Deferred Compensation for Executives under Sec. 409A (Part II) — footnotes

³²The plan must not give the administrative committee the power to reduce the exercise price under any circumstances, except for the usual pro-rata adjustments of option amounts and exercise prices in the case of recapitalizations or mergers.

³³See Prop. Regs. Sec. 1.409A-1(b)(5)(i).

³⁴See Prop. Regs. Sec. 1.409A-1(b)(5). The valuation rules for such stock are, in general, no less clear than comparable guidance in other contexts of administrative and case law; see Prop. Regs. Sec. 1.409A-1(b)(5)(iv).

³⁵Notice 2005-1, IRB 2005-2, 274 described the Service’s concern about abuses of the SAR rules by, among other things, combining a SAR with a mandatory buyback of stock delivered on exercise. This was one of the areas for which the IRS has specifically asked for comments; see id. at Q&A-4.

³⁶See Prop. Regs. Sec. 1.409A-1(b)(5)(iv)(A).

³⁷See id. Interestingly, the proposed regulations permit any corporation, not merely those subject to specific foreign laws, to employ this method.

³⁸“The determination of whether a valuation method is reasonable, or whether an application of a valuation method is reasonable, is made based on the facts and circumstances as of the valuation date”; see Prop. Regs. Sec. 1.409A-1(b)(5)(iv)(B)(1).

³⁹See Prop. Regs. Sec. 1.409A-1(b)(5)(iv)(B)(1).

⁴⁰See Prop. Regs. Sec. 1.409A-1(b)(5)(iv)(B)(2) and Sec. 401(a)(28).

⁴¹See Sec. 414(b) and Prop. Regs. Sec. 1.409A-1(b)(5)(iii).

⁴²See Prop. Regs. Sec. 1.409A-1(b)(6).

⁴³See Prop. Regs. Sec. 1.409A-1(b)(6)(ii).

⁴⁴Prop. Regs. Sec. 1.409A-1(b)(5)(v)(E).

⁴⁵See Notice 2005-1, note 35 supra, at Q&A-4(d)(ii).

⁴⁶The preamble to the proposed regulations (REG-158080-04 (10/4/05), Section II.C.2) states: “the legislative history states that section 409A does not cover grants of stock options where the exercise price can never be less than the fair market value of the underlying stock at the date of grant (a non-discounted option). See H.R. Conf. Rep. No. 108-755, at 735 (2004). Thus an option with an exercise price that is or may be below the fair market value of the underlying stock at the date of grant (a discounted option) is subject to the requirements of section 409A.” According to Prop. Regs. Sec. 1.409A-1(b)(5), “[s]tock options, stock appreciation rights and other equity-based compensation. (i) Stock rights. (A) Nonstatutory stock options not providing for the deferral of compensation. An option to purchase service recipient stock does not provide for a deferral of compensation if—(1) The amount required to purchase stock under the option (the exercise price) may never be less than the fair market value of the underlying stock (disregarding lapse restrictions as defined in 1.83-3(i)) on the date the option is granted and the number of shares subject to the option is fixed on the original date of grant of the option.” The language in Notice 2005-1, note 35 supra, is comparable; see id. at Q&A-4(d); and REG-158080-04, Section I.B.

⁴⁷Quite apart from the Sec. 409A issue, drafters may not want to include such a provision in their plans because of the potential charge to the company’s income resulting from such a repricing.

⁴⁸See Prop. Regs. Sec. 1.409A-1(a)(3)(i).

⁴⁹See Prop. Regs. Sec. 1.409A-1(a)(3)(ii).

⁵⁰See REG-158080-04, note 46 supra, at Section II.G.1.

⁵¹In this context, “window program” is designed to cover circumstances in which the employer offers employees special incentives to elect early retirement. The theory here is that the distinction between involuntary and voluntary retirements may be a little unclear.

⁵²This is $200,000, plus annual cost-of-living adjustments. For 2006, the amount is $220,000; see Notice 2005-75, IRB 2005-45, 929.

⁵³Notice 2005-1, note 35 supra, did not actually define performance-based compensation, but merely gave the service provider the benefit of the six-month rule for so-called “bonus” compensation; see id. at Q&A-22. The legislative history to Sec. 409A indicates that the definition was intended to be close to that employed in the regulations under Sec. 162(m), the statute that restricts the deduction of certain compensation in excess of $1 million. One troubling aspect of the notice’s definition was that, unlike its counterpart in the Sec. 162(m) regulations, the bonus could not be computed solely on the basis of performance of the service recipient’s stock in the marketplace; see Notice 2005-1. Prop. Regs. Sec. 1.409A-1(e)(3) has eliminated this difference.

⁵⁴See Prop. Regs. Sec. 1.409A-1(e)(1).

⁵⁵Of course, this last provision may be of little help to service recipients that are public companies, because the establishment of material modifications to compensation plans for their executive officers will, quite apart from Sec. 409A, usually require approval by the compensation committee, the full board of directors or even the company’s stockholders; cf. Rule 16b-3(d), promulgated under the Securities Exchange Act of 1934, as amended; National Association of Securities Dealers Automated Quotation System (NASDAQ) Marketplace Rules Section 4350(i)(1)(A); New York Stock Exchange Listed Company Manual Section 303.A.08; and Sec. 162(m).

⁵⁶See Sec. 409A(a)(4)(C) and Prop. Regs. Sec. 1.409A-2(b).

⁵⁷See Prop. Regs. Sec. 1.409A-2(b)(5).

⁵⁸There is a sort of virtual exception as well. If the service recipient is either unwilling or unable to make a payment to the service provider when it is due and if the parties are acting in good faith, the delay in payment is not treated as a deferral. The parties are obligated to make the payments as soon as practicable; see Prop. Regs. Sec. 1.409A-3(e).

⁵⁹See Prop. Regs. Sec. 1.409A-1(h)(1).

⁶⁰See Prop. Regs. Sec. 1.409A-1(h)(2).

⁶¹See Sec. 409A(a)(2)(B)(i) and Prop. Regs. Sec. 1.409A-1(i). This definition is borrowed from the definition of “key employee” in Sec. 416(i)(1)(A).

⁶²See Prop. Regs. Sec. 1.409A-3(g)(4).

⁶³On March 28, 2006, the Social Security Administration issued a final rule establishing a new disability determination process; the new rule is effective as of Aug. 1, 2006.

⁶⁴See Prop. Regs. Sec. 1.409A-3(g)(5).

⁶⁵See id.

⁶⁶Pending such guidance, taxpayers are asked to analogize as best they can about how to treat corporate service recipients.