On April 10, 2007, the IRS and the Treasury Department issued long-awaited final regulations interpreting Section 409A of the Internal Revenue Code (referred to hereafter as the “409A Regulations” or “Final Regulations”). The 400-page document represents a two-year effort to apply the rules of Section 409A to the many compensatory programs that involve a deferral of compensation. It is essential that employers note the Dec. 31, 2007, deadline and take any needed steps to avoid the harsh consequences of noncompliance—i.e., plan participants suffering accelerated income tax, plus a 20 percent penalty tax and interest.
What follows is a brief summary of Section 409A, a list of action steps for employers to take before Dec. 31, 2007, and links to expanded discussions of key topics under Section 409A.
Introduction to Code Section 409A and Regulations
Code Section 409A applies to most arrangements that involve a deferral of compensation into a future tax year. Common examples include supplemental executive retirement programs, incentive bonus programs, stock options, stock appreciation rights, and severance agreements. All arrangements that are potentially subject to Section 409A must either fit an exemption (of which there are many) or comply with Section 409A for periods beginning on or after Jan. 1, 2005. However, the IRS has agreed to be lenient for periods prior to the effective date of the Final Regulations. Specifically, for the period between Jan. 1, 2005, and Dec. 31, 2007, an employer’s efforts to comply with Section 409A will be judged based on a standard of whether the employer has made a reasonable, good faith attempt to comply. In addition, prior to Dec. 31, 2007, plan documents need not be amended or updated to reflect Code Section 409A.
Now that Final Regulations have been issued, all deferred compensation arrangements that do not qualify for an exception must be in full operational and documentary compliance with Section 409A and the Final Regulations after Dec. 31, 2007. For arrangements that must embrace full compliance, this means plan documents must specify the amounts being deferred, the time and form of payment, and the conditions under which initial or subsequent deferral elections may be made.
Action Steps in Preparation for Dec. 31, 2007, Compliance Deadline
In order to meet the Dec. 31, 2007, deadline for compliance, employers should take the following steps:
1) Inventory plans and arrangements
Identify potentially affected plans and arrangements by reviewing not only traditional nonqualified retirement plans such as supplemental executive retirement plans (SERPs), but also annual bonus plans, executive employment agreements, severance arrangements, stock options, restricted stock units, equity compensation awards, post-retirement reimbursements, and long-term incentive plans. Note that Section 409A applies not only to plans for employees, but also arrangements covering non-employee directors and certain other independent contractors.
2) Identify grandfathered benefits
Benefits that were accrued and vested by the end of 2004 and that have not been “materially modified” are grandfathered and exempt from Section 409A. Employers should identify whether any deferred compensation arrangements (or portions of deferred compensation arrangements) qualify for grandfathering. Where a portion of a plan’s benefit qualifies for grandfathering, employers should assess whether the advantages of avoiding Section 409A on that portion outweighs the administrative burden of separately accounting for the grandfathered portion.
3) Determine if any exemptions apply
The 409A Regulations provide various exemptions for short-term deferrals, severance arrangements, equity compensation awards, etc. Employers should determine whether current deferred compensation arrangements qualify for an exemption.
4) Amend covered plans
Plan documents subject to Section 409A must be modified by Dec. 31, 2007, to comply with the 409A Regulations. For example, plan documents must reflect the new rules controlling deferral elections, the timing and form of distributions, and subsequent changes to earlier elections.
5) Take appropriate board action
Amendments to plan documents should be approved by the board of directors (or another appropriate body) by Dec. 31, 2007. To avoid emergency year-end meetings and holiday scheduling problems, board approval should be sought well in advance of the end of the year.
Click on any of the following topics for a more in-depth discussion of the key elements of the new Code Section 409A regulations, changes from the proposed regulations, and detailed action steps:
- Deferral Elections and Subsequent Election Changes
- Deferred Compensation Payment Rules
- Definition of “Service Provider”
- Severance Plans under Section 409A
- The Short-Term Deferral Exemption
- What is a Substantial Risk of Forfeiture
- Stock Options, Stock Appreciation Rights and Restricted Property
- Split-Dollar Life Insurance
Deferral Elections and Subsequent Election Changes
A. Initial Elections of Time and Form of Payment
If a deferred compensation plan permits a participant to select the future time and form of payment of deferred compensation, the participant must make an “initial election” of that future time and form of payment prior to the taxable year in which the participant has a “legally binding right” to the compensation. For example, if a plan permits a participant to elect by Dec. 31 to defer an amount of compensation earned in the following calendar year, then the participant must also by Dec. 31 elect the future time and form of payment. Under the 409A Regulations, this election is the participant’s “initial election” as to the time and form of payment. The same timing rule applies even if the plan only provides employer-provided, nonelective contributions, but permits the participant to elect the future time and form of payment for those amounts.
If a deferred compensation plan does not permit a participant to elect the future time and form of payment of deferred compensation, then the plan document must specify the time and form of payment no later than the later of (i) the time the participant has a legally binding right to that deferred compensation or (ii) the date the participant would have been required to make that time and form of payment election if the plan permitted a participant election.
Under a one-time window, plan participants may make (or make new) initial elections of the future time and form of payment of their existing deferred compensation plan benefits by Dec. 31, 2007. If the plan does not facilitate participant elections, then the plan document must specify the future time and form of payment of existing deferred compensation by Dec. 31, 2007. The only exception to this Dec. 31, 2007, initial election rule is for deferred compensation that was accrued and vested prior to Jan. 1, 2005, and therefore is capable of being grandfathered.
1. Changes in final regulations
a. Bonuses. The 409A Regulations clarify that even where a bonus is discretionary, so that the legally binding right to the bonus does not arise until after the applicable period of service has begun, the participant’s bonus deferral election (election of the deferral amount and the future time and form of payment) still must occur before the year in which the period of service begins. This rule applies in the absence of some other applicable exception (for example, see the “performance-based compensation” rule described below).
b. First year of eligibility. In the first year a service provider becomes eligible to participate in a plan, he or she may make an initial deferral election within 30 days after becoming eligible. This initial election will only apply with respect to compensation paid for services to be performed after the election. This means the deferral election covers no more than an amount equal to total amount of compensation for the performance period multiplied by the ratio of (i) the number of days remaining in the performance period after the election is made, over (ii) the total number of days in the performance period.
The 409A Regulations also clarify how to treat participants who step in and out of plan eligibility. Specifically, if a service provider has ceased to be eligible to participate in a plan (other than being entitled to the accrual of earnings), regardless of whether all amounts previously deferred under the plan have been paid, and then subsequently becomes eligible to participate in the plan again, that service provider may be treated as being initially eligible to participate in the plan. This rule only applies if the person had not been eligible to participate in the plan and had not accrued any benefits at any time during the 24-month period ending on the date he or she again became eligible. If that 24-month break occurs, the rehired participant may make an initial deferral election within 30 days after again becoming eligible to participate in the plan.
2. Performance-based compensation. An exception to the general initial deferral election rule applies to performance-based compensation. The term “performance-based compensation” means compensation that is contingent (either as to the amount or the entitlement to receipt) on the satisfaction of pre-established organizational or individual performance goals that relate to a performance period of at least 12 consecutive months. An initial deferred election may be made for performance-based compensation by the date six months before the end of the performance period, if (i) the service provider performs services continuously from the later of the date the performance period starts or the date the performance criteria are established through the date the initial deferral election is made, and (ii) no election to defer performance-based compensation is made after the compensation is readily ascertainable (substantially certain to be paid.) The 409A Regulations clarify that where a portion of an award would qualify as performance-based compensation and another portion does not, the portion that would qualify may be bifurcated and designated separately under the terms of the plan, so that each portion is determined independently of the other.
B. Initial Deferral Election Regarding Separation Pay
The 409A Regulations state that where separation pay is the subject of bona fide, arm’s length negotiations at the time of a service provider’s separation from service, an initial deferral election may be made up to the time the service provider obtains a legally binding right to the payment. See the discussion below regarding severance plans.
C. Subsequent Changes in Time and Form of Payment
If a plan permits subsequent changes in time and form of payment elections, the following conditions must be met:
- The plan must require that the subsequent election not take effect until at least 12 months after the date on which the subsequent election is made;
- In the case of a subsequent election related to a payment that is not on account of death or disability or unforeseen emergency, the plan must require that the payment with respect to which the subsequent election is made be deferred for a period of not less than five years after the date the payment would otherwise have been made (or in the case of a life annuity or installment payments treated as a single payment, five years after the date the first amount was scheduled to be paid); and
- The plan requires that this subsequent election be made not less than 12 months before the date the payment is scheduled to be made or the first amount is scheduled to be paid.
The 409A Regulations state that installment payments will be treated as a single payment unless the plan provides at all times that installment payment are to be treated as a right to a series of separate payments for purposes of these subsequent election rules. A plan adopted before Dec. 31, 2007, may provide that installments will be treated as a right to a series of separate payments if that designation is set forth in writing by Dec. 31, 2007.
The final 409A Regulations state that these subsequent election rules governing changes in the time and form of payment apply to elections by beneficiaries, as well as elections by service providers or service recipients with respect to the time and form of payment to beneficiaries.
The 409A final regulations also clarify that a permitted subsequent election will not be a prohibited acceleration of a payment. For example, an election to change from installments over 10 years to a lump sum payment is permitted if the election is made at least 12 months before the installment payments were scheduled to commence, and if the lump sum payment will not be made until at least five years after the date the installment payments were scheduled to commence. Even though the lump sum is paid before some installments are due, this will not be an impermissible acceleration.
Checklist of Action Steps
- Complete or revise prior initial deferral elections by Dec. 31, 2007.
- Determine whether to permit subsequent elections to change the time and form of payment.
- Amend plan and election forms before Dec. 31, 2007.
- If the plan permits installments, decide whether to make the series of separate payments election by Dec. 31, 2007
Deferred Compensation Payment Rules
The 409A Regulations require that payments under a deferred compensation plan be made no earlier than a fixed date or in accordance with a fixed schedule, or upon the occurrence of: 1) separation from service, 2) death, 3) disability, 4) change in control, or 5) unforeseeable emergency. Although acceleration of payment is generally prohibited, it is permissible for a plan to provide for distributions upon the earlier of, or the later of, two or more of these specified events. Distributions to certain “specified employees” resulting from a separation from service must not be made for at least six months following the separation. Any subsequent election to change the time or form of payment may not take effect for 12 months and must set a new payment date that is at least five years after the date the payment would otherwise have been made.
B. Determining an Objective Payment Date
For distribution upon a fixed date or in conjunction with a permissible payment event (i.e. separation from service, death, disability, a change in control, or unforeseeable emergency), a plan must either state the date of the event itself as the payment date or designate an objectively determinable date following the event on which payment will be made. A payment will be treated as made on the designated distribution date if it is made by the later of: 1) the end of the year containing the designated date, or 2) the 15 th day of the third month following the designated date. Payment may be made before the designated date only if it is made within 30 days before the designated date and the participant is not allowed to elect the taxable year of payment. Plans providing for payment “as soon as administratively feasible” following a payment event will be treated as providing for an objectively determinable date only if the plan expressly provides that the participant is not allowed to elect the taxable year of payment and the payment period is expressly restricted to one taxable year or is no longer than 90 days.
C. Determining Whether a “Separation from Service” Has Occurred
The 409A Regulations provide that a service provider will be treated as separating from service when, based on the facts and circumstances, the parties reasonably anticipate at the time that no further services would be performed. A separation from service is also deemed to occur if the parties reasonably believe that the level of a service provider’s services will permanently decrease to 20 percent or less of his or her average service level over the preceding three-year period. The regulations provide rebuttable presumptions under which a service provider is presumed to separate from service if the level of services performed actually decreases to 20 percent or less of his or her average service level. A service provider is presumed not to have separated from service if the level of services performed continues at least 50 percent or more of his or her average service level.
D. Multiple Payment Events
A plan may provide for different forms of payment for different distribution events. Similarly, the 409A Regulations permit plans to provide for an alternate payment schedule if a specific distribution event occurs before or after a specified date. Different times and forms of payment may also be designated for different types of separation from service. It is important to note, however, that any alteration of an existing distribution schedule is subject to the subsequent deferral election rules and the general prohibition on accelerated distributions. A change from one life annuity form to another actuarially-equivalent form prior to the commencement of payment will not be considered a change in the time or form of payment and will therefore not be subject to the subsequent election rules.
E. Key Employee Rules
As noted above, distributions to “specified employees” following a separation from service must be delayed for at least six months following the separation. A “specified employee” is a “key employee” of a publicly-traded company or subsidiary of a publicly traded company, including one traded on a foreign exchange. The term “key employee” is defined in Code Section 416(i). There are complicated rules to identify the key employees as of a specific date, or to create an over-inclusive list that covers all key employees. In lieu of determining whether or not a participant is a “key employee” for purposes of the delayed payment requirement, a plan may provide that payments to all participants upon separation from service will commence six months after that date.
F. Distributions Upon Plan Termination
In limited circumstances the plan sponsor is permitted to terminate a plan and distribute benefits without running afoul of the prohibition on acceleration of payments. The 409A Regulations provide that a plan termination will not violate the prohibition on acceleration of payments if:
- the termination does not occur proximate to a downturn in the financial health of the plan sponsor;
- all plans of the same type maintained by the employer are terminated with respect to all participants;
- no payments are made within 12 months of the plan termination, aside from those that would have been made but for the termination;
- all payments are made within 24 months of the termination; and
- the plan sponsor does not adopt a plan of the same type for a period of three years following the date of the plan termination.
The 409A Regulations also provide that it is permissible to terminate a plan in connection with a change in control, corporate liquidation, with the approval of a bankruptcy court or in other circumstances as prescribed by the IRS.
Checklist of Action Steps
- Verify that the plan appropriately fixes a payment date.
- If the plan allows multiple payment events, assess whether different payment options apply to the different payment events.
- For employers that are publicly traded companies, determine how to best identify specified employees subject to the six-month delay.
Definition of “Service Provider”
Section 409A applies to “service providers,” which includes employees and directors, but excludes some independent contractors. Under the 409A Regulations, the exemption for compensation earned by certain “independent contractors” is expanded by:
- Adding new rules for testing when entities are “related,”
- Adding a safe-harbor for determining when an independent contractor’s service will be “significant,” and
- Adding a new exception for deferred compensation earned in connection with service for certain “related entities.”
In order for a service provider to qualify as an “independent contractor,” the person must provide significant services to two or more entities to which the service provider is not related and that are not related to one another. Services are considered significant if revenues derived from a single employer do not exceed 70 percent of the total revenues earned by the person in the taxable year. In other words, to maintain a contractor’s “independent” status, he or she may not derive more than 70 percent of his or her revenues from a single source.
The 409A Regulations also liberalized the definition of what is a “related entity.” The result is that a higher level of ownership—50 percent rather than 20 percent—is required for two entities (or the service provider and a particular entity) to be treated as “related.” The higher threshold will allow more service providers to qualify as “unrelated” and therefore able to avoid the Section 409A by qualifying as an “independent contractor.”
Checklist of Action Steps
- Identify any deferred compensation arrangements that apply to non-employee workers (i.e., those reported on an IRS Form 1099, rather than a Form W-2) and determine whether those workers qualify as independent contractors under the 409A Regulations.
- For individuals who seem to qualify as independent contractors under Section 409A, obtain some written assurances for your files regarding their satisfaction of the revenues threshold as well as the “related entity” definition. (This is not information that a typical employer would have with respect to independent contractors, and having some information in the file will support the employer’s treatment of the individuals as true independent contractors.)
Severance Plans under Section 409A
A. Severance Pay Plans
With respect to severance payments, Section 409A generally applies to voluntary terminations of employment, but does not apply to involuntary terminations. However, there are exceptions to these general rules and special provisions that need to be followed to avoid unintended results. Issues with Section 409A are most likely to arise with respect to pre-negotiated severance pay agreements (often found in employment agreements) or severance plans when there is an attempt to change the timing or amount of payments. In addition, issues can arise when there is a negotiated severance package upon termination of employment and payments are to be made over time.
B. Voluntary Terminations
Severance arrangements following a voluntary termination of employment generally are subject to Section 409A. Thus, for example, if an employment agreement provides for severance pay upon a voluntary termination of employment, the terms of payment must satisfy the requirements of Section 409A. In these situations it is generally easy to comply with Section 409A because the agreement will specify the amount to be paid and the timing, with payments triggered by the termination of employment (an acceptable distribution event under Section 409A). Similarly, if an employer and employee agree to a series of severance payments upon voluntary termination, such payments are subject to Section 409A unless otherwise exempt (e.g., under the short term deferral exception, discussed below).
C. Involuntary Terminations and “Good Reason” Resignations
Payments on involuntary termination of employment are not subject to Section 409A if such payments do not exceed the lesser of $440,000 (as adjusted for inflation) or two times the employee’s annual base salary, and if all payments are made by the end of the second calendar year after the termination of employment. If severance pay exceeds such amounts, only the excess amounts must satisfy Section 409A. Again, however, even if an element of severance pay is subject to Section 409A, in most cases it is generally easy to comply.
Payments on involuntary termination may also qualify for the short-term deferral exemption discussed below. Because such payments are generally subject to a risk of forfeiture, if all payments are completed within 2-1/2 months after the year in which severance occurs, they will be exempt from 409A without regard to amount. Because these are exemptions to 409A, the six-month delay rule for payments of deferred compensation to a specified employee does not apply.
The proposed regulations did not provide any special treatment for deferred compensation paid upon a “constructive termination” or voluntary termination for “good reason.” It was treated simply as a resignation, not entitled to any of the exceptions for involuntary terminations, and therefore subject to all the 409A restrictions. Because payments on termination for “good reason” are common in executive employment agreements, this position was controversial.
In the final regulations, the IRS changed its position dramatically. The final regulations recognize voluntary termination for “good reason” that “occurs under certain limited bona fide conditions” as equivalent to an involuntary termination. The employee can satisfy either a “facts and circumstances” test or a safe harbor. To meet the safe harbor, the separation from service must occur within two years of and arise from one of several listed good reasons, such as a unilateral material decrease in compensation, responsibilities, or budget; the amount and form of severance must be substantially identical to the severance that would be received if the employer involuntarily terminated the employee; and the employee must have provided notice within 90 days of when the good reason arose, with at least a 30-day opportunity for the employer to cure the problem. Situations that do not fit the safe harbor may still qualify under the facts and circumstances test, but we can expect employment agreements and severance packages to be drafted or amended to meet the safe harbor.
The change is important because if a resignation due to “good reason” is the equivalent of an “involuntary separation,” then it can qualify for the various exceptions for “separation pay plans” or the short-term deferral exception discussed above. The IRS expressly says that this means a key employee in a publicly-traded company can get around the six-month delay rule, even though they terminated voluntarily.
D. Window Programs
Section 409A does not apply to “window program” severance payments. These are limited periods—no longer than 12 months—where an employer offers severance pay to those employees who choose to terminate employment. Such programs are subject to the same limitations as involuntary terminations (limited pay over no more than two years).
E. Deferring Severance Pay
If an employer and employee negotiate a severance package upon termination of employment (i.e., there is no predetermined contractual right to the agreed upon amount), the employee may elect to defer the severance pay any time before there is a binding right to the payment. Similarly, a participant in a window program may defer payments at any time before the election to participate in the window program becomes irrevocable. Deferrals of severance pay would then be subject to the general rules of Section 409A, limiting the right to accelerate or further defer payments.
F. Additional Severance Benefits
The final regulations contain a laundry list of additional benefits that can be provided upon severance, whether voluntary or involuntary. Their exemptions can be used together with those discussed above, and in any combination. They include payment of COBRA premiums, reimbursement of business expenses and moving expenses, and outplacement assistance and other in-kind benefits, provided over a limited time after severance.
Checklist of Action Steps
- Inventory all “severance pay” arrangements, including provisions found in employment agreements.
- Assess which severance arrangements already meet an exemption or comply with Section 409A, and which will require modification by the compliance deadline.
- Decide whether to revise “good reason” voluntary termination benefits to meet the safe harbor.
The Short-Term Deferral Exemption
One of the most significant exceptions under Section 409A is the exception for “short-term deferrals.” For this purpose, a deferral of compensation is considered short-term if the amount is actually or constructively received by the service provider by the later of (i) 2-1/2 months after the end of the service provider’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture, or (ii) 2-1/2 months after the end of the service recipient’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture (subject to certain extensions for unforeseeable events). A payment that is never subject to a substantial risk of forfeiture is considered to be free of all substantial risks of forfeiture (for purposes of the preceding rule) on the first date the service provider has a legally binding right to payment.
This is essentially the same short-term deferral rule contained in the proposed regulations. However, the Final Regulations liberalize the standard under which a payment can be a short-term deferral even if it is delayed due to unforeseeable events. The proposed regulations provided generally that payment could be delayed if the payment would jeopardize the service recipient’s solvency and the insolvency was unforeseeable at the time the service provider obtained the right to the payment. The Final Regulations modify this rule so that generally the payment may be delayed where the payment would jeopardize the ability of the service recipient to continue as a going concern.
The short-term deferral exception does not apply if the service recipient has an election with respect to the taxable year in which payment of the compensation is scheduled to occur. For example, if an employer provides employees with an opportunity to defer a year-end bonus, then that deferral and the payment of amounts deferred would be subject to Section 409A regardless of whether the payment was made with the 2-1/2 month period. To the extent that an arrangement requires payment relatively close to vesting, such as annual bonus arrangements that are paid within the prescribed 2-1/2 month period, the short-term deferral exception should keep the arrangement outside the scope of Section 409A. This exception may also be useful with respect to equity compensation arrangements, such as restricted stock units, performance shares and other types of long-term incentive programs, by paying the associated compensation within the 2-1/2 month period following the year of vesting to avoid the application of Section 409A.
Checklist of Action Steps
- From the inventory of deferred compensation arrangements, determine which are already exempt from Section 409A by virtue of constituting a short-term deferral.
- Identify any deferred compensation arrangements that could easily, with minor modifications, fit within the short-term deferral exemption.
What is a Substantial Risk of Forfeiture?
The Final Regulations generally adopt the definition of substantial risk of forfeiture contained in the proposed regulations. It is important to note the Final Regulations do not adopt a definition of substantial risk of forfeiture that is the same as the definition under Section 83.
Compensation is subject to a substantial risk of forfeiture for the purposes of Section 409A if entitlement to it is conditioned on the performance of substantial future services by any person, or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial (that is, no risk of forfeiture exists if enforcement is unlikely). For example, a requirement of continued employment at the end of a bonus determination period to be eligible for a performance bonus, or a condition requiring completion of a corporate transaction to receive a retention bonus would be substantial risks of forfeiture. The 409A Regulations explicitly provide that a payment conditioned on an involuntary separation from service without cause is a substantial risk of forfeiture if there is a substantial risk that the service provider will not be involuntarily separated from service without cause.
Alternatively, a non-compete will not constitute a substantial risk of forfeiture under Section 409A. Rolling deferrals (that is, extending the risk of forfeiture) will also not constitute substantial risks of forfeiture. And, a requirement that an employee sign a release of claims to receive a benefit is not treated as a substantial risk of forfeiture under Section 409A.
The determination of whether deferred compensation is subject to a substantial risk of forfeiture is important for two reasons in addition to measuring the deferral period for the purposes of the short-term deferral exception:
- Grandfathering. Deferred compensation that accrued and vested as of Dec. 31, 2004, is grandfathered and not subject to the application of Section 409A. “Vested” for these purposes means no longer subject to a substantial risk of forfeiture.
- Timing of Tax under Section 409A. Compensation deferred in violation of Section 409A is subject to income tax, an additional 20 percent excise tax and interest as of the date when those amounts are no longer subject to a substantial risk of forfeiture.
Checklist of Action Steps
- Although Section 409A first became effective Jan. 1, 2005, it can apply to items of deferred compensation granted prior to 2005, but first vested at a later date. Determine whether any items of deferred compensation granted prior to 2005 were subject to a substantial risk of forfeiture, and first became vested after Jan. 1, 2005. If so, those items must comply with Section 409A.
- Identify any elements of deferred compensation that are subject to a substantial risk of forfeiture, and confirm that the annunciated risk continues to constitute a “substantial risk of forfeiture” under the Final Regulations.
Stock Options, Stock Appreciation Rights and Restricted Property
The Final Regulations generally follow the proposed regulations, but in certain instances take a different (and generally welcome) approach. Specifically, the regulations provide that stock options and stock appreciation rights tied to “service recipient stock” (described below) are exempt from Code Section 409A if:
- The exercise price associated with the option, or base value associated with a stock appreciation right, may never be less than fair market value of the underlying stock, determined as of the date of grant;
- The option or appreciation right does not include any feature for deferral of compensation (other than a deferral in the recognition of any appreciated value of the underlying stock after the grant date); and
- The exercise of the option and/or transfer of stock is subject to taxation under Code Section 83.
The Final Regulations confirm (as did the proposed regulations) that statutory stock options granted pursuant to programs under Code Sections 422 or 423 do not constitute deferred compensation, and therefore are not subject to Section 409A. However, this exception can be lost if the statutory option is extended or otherwise modified in a fashion that results in treating the modified option as a new option grant that does not constitute a statutory option.
B. Service Recipient Stock
The exception for stock options and stock appreciation rights only applies to common stock of the “service recipient.” Generally, the “service recipient” will be the employer, but the issue becomes complicated in connection with business structures that involve multiple corporations. In this regard the Final Regulations require the stock to be issued by an “eligible issuer” of service recipient stock. To be an eligible issuer a corporation must be the corporation for which the service provider provides direct services on the date of the grant, as well as any other corporation that is part of the same control group. The control group analysis cross-references the regulations under Code Section 414(c), but decreases the common ownership threshold of at least from 80 percent to 50 percent. In addition, if there are “legitimate business criteria,” the employer can be an entity in which the common ownership percentage may be adjusted down even further to 20 percent.
In addition, the 409A Regulations specifically state that equity interests in entities other than corporations (LLCs, for example) may also constitute service recipient stock to the extent that the IRS issues further guidance.
C. Expanded Rule for Extending Exercise Date
The proposed regulations provided that an option’s term could not be extended beyond the close of the calendar year in which the extension occurred, or two and one-half months from the regular expiration date, whichever was later. The 409A Regulations provide much greater flexibility. Specifically, the exercise period associated with an option or stock appreciation right may be extended to a date no later than the earlier of (i) the latest date on which the stock right could have expired by its original terms under any circumstances, or (ii) the tenth anniversary of the original grant date. This represents welcome relief, particularly for the very common situation in which an option provides that it will expire within three months following a termination of the holder’s employment, and the employer desires, in connection with a termination of employment, to extend that three month period.
D. Determination of Fair Market Value
To qualify for the exception from Section 409A, a stock right must be based on the fair market value of the underlying stock, determined as of the date of grant. For stock that is readily tradable on an established market, the 409A Regulations clarify the acceptance of an “average selling price.” For stock that is not readily tradable on an established market, the final regulations follow the proposed regulations in providing three evaluation methods that will be presumed to be reasonable. The three methods include (i) the use of an independent appraisal, (ii) the use of a valuation formula that is then used for all relevant purposes, and (iii) the use of a good faith written report for the illiquid stock of a startup company (defined as a company that has been in business for less than 10 years and is not traded on an established market).
With respect to the use of a valuation formula, the 409A Regulations clarify that the formula need not be used for all non-compensatory purposes, such as regulatory filings, loan covenants, etc. Instead, the valuation formula must apply to the issuer, as well as any person that owns stock possessing more than 10 percent of the total voting power of the issuer (other than an arms-length transaction involving the sale of all, or substantially all, of the outstanding stock of the issuer). And with respect to the safe harbor presumption for illiquid startups, the 409A Regulations clarify the standards to be used in determining whether a person has sufficient experience and skill to provide a valuation report. Generally, a person must have at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity or comparable experience in a line of business or industry in which the service recipient operates.
E. Restricted Property
As was the case in the proposed regulations, the Final Regulations provide that a grant of restricted property will generally not constitute a deferral of compensation for purposes of Section 409A. This is the case even if a service provider receives a vested right to receive non-vested property in the future. The Final Regulations provide that the risk of forfeiture to which the property is subject must constitute a substantial risk of forfeiture, as defined under Section 409A.
Checklist of Action Steps
- Verify that all stock option plans and stock appreciation rights arrangements relate to common stock of an eligible “service recipient.”
- Verify that stock options and stock appreciation rights issued after Jan. 1, 2005 (or first becoming vested after Jan. 1, 2005) were issued based on a fair market value of the stock, determined as of the time of grant. Any “below-market” grants may be corrected, but action must be taken prior to Dec. 31, 2007. In addition, any replacement compensation may not flow to the optionee prior to Jan. 1, 2008.
A split-dollar arrangement may involve a promise to transfer a future economic benefit in a manner that creates a deferral of compensation subject to Code Section 409A. Although the 409A Regulations do not address split-dollar life insurance, IRS Notice 2007-34, which was issued on the same day as the 409A Regulations, does offer substantive guidance regarding the application of the new law to these arrangements.
According to Notice 2007-34, split-dollar arrangements that function to provide for a deferral of compensation will generally be subject to Code Section 409A. Those that provide purely death benefits (as defined in the Code Section 409A regulations) or that provide for payment meeting the short-term deferral exception are not subject to Code Section 409A.
For split-dollar arrangements containing both grandfathered and non-grandfathered benefits, the Notice provides a safe harbor method for determining the grandfathered benefit and allocated earnings. Finally, the Notice addresses the distinction between “economic benefit” split-dollar arrangements, which are subject to Code Section 409A, and loans, which do not qualify as deferred compensation unless the split-dollar loan is waived, cancelled or forgiven.
Checklist of Action Steps
- Identify any split-dollar arrangements, or potential split-dollar arrangements.
- Because split-dollar arrangements can be very complicated, employers should seek independent advice from legal counsel or the insurance broker that structured the arrangement.