Originally published November 22, 2005
The IRS recently issued proposed regulations under Section 409A of the Internal Revenue Code, which governs the tax treatment of various forms of non-qualified deferred compensation. Although the regulations are not yet final, the IRS indicated that compliance with the proposed regulations or with IRS Notice 2005-1, issued in December 2004, would constitute good faith compliance with Section 409A.
This Alert will discuss the effect of Section 409A and the proposed regulations on various types of stock-based compensation. For a discussion of other aspects of Section 409A, see our recent Alerts:
"Deferred Compensation: What To Do Now"
"409A Proposed Regulations on Separation Pay Arrangements"
"Stock Option Pricing for Emerging Growth Companies."Background
Compliance with Section 409A
. If a plan or other arrangement is treated as a deferral of compensation subject to 409A-- i.e., if no exception applies--then the arrangement must comply with strict rules regarding (1) when the initial election to defer compensation must be made; (2) what events qualify as permissible payment events; and (3) when and how the arrangement may be modified or cancelled.Consequences of noncompliance
. If Section 409A applies to an arrangement but the arrangement fails to comply with the applicable requirements, all compensation deferred under the arrangement (and under any similar arrangements involving the same employee) for the current year and all preceding years will be taxable to the employee, together with interest from the date of the original deferral and a 20 percent penalty.Practice tip:
Because of the severe consequences of noncompliance, we expect that most companies and their employees will either take advantage of exceptions to Section 409A or will comply with its requirements.Exception for Tax-Advantaged Arrangements
Incentive stock options and employee stock purchase plans are not subject to Section 409A. These arrangements, however, may become subject to Section 409A if the statutory requirements or holding periods are not satisfied. Also, qualified employee benefit plans are generally exempt from 409A. This includes ESOPs and other qualified plans that hold employer stock.
Nonstatutory Stock Options and SARs
Nonstatutory options
. Nonstatutory stock options will not be treated as a deferral of compensation subject to 409A if three conditions are satisfied:1. The option has an exercise price that will never be less than the fair market value (FMV) of the underlying stock on the date of grant;
2. The option does not permit a further deferral of income beyond the time of exercise or transfer of the option (or, if the option is exercised for restricted stock, beyond the time the stock vests); and
3. The option is exercisable for stock that qualifies as "service recipient stock" as defined in the proposed regulation.
FMV exercise price
. The proposed regulation provides guidance on acceptable methods of valuing stock that is not publicly traded. Employers may be entitled to a presumption that the valuation is correct if they take advantage of a "safe harbor" valuation method. The FMV exercise price requirement and the valuation safe harbors are discussed in greater detail in our "Stock Option Pricing for Emerging Growth Companies" Alert (see above link).No further deferrals
. Under prior law, some employers allowed employees to contribute stock received upon exercise of a nonstatutory option into a "rabbi trust" or other nonqualified deferred compensation arrangement. Under Section 409A and the proposed regulations, the utility of these techniques to defer taxation will be severely limited, and, unless structured properly, will trigger the Section 409A penalties.Service recipient stock
. The "service recipient stock" requirement is an important limitation. A stock option generally will not qualify for exception from Section 409A, even if it is granted at FMV, if it is not exercisable for that class of common stock of the employer that has the greatest value of any class of common stock, or a class of common stock that has substantially similar rights to stock of such class (disregarding voting rights). Affiliated group principles apply, so that, for example, employees of corporate subsidiaries may be granted options on either the stock of their employer or stock of the parent corporation. However, if the employer corporation or a member of its affiliated group has publicly traded common stock, the option must be exercisable for that publicly traded stock. Stock that is subject to a mandatory repurchase obligation or put or call right (other than a "lapse restriction") at a price other than FMV also will not qualify as service recipient stock.Practice tip:
The definition of an affiliated group under Section 409A is not limited to corporations that are connected by 80 percent ownership. Thus, a corporate participant in a joint venture can grant stock options to employees of the joint venture company even if the corporation’s stock ownership of the joint venture is as low as 20 percent.American depositary receipts of a non-U.S. corporation can qualify as service recipient stock under the same rules that apply to domestic employers. Stock of a corporation that is designed solely as an investment vehicle will not be treated as service recipient stock except with respect to employees who actually provide services to that corporation.
Stock appreciation rights.
Under Notice 2005-1, stock appreciation rights (SARs) were exempt from coverage by Section 409A only if they were stock-settled SARs of public companies. Under the proposed regulations, SARs of both public and private companies will be exempt from Section 409A, regardless of whether they are settled in cash or in stock, if they satisfy conditions similar to those that apply to nonstatutory stock options, described above. That is, the SAR must provide for payment to the employee of an amount equal to the appreciation in the FMV of the stock from the date of grant to the date of exercise—i.e., the base price cannot be set lower than FMV. Payment under the SAR must be measured with reference to "service provider stock," and the SAR cannot provide for any further deferral beyond exercise.Modifications, renewals and extensions.
If otherwise exempt nonstatutory stock options or SARs are modified, renewed, or extended, they may become subject to Section 409A. A reduction in exercise price is treated as a modification and as a new grant that must be tested for the FMV exception. Multiple repricings may cause the arrangement to fall outside the exception. Extension of the term of an option will cause the option to be subject to Section 409A (and likely to fail to qualify) from the grant date, although certain short-term extensions of the period for exercise are permitted.The proposed regulations permit some changes to outstanding options and SARs. For example, the exercise date of nonstatutory stock options can be accelerated, options can be cashed out for the spread, and options can be amended to allow payment of the exercise price with previously owned stock or to permit the withholding of stock to satisfy withholding taxes.
Dividend or dividend equivalent rights.
If nonstatutory stock options or SARs provide for the payment of amounts in lieu of dividends at the time of exercise, that payment may be treated as a reduction in the exercise price and cause the option or SAR to fail to satisfy the FMV requirement. Possible solutions include paying the dividend amounts at the time of vesting or setting up a separate, qualifying arrangement for dividends.Restricted Stock, Restricted Stock Units, and Similar Arrangements
Current grants of restricted stock excluded
. The current transfer of stock or other property to an employee will not be subject to Section 409A, regardless of whether the stock or other property is subject to vesting or whether the employee makes a Section 83(b) election to be taxed currently on any bargain amount. A promise to transfer stock to an employee in a future year, however, may be subject to Section 409A.Practice tip:
If a company is relying on a "safe harbor" method of valuing its stock for purposes of nonstatutory stock option or SAR grants, it is required to use that method of valuing its stock consistently for all equity compensation purposes. Presumably, the safe harbor valuation method will have to be used even for arrangements that are excluded from coverage by Section 409A, such as grants of ISOs and restricted stock.Restricted stock units.
Restricted stock units (RSUs) that allow employees to receive stock after satisfying a service or vesting period are not eligible for the FMV exception that applies to nonstatutory options and SARs. If properly structured, however, RSUs may be excluded from Section 409A under the "short-term deferral" exception. Alternatively, RSUs may be structured to comply with Section 409A.Short-term deferrals.
To qualify under the short-term deferral exception, RSUs must provide for payment to the employee within the employee’s taxable year in which the RSU is no longer subject to a substantial risk of forfeiture (i.e., when it "vests") or within two and one half months after the end of that year.Practice tip:
Vesting is key to the availability of the short-term deferral exception. Note that vesting has a special, narrower meaning in the Section 409A context. For example, for Section 409A purposes a non-competition restriction generally will not qualify as a valid vesting restriction. Also, a vesting restriction may not be respected if the employee owns a significant amount of the stock of the employer (by vote or value) and the facts indicate that the forfeiture restriction may not be enforced. Finally, the extension of a vesting period after it is initially established will not be respected (i.e., "rolling" deferrals are not permitted).Compliance with Section 409A.
RSUs can also be structured to comply with the Section 409A requirements for a valid deferral.Permissible payment events. Generally, under Section 409A payment of deferred compensation may not be discretionary with the employer or employee, but must be made at a specified time (or on a fixed schedule) or upon the occurrence of a permissible event. Permissible payment events include separation from service (but payments to key employees of public companies must be delayed until at least six months after separation from service); a change in ownership or control of the employer or in the ownership of a substantial portion of the assets of the employer; death; disability; or an unforeseeable emergency.
The proposed regulations allow the use of more than one triggering event. For example, an employee could be entitled to payment at the earlier of a fixed date or a change in control.
The ability to change the time or events that will trigger payment after the arrangement is in place is subject to strict limitations. Generally, the decision to make a change (e.g., to defer the time of payment) must be made at least 12 months in advance of when the payment would otherwise be made, and the new payment date must be at least five years from the original payment date.
Initial deferral elections. To comply with Section 409A, an election to defer compensation generally must occur prior to the taxable year in which the services are performed that give rise to the compensation. For an arrangement in which the employee does not have an election with respect to the time or form of payment, the proposed regulation requires that the time and form of payment be specified at the time the arrangement is entered into. These rules, combined with the permissible payment event rules discussed above, mean that RSUs must provide in advance for a fixed payment date or schedule, or for payment at the time of a fixed event, such as a public offering or a change in control. Employees cannot effectively have the discretion to decide when to exercise RSUs and receive payment.
Practice tip:
An exception to the initial deferral election rules may provide some additional flexibility in structuring RSUs. An employer may grant employees RSUs with a fixed payment date or schedule (or other permissible event trigger) and allow employees to elect, within 30 days of receiving the RSUs, to defer payment to a later fixed date or schedule. This exception applies only if the RSU does not vest for at least 12 months after the deferral election is made and the employee is required to provide at least 12 months of services.Performance-based compensation
. Employees can be given more flexibility on the timing of an election to defer if the deferred compensation is performance-based compensation. An election to defer payment (e.g., to a fixed date later than the date specified in the original grant) may be made up to six months prior to the end of the performance measurement period, provided that the measurement period is at least 12 months in duration. Although the proposed regulation treats appreciation of the employer’s stock as a valid performance measure for this purpose, with a typical RSU the employee will be entitled to a payment even if the stock does not appreciate. Thus, a typical RSU will not be eligible for the special six-month rule for performance-based compensation unless the vesting of the RSU is subject to other performance measures.Phantom stock and other equity-based arrangements.
The proposed regulations do not contain any special exceptions for other equity-based compensation arrangements, such as phantom stock and performance units. These arrangements must either be structured to qualify as short-term deferrals or comply with Section 409A, based on the same rules that are discussed above for restricted stock units.Partnerships
Limited guidance on partnerships
. A payment by a partnership to a partner for services can be made in the form of an equity-like interest in the partnership. Although the preamble to the proposed regulations and Notice 2005-1 indicate that certain compensatory payments to partners (e.g., salary-like payments) may be subject to Section 409A if the payments are deferred, partner compensation in the form of profit allocations that are subject to significant entrepreneurial risk appear to be outside the coverage of Section 409A at this point. Treasury and IRS intend to offer additional guidance on Section 409A and partnership deferrals in the future.The IRS has recently issued proposed guidance on compensatory transfers of interests in partnerships (see IRS Notice 2005-43). The possible interaction of this guidance (if and when it is finalized) and the Section 409A guidance still to come leaves this area subject to considerable uncertainty.
Recommendations
New plans and arrangements.
Because of the severe penalties for noncompliance, employers implementing new equity-based compensation arrangements must cope with the changed landscape due to Section 409A. For early-stage start-up companies, a combination of current grants of restricted stock and the use of incentive stock options, both exempt from Section 409A, may be an attractive strategy. For later stage companies that want to continue to make large option grants, Section 409A, together with accounting and securities law considerations, will point in the direction of obtaining regular outside appraisals of stock values. Companies that want to continue to use RSUs and similar arrangements will face reduced flexibility, since such arrangements may no longer permit an employee to wait to decide when to exercise but, absent the occurrence of a change of control or other permissible acceleration trigger, must pay out on a fixed schedule.Existing plans and arrangements.
Since Section 409A is already effective, employers must take action to ensure that their existing plans and outstanding awards and contracts do not incur acceleration and interest and penalties associated with Section 409A.2005 Action
. In some cases action must be taken in 2005. For example, this year employers may buy out or permit employees to exercise stock options or SARs with a discounted exercise price, and they may terminate plans that do not qualify under Section 409A.2006 Action
. Other employer action, including the amendment of plans to comply going forward, may still be timely in 2006, although plans and arrangements have been required to be operated in good faith compliance with Section 409A since the beginning of 2005. An employer may amend discounted stock options or SARs in 2006 to increase exercise prices to qualify under the FMV exception, provided that no compensating payments are made to employees in 2006. Employers may also amend arrangements in 2006 to allow employees to change their elections as to the time and form of payment of deferred compensation, provided that the change does not accelerate payment into 2006.The transition rules for existing arrangements and the action steps for employers and employees are summarized in greater detail in our Deferred Compensation: What To Do Now Alert (see above link).
The new Section 409A rules are complex, and this is intended as only a brief overview. For more information, please contact:
Richard W. Ashley III, David F. Boyle, Michael T. Frank, William H. Hoffman, Joseph A. (Tony) Hugg, Ian S. Kopelman, John E. Kratz, Jr., Mark Muedeking and Linda Marotta Thomas.
This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.
