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Deferred Compensation for Executives under Sec. 409A (Part II) This two-part article discusses how Sec. 409A and the current proposed regulations apply to deferred compensation arrangements. Part II covers the applicability of Sec. 409A to equity-based compensation arrangements, permitted distributions and the election to defer compensation. Stuart R. Singer Author’s note: The author acknowledges the kind assistance on a number of accounting questions of Melody Thornton, Tax Manager, and James Ledwith, Audit Partner, in the San Diego, CA, office of J.H. Cohn, LLP. For more information about this article, contact Mr. Singer at SSinger@jenkens.com.
Executive Summary
Sec. 409A and the current proposed regulations impose a new set of rules for taxation of deferred compensation. Part I of this two-part article, in the July 2006 issue, discussed the introduction of Sec. 409A and the plans and types of deferred compensation subject to it. Part II, below, covers the applicability of Sec. 409A to equity-based compensation arrangements, permitted distributions and the election to defer compensation.
Stock Options One of the more difficult areas of Sec. 409A coverage is stock options. First, as might be expected, incentive stock options (ISOs) are generally not treated as deferral of compensation for Sec. 409A purposes, although the proposed regulations provide a warning for plans that permit such options to be extended or otherwise modified in a manner that produces a nonqualified stock option (NQSO) as the successor. Under Prop. Regs. Sec. 1.409A-1(b)(5), such a modification would generally be treated as the grant of a new option and would be governed under the rules applicable to NQSOs. NQSOs may escape characterization as deferral of compensation under Sec. 409A if, under the plan:
SARs The proposed regulations provide the same exemption rules for stock appreciation rights (SARs) as for NQSOs, generally not treating SARs as deferred compensation if:
Because private companies are covered by these rules, the proposed regulations contain detailed rules on how to determine the underlying stock’s FMV and a definition of what constitutes such stock.34 There are also special rules in Prop. Regs. Sec. 1.409A-1(b)(5)(iii) (D) designed to limit the potential abuse of granting options and SARs to employees in affiliated entities.35
Stock Valuation The proposed regulations address the valuation of stock underlying options and SARs for Sec. 409A purposes. For stock that is “readily tradable on an established securities market,” the value may, in general, be:
If certain other criteria are met, taxpayers may also use an average daily trading price over a fixed period during the 30 days before or after the grant date; this rule was apparently included to accommodate certain corporations subject to foreign laws.37 For stock that is not readily tradable, the corporation merely has to use a “reasonable application of a reasonable valuation method.”38 Whether or not a method is “reasonable” depends on the usual factors, i.e.:
In general, a valuation is not reasonable if it is more than 12 months old or, regardless of its age, it does not take into account material recent developments. The proposed regulations provide limited safe harbors for corporations that are not confident that their internal valuation skills are intrinsically reasonable, including the use of an independent appraiser (in much the same manner as an employee stock ownership trust making its annual valuation of employer securities).40
Determining Which Entity Issued the Underlying Stock Treasury continues to be wary of arrangements under which a service provider could take advantage of the general exclusion for certain stock rights, by receiving stock of an entity related to the service recipient and then using that entity as an investment vehicle. Subject to that prohibition, a service provider can receive stock in any corporation that is a member of the group as the service recipient. For this purpose, a group is defined in the same manner as a “controlled group” under the qualified plan rules, except that a corporation can elect to use a 50% standard instead of 80%.41
Restricted Stock Actual grants of restricted stock are generally not treated as a deferral of compensation, because such grants—due to the restriction—are not currently includible in income under Sec. 83. On the other hand, an award that is essentially a promise to make such a transfer at some point in the future (commonly known as a restricted stock unit), may constitute deferred compensation under Sec. 409A.42 If the grant is a promise to deliver stock that itself is subject to a restriction that constitutes a “substantial risk of forfeiture,” then such award will not be deferred compensation for Sec. 409A purposes, until and unless the restriction has been removed.43
Modification of Stock Options, SARs and Certain Other Rights In general, any material modification of an equity-based right will be treated as the grant of a new right, to be assessed on its own terms, including the requirement that the grant be based on stock exercisable at a price no less than the FMV at the time of such modification. For this purpose, modifications include reduction of the exercise price, addition of other deferral elements and extension of the exercise period (with certain limited exceptions). A modification that actually restricts or reduces the benefits granted to the service provider will not ordinarily be treated as a material modification constituting treatment as a new grant. A modification that shortens the vesting period for exercise is not generally a material modification, although companies and service providers should be cautioned that if the grant is already treated as a deferral of compensation under Sec. 409A, such a change in the vesting schedule, if tied to a distribution event, could constitute an impermissible acceleration.44 The proposed regulations dealing with modifications raise an interesting issue of interpretation. On the one hand, an actual reduction in exercise price is treated as a “modification” under Prop. Regs. Sec. 1.409A-1(b)(5)(v). On the other hand, the language dealing with stock options in Notice 2005-145 and the proposed regulations is very different, suggesting that unless there is no possibility during the life of the stock right for a reduction in the exercise price, such right will be treated as deferred compensation for Sec. 409A purposes. For example, Notice 2005-1 states that “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 on the date the option is granted.” The preamble to the proposed regulations suggests that whenever the terms of the stock agreement or those of the plan under which the right is granted provide the plan administrator with a general power to modify the terms of outstanding grants of stock rights, none of the grants will be excluded from treatment as deferred compensation under Sec. 409A.46 Pending clarification of this language, drafters should ensure that plan committees have no discretion to reduce the exercise price of any outstanding options or SARs.47
Non-U.S. Plans and NRAs Because Sec. 409A’s coverage is so broad, Treasury has spent a fair amount of time and effort carving out exceptions for circumstances that were clearly not intended to be regulated by the statute. The best example is the treatment of persons and transactions involving non-U.S. jurisdictions. First, Sec. 409A generally does not include a deferral arrangement for an individual when the contributions are excludible from Federal income tax pursuant to any bilateral income tax convention.48 Second, Sec. 409A does not apply to any broad-based foreign retirement plan maintained by a non-U.S. person.49 For this purpose, under Prop. Regs. Sec. 1.409A-1(a)(3)(v), such a plan is one that is written, is nondiscriminatory, covers nonresident aliens (NRAs) and does not provide additional benefits beyond those related to retirement and separation. Third, under Prop. Regs. Sec. 1.409A-1(a)(3)(iii), Sec. 409A does not include any non-U.S. plans in which U.S. persons, who are not eligible to participate in a U.S.-based plan, participate to the extent of nonelective deferrals of foreign earned income (but only up to the usual Sec. 415 ceilings). Finally, under Prop. Regs. Sec. 1.409A-1(a)(3)(iv), Sec. 409A does not include any arrangements that are part of a so-called totalization agreement for payroll taxes or a similar arrangement required under foreign law.
Separation Pay Sec. 409A regulates certain payments made on the condition of termination of employment or consultancy, on the premise that, at least for key employees, it would be an easy matter to characterize as “severance” or “separation” plans many arrangements that are, in substance, deferred compensation plans. For this purpose, separation pay includes certain medical coverage under Prop. Regs. Sec. 1.409A-1(b)(9)(iv). Although the risk of abuse of a severance provision is obviously much more significant in the case of a voluntary termination, Treasury’s view is that Congress intended to cover both voluntary and involuntary terminations, because either type could reasonably be part of a predetermined arrangement for deferral of compensation.50 Sec. 409A does not cover any severance arrangement contained in a collectively bargained agreement (determined by the Department of Labor to have been arrived at in good-faith, arm’s-length negotiations between management and labor) either for an involuntary separation or as part of a so-called window program.51 In either circumstance, the amount payable under the severance provision is equal to the lesser of (1) two years’ annual compensation or (2) two years of the annual cap for qualified plans52; the severance provision requires payment in full no later than December 31 of the second calendar year after the calendar year in which the separation has occurred. There is also a limited exception for continuation of certain benefits, including health insurance and moving expenses, under Prop. Regs. Sec. 1.409A-1(b)(9)(iv).
Election to Defer Compensation Performance-Based Compensation Generally under Sec. 409A(a) (4)(B)(i), any election by a service provider to defer compensation for any tax year must be made before the beginning of such tax year. A 30-day grace period is available after the date on which participants first become eligible to participate in the plan. For “performance-based compensation,” when the performance period is at least 12 months in duration, a service provider may make the decision to defer on or before the date that is six months before the end of the performance period.53 In effect, the statute gives the person earning the compensation additional time in which to figure out how much compensation he or she might expect to earn during the year and then to do some personal financial planning. The proposed regulations provide that performance-based compensation must relate to the performance of services over at least 12 consecutive months. During the first 90 days of the performance period, the performance standards must be set forth in writing and, at the time the performance standards are set, it must be uncertain whether or not those standards can be met.54 The proposed regulations provide that the performance standards may include certain subjective criteria if they are related to the service recipient’s performance and the judgment of performance is not made by a person related to, or under the control of, the service provider. Finally, payments may qualify as performance-based compensation even if they have not been approved by the compensation committee (or the entire board of directors) of the service recipient or by the company’s stockholders.55
Subsequent Elections to Defer Payments Sec. 409A provides that, after the first election to defer distribution, a service provider can make an additional election for a further deferral, if the plan requires that:
A plan can also provide for special dispensations for subsequent deferrals in circumstances when timely distribution would create hardship for the service recipient or the service provider, such as payments that would:
In all cases, the plan must provide that the deferred payment be made as soon as reasonably possible without violating the specific law in question. Treasury may provide, in future regulations, other permissible exceptions.57
Permitted Distributions In General One of the difficulties in coping with administrative guidance for a statute that breaks new ground is that the necessary coverage of the myriad details of implementation can deflect focus from the main issue. The genesis of Sec. 409A was the perceived abuse of nonqualified deferred compensation arrangements by highly paid employees and consultants. Essentially, the statute provides that many of the extra rights to distributions which service providers had previously attached to their deferral arrangements will now have the effect of making all of deferred amounts immediately taxable. Sec. 409A provides an exclusive list of the types of permitted distributions of deferred compensation amounts; anything else is prohibited.58 There are six major circumstances under which a plan may provide for distributions of deferred compensation without being subject to the penalty provisions: 1. Separation from service; 2. Disability; 3. Death; 4. A specific time or times scheduled in advance; 5. An unforeseeable emergency; and 6. A change in ownership or effective control of a corporate service recipient, under Sec. 409A(a)(2)(A).
Separation from Service In the case of employees, separation by termination of employment is a fairly straightforward concept, including (1) actual termination and (2) constructive termination, when a leave of absence exceeds six months and there is no legal right to re-employment.59 In the case of independent contractors, “separation” means expiration of all contracts for the performance of services, if such expiration constitutes termination of the contractual relationship between the service provider and the service recipient.60 If the employee in question is a “specified employee,” a distribution cannot be made until after the end of the six-month period following termination. For this purpose, a “specified employee” means a person who earns more than $130,000 from a publicly traded corporation, owns at least 5% of the equity of such corporation, or owns at least 1% of the equity and earns more than $150,000.61
Disability or Death For Sec. 409A purposes, a disabled person means one who is unable to engage in any “substantial gainful activity” from a medically determinable physical or mental impairment that can be expected to result in death or to last for a continuous period of at least 12 months.62 The proposed regulations also allow the use of a determination by the Social Security Administration of total disability for this purpose.63
Specific Time or Times Scheduled in Advance To comply with Sec. 409A, the specific time or schedule of times must be fixed and objectively determinable at the time of the original deferral of compensation, under Prop. Regs. Sec. 1.409A-3(g)(1). This schedule may be triggered by the occurrence of an event that has the effect of eliminating a substantial risk of forfeiture.
Change of Control The continued ability to use a change of control of a corporate service recipient as a distribution trigger is one of the few bright spots for planners of deferred compensation arrangements. For Sec. 409A purposes, a change of control is a change of more than 50% of the equity of a corporation. Also, there may be a change in “effective” control when a person or group acquires at least 35% of the corporation’s equity or effects a replacement of a majority of the board of directors. Moreover, there is an ownership change of a “substantial portion” of a corporation’s assets when at least 40% of the corporation’s gross market value is acquired by a person or group.64 Finally, the proposed regulations address the specific issue of deferred payments to certain key executives of a target company as part of an acquisition of the target’s stock, when those payments are conditioned on future performance of the target or its assets. Basically, such arrangements are deemed to fall within the permitted arrangements of Sec. 409A, as long as the terms and conditions of the deferred payment are the same as those for the target’s nonemployee-stockholders.65 However, it is not clear how the employee-stockholders could take advantage of this rule if there are no nonemployee-stockholders.
Unforeseeable Emergencies This saving provision seems reasonable on its face; one merely has to determine which emergencies are foreseeable and which are unforeseeable and whether such expenses can be reasonably covered by other assets. Under Prop. Regs. Sec. 1.409A-3(g)(3), unanticipated medical and drug costs not covered by insurance are unforeseeable. Funeral expenses of a dependent are treated as unforeseeable. College expenses for a child are, however, foreseeable. All of these examples are, of necessity, unclear; the result will depend on the specific facts and circumstances.
Acceleration of Distributions Under Sec. 409A, Treasury has blanket authority to determine which types of accelerated distributions are permitted and which are not. Generally under Prop. Regs. Sec. 1.409A-3(h), the inclusion in any plan of an acceleration provision is prohibited, except for the following:
Areas Not Yet Addressed Currently, Treasury is working on further guidance for compliance with Sec. 409A and has asked for comments on regulation of a few specific areas, including:
This list, of course, is not comprehensive, nor is Treasury bound by any limits on the areas in which it will provide new or amended regulations.
Housekeeping and Planning Cleaning Up Existing Plans Bearing in mind the range of arrangements that are considered “plans” for Sec. 409A purposes, a practitioner’s first step should be to make an inventory of everything that could be regulated, including all types of compensation agreements, retirement arrangements, employment agreements, noncompetition agreements, equity-participation agreements and severance agreements. The second step is to determine when changes have to be made to get the plan into compliance prospectively. The third step is to decide whether to make the changes in the existing arrangements or to seal off those arrangements and draft new ones.
Auditing and Updating All Records and Recordkeeping Because of the far greater risks and difficulty of complying with the new rules, practitioners should take particular care to ensure that the company knows at any given time how much is being paid or accrued for services of all kinds. Every bank account and escrow and trust arrangement must be checked regularly.
Inspecting Agreements for Presence of Compensation Deferral Every agreement entered into by a business that involves, even indirectly, compensation for services must be examined for compliance with Sec. 409A. This includes not only agreements formally designated as such, but also all agreements for the sale of goods that contain a service element and, most importantly, any formal corporate resolutions or informal writings that could constitute compensation agreements.
Revising Tax Due Diligence Checklist for Potential Acquisitions Every adjustment and test check made for the company should be reflected in a concomitant change to the company’s (or practitioner’s) standard request list for due diligence information in the circumstance of a potential acquisition of another company.
Conclusion The proposed regulations have answered a few questions, raised some new ones and require educated guesses on the treatment of different types of transactions. In addition, because Sec. 409A’s scope covers virtually every type of deferred compensation, tax advisers can reasonably conclude that knowledge of the rules will be required, and uncertainty will continue, for the foreseeable future |
