlough is not a “separation from service” so long as it qualifies as a “bona fide” leave of absence. A “bona fide” leave of absence is one where there is a reasonable expectation that the employee will return to perform services for the employer, and where either: (a) the leave is less than six months or (b) the leave of absence exceeds six months but the employee has either a contractual or a statutory right to reemployment. Furloughs related to business disruption due to COVID-19 likely will be treated as bona fide leaves of absence under Section 409A, and therefore will not result in an immediate “separation from service” if the employer reasonably expects to recall the furloughed employees within six months. If the leave exceeds six months and the individual does not have a contractual right to reemployment, the employment relationship would be deemed terminated on the first date following the six-month period.”
 

Impact on Incentive Stock Options

Furloughs that exceed 90 days in length may impact the treatment of Incentive Stock Options. As described in an article ("Common Questions & Answers Regarding Coronavirus-Related Layoffs and Furloughs and the Impact on Stock Options and Deferred Compensation") by Blais Halpert Tax Partners LLP, “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).”

As companies navigate through difficult business decisions, the determination of how a furlough will be classified is an important one to understand in assessing the impact on equity awards and other benefits.