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Impact of IRC §409A on Compensatory Equity Arrangements

May 03, 2006

What is §409A of the Internal Revenue Code?

  • §409A contains detailed requirements affecting nonqualified retirement plans and other forms of deferred compensation.
    • Focus of new law is to clamp down on perceived abuses related to election timing, distribution timing, and ability to accelerate payouts.


Broad definition of "deferred compensation"

  • A plan provides for deferred compensation if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right to compensation during a taxable year which is be paid (and taxed) in a subsequent year.
    • A legally binding right does not mean a vested right.
    • A legally binding right to compensation may exist even where the right is subject to conditions, including conditions that constitute a substantial risk of forfeiture.
      • EXAMPLE: In Year 1, the Company promises Employee X a "percentage of profits" bonus for three years to be paid within 2-1/2 months of the end of Year 3 if X is still employed by the Company. X has a legally binding right to the payment of the compensation in Year 1, subject to the conditions being met. However, see short-term deferral exception, below.
    • A straight-forward example of deferred compensation is an employee electively deferring her 2007 calendar year bonus, by means of an election in 2006, to the period after termination of service with the service recipient.
    • A more unexpected example is an option.
    • Exception for short term deferrals (paid (and taxed) within 2-1/2 months after close of year (either service provider’s or service recipient’s) in which the amount is no longer subject to a substantial risk of forfeiture).


What is a service provider?

  • A service provider includes an individual (think employees), corporation subchapter S corporation or partnership, but not an entity on the accrual basis, that provides services.
  • A service provider includes directors and certain other independent contractors, e.g. persons who do not provide services to more than one service recipient.


What is a service recipient?

  • A service recipient is the person (individual or entities) for whom services are performed and all persons with whom such person would be considered a single employer under §414(b) (employees of a controlled group of corporations) or §414(c) (employees of partnerships, etc. under common control).
    • This definition can become important in determining if employment with the service recipient has terminated.
    • EXAMPLE: Individual A serves as an outside director of Parent (a public company) and two of its subsidiaries. A mandatorily retires from Parent’s board because of reaching the age limitation on service, but remains on the subsidiary boards. A has deferred fees from all three boards, and elected to receive his deferred compensation in a lump sum after termination of service. A does not terminate service until retirement from all three boards.


Status of Guidance

  • Currently have proposed regulations that can be relied upon; new proposed /or/ temporary /or/ permanent regulations should be released in the fall.


Why do we care about §409A?

  • There’s a penalty on the service provider (e.g. employee or director) of 20% of the compensation for failure to comply with §409A.
    • We’re still awaiting guidance on measuring "compensation" and timing of penalty (e.g., how would you value non-compliant options, and when?).
    • No penalty on service recipient (absent indemnification to service provider by service recipient)
    • There’s also an interest component.


What equity arrangements are excluded from §409A?

  • Incentive Stock Options (ISO’s) under §422 of the Code.
  • Qualifying employee stock purchase plans (ESSPs) under §423 of the Code.
  • Restricted stock taxed under Section 83 of the Code (but not restricted stock units or "RSUs," which are subject to §409A). See short-term deferral exception, above.
  • Certain nonqualified stock options (NQSOs) and stock appreciation rights (SARs). See remainder of outline.


What arrangements are grandfathered under §409A?

  • Rights earned or vested by 12/31/04 so long as no "material modifications" after 10/3/04. If value continues to accrue after that date, e.g., in a phantom equity plan, the plan is subject to §409A.
    • The standard for "material modifications" is different from the standard for "modifications," discussed below. In general, a "material modification" is the enhancement or addition of rights or benefits under a plan.
  • Window in 2006 to make amendments to comply with §409A. Query whether this period will be extended. Bottom line: don’t count on it.


Equity Plans with Payouts on a Fixed Timetable

  • Examples include phantom equity plans that pay out on termination of employment or a Change in Control, whichever first occurs (NOTE: IPOs are not acceptable payout events under §409A).
    • §409A regulations contain a Change in Control definition. Query: Should definitions always track the §409A definition?
  • Payout formula can vary (no requirement for FMV payout) as long as situations triggering payout are set when plan established.
    • EXAMPLE: Payout could be based on (i) "book value" if voluntary termination or termination for Cause, (ii) a multiple of earnings or other formula if termination without Cause or a voluntary termination for Good Reason, and (iii) FMV or a Change in Control.
  • No acceleration of payout allowed, absent fitting under various termination of plan provisions in regulations, or for fixed dollar amounts established at inception of plan or applying only to future deferrals.
    • EXAMPLE: Once balance dips below $50,000, amount is paid in a lump sum.
  • Period for payout must be fixed when plan established; can be different for different payout events.
    • EXAMPLE: 5-year payout with interest for Good Reason terminations and terminations without Cause; 10-year payout with interest for voluntary terminations and termination for Cause; lump sum payout if Change in Control, except if shareholders paid over time in which case plan participants are paid out on the same basis.


Equity Plans Without Fixed Payouts

  • Examples would include NQSOs and SARs when payout (exercise) is in control of optionee, not fixed when NQSO or SAR is granted.
  • If an NQSO or SAR (jointly referred to as an "option") is awarded that has a fixed exercise date, the rules above apply. This is a very unusual case.
  • §409A regulations have many requirements. In public companies, these are more easily met. For private companies, they are difficult to meet.
    • FIRST REQUIREMENT: Option has to have an exercise price equal to FMV on date of grant
      • For options granted no later than December 31, 2004, a good faith attempt to set the price at not less than FMV will suffice per Notice 2006-4.
      • For options granted after December 31, 2004 and before the effective date of final regulation, Q&A4(d)(ii) of Notice 2005-1 will continue to apply (any reasonable valuation method), a lesser standard than that in the proposed regulations. Notice 2006-4.
      • No longer "how low can you go."
      • Dealing with discounted options issued after, or not vested by, December 31, 2004.
        • Impose a fixed exercise date.
        • Increase exercise price to FMV on date of grant, and make up difference through a qualifying §409A plan.
      • Modifications of options that are otherwise grandfathered subjects them to §409A, and is treated as a new grant. If it’s a new grant, the exercise price has to be FMV on date of grant.
        • A modification is any change that may provide the holder with a direct or indirect reduction in the exercise price or an additional deferral feature.
        • Accelerating vesting, or shortening the exercise period, is not a modification.
      • Extensions of the period for exercise of an option may subject the option to §409A from date of original grant.
        • There’s a limited exception for extensions that do not extend beyond the taxable year that the option would have otherwise expired, or 2-1/2 months thereafter.
        • The IRS is looking at this rule. Option extensions are common in severance packages, especially for public companies.
    • SECOND REQUIREMENT: Number of shares fixed at grant.
    • THIRD REQIREMENT: Option cannot provide for further deferral.
    • FOURTH REQUIREMENT: Option has to be for service recipient stock
      • For a service provider to a public company, or one of its affiliates, service recipient stock is the common stock that is readily tradable on an established securities market.
    • For private companies, service recipient stock is the class of common stock having the greatest aggregate value of common stock issued and outstanding, or common stock with substantially similar rights (disregarding differences in voting rights).
      • The following is NEVER service recipient stock:
        • stock that is preferred as to liquidation or dividend rights
        • stock that is subject to a mandatory repurchase obligation /or/ a put /or/ a call that does not lapse and is based on a measure other than FMV. THIS IS THE RUB!


What is fair market value (FMV)?

  • For stock that is not readily tradable on an established securities market, FMV means a value determined by the reasonable application of a reasonable valuation method, per the proposed regulations. It’s a facts and circumstances determination.
    • factors to be considered include:
      • value of tangible and intangible assets
      • present value of future cash flows.
      • the market value of stock or equity interests in similar publicly-traded corporations
      • other relevant factors such as control premiums or discounts for lack of marketability (unstated is minority discounts, but presumably allowed).
  • Value becomes unreasonable when circumstances change or the valuation becomes stale (>12 months after valuation date).
  • Presumptively reasonable methods:
    • Independent appraisal that meets the ESOP requirements and is no more than 12 months old.
    • A formula value that is part of a nonlapse restriction, but only if used for all purposes, including non-compensatory purposes like regulatory filings, loan covenants and other third-party arrangements.
    • A valuation (other than by an independent appraiser) made in good faith and evidenced by a written report that takes into account the relevant factors if dealing with illiquid stock of a start-up corporation.
      • Stock cannot be readily tradable on an established securities market.
      • Business (and any predecessor’s business) can’t be more than 10 years old.
      • Can’t reasonably anticipate at time of valuation that there will be a Change in Control or an IPO within 12 months of the valuation.
      • Stock can’t be subject to a repurchase obligation, put or call (other than a lapse restriction or right of first refusal).

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