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Section
409A Compliance:
Equity Compensation
(March
6, 2006)
Stock Options and Stock Appreciation Rights
Restricted Stock and Other Types of Equity
Compensation
Final Thoughts
When reading Internal Revenue Code Section 409A, the proposed
regulations and the many articles published on the subject, one gets the
impression that the new deferred compensation rules apply to every
possible form of compensation and benefits a company might want to
provide for its employees and other service providers. This isn’t quite
the case, but it is clear that the new rules have an extraordinary
reach, far beyond what traditionally has been considered “deferred
compensation”. Even equity compensation is potentially subject to
Section 409A. In this alert, the last in our series regarding Section
409A compliance and the Treasury Department’s proposed regulations
published last fall, we will discuss the application of the new rules to
stock options and other forms of equity compensation.
As
it is defined under Section 409A, “deferred
compensation” includes stock options and stock appreciation rights (SARs).
Stock options and SARs would not work very well if they had to comply
with Section 409A, and fortunately the initial IRS guidance issued in
December of 2004 exempted from Section 409A non-discounted options, as
well as certain non-discounted SARs issued by public corporations. The
proposed regulations extend this relief to non-discounted SARs issued by
all corporations.
Under the proposed regulations, stock options and SARs must satisfy
three conditions to be exempt from Section 409A:
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The
exercise price for the option or the base price for the SAR can
never be less than the fair market value of the underlying stock
as of the date of grant. In effect, this means the award cannot
have special features (e.g. dividend equivalents) tied to
exercise of the award because the IRS treats such features as a
discount on the exercise price.
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The
option or SAR cannot have any features that would defer taxation
beyond the exercise date, other than a vesting schedule applicable
to the stock received upon exercise. Note that the favorable tax
attributes or incentive stock options are not considered deferral
features that would violate this rule.
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The
underlying stock must be common stock of the employer or of a
closely affiliated entity. If the underlying stock is not publicly
traded, the common stock must represent the highest value class of
the corporation’s stock, disregarding differences in voting rights,
and the stock cannot have dividend or liquidation preferences or
other features such as repurchase obligations based on a value other
than fair market value.
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Valuation
The valuation of the underlying stock is critically important. If the
issuer has designed the award to qualify for the exemption but the stock
is undervalued, the exercise or base price will be less than the stock’s
fair market value and the stock option or SAR will be considered a
discounted award. In that case, the award would be immediately taxable
under Section 409A (unless it was designed to comply with the Section
409A deferral and distribution rules). The award recipient would be
required to report the amount of the discount as ordinary income when
the award vests, and the income would also be subject to the 20%
additional tax and an interest penalty. The award recipient may be
taxed in the same way in every subsequent year on any increase in the
spread between the exercise price and the underlying stock’s fair market
value. To avoid these severe tax consequences, the fair market value of
the stock must be determined accurately.
If
the stock is readily tradable on an established securities
market, determining the fair market value of the underlying stock is
easy. The proposed regulations allow the use of several different
valuation approaches based on the stock’s trading price at the time the
option or SAR is granted.
Determining fair market value for stock that is not readily tradable is
more challenging. In essence, the proposed regulations provide that
fair market value may be determined by the reasonable application of a
reasonable valuation method that takes into account all available,
material information. This is a fairly vague standard considering the
potential taxes at stake, and fortunately the proposed regulations
provide three safe harbor valuation methods. Any of these methods will
be presumed to result in reasonable valuations unless the IRS can
establish that use of a particular method was grossly unreasonable under
the circumstances.
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Modification
A
stock option or SAR that otherwise qualifies for the exemption from
Section 409A can lose its exemption if it is modified in certain ways.
According to the proposed regulations, a modification will cause the
option or SAR to be treated as a “new grant” if it provides the holder
with (a) a direct or indirect reduction in the exercise price, (b) a
deferral feature, or (c) an extension or renewal of the term, subject to
the special rule on extensions discussed below. The “new grant” will be
considered a discounted option or SAR (and as described above will be
immediately subject to tax under Section 409A) if at the time of the
modification the fair market value of the underlying stock exceeds the
option exercise or SAR base price.
Probably the most controversial provision in the proposed regulations
deals with extensions of stock options and SARs. As a general rule, the
proposed regulations provide that the extension of the exercise period
will cause the option or SAR to be treated as deferred compensation
subject to Section 409A, retroactive to the original date of grant.
The regulations impose this result even if the option or SAR is “under
water” at the time of the extension. The proposed regulations carve out
a very limited exception for certain extensions of a relatively short
duration. The extension cannot go beyond the end of the calendar year
in which the grant would have otherwise expired, or if later the 15th
day of the third month following the normal expiration date.
Unfortunately, this exception does not go far enough to accommodate
common practices, such as the extension of options and SARs following
involuntary termination of employment.
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Transition Opportunities for Discounted Grants
If
a discounted stock option or SAR is not eligible for “grandfathered”
status under Section 409A (i.e., it was not vested as of December 31,
2004), it can be brought into compliance under the transition rules. If
it was exercised or cancelled in 2005, the option or SAR will be deemed
to have been cured. Otherwise, the option or SAR must be amended by no
later than December 31, 2006, either to comply with the Section 409A
rules or to qualify for the exemption. To qualify for the exemption,
the option’s exercise price or the SAR’s base price must be adjusted to
equal or exceed the fair market value of the underlying stock as of
the original date of grant. Subject to certain restrictions, the
proposed regulations allow the option or SAR holder to be compensated
for the lost discount. However, the compensation cannot be paid or
become vested in 2006.
The proposed regulations make it clear that the issuance of
restricted stock is not subject to Section 409A, even if the value of
the restricted stock will be excluded from the recipient’s income until
a later year under the Section 83 rules (absent an 83(b) election).
While a promise to transfer restricted stock in a future year may
be subject to Section 409A, the arrangement can be designed to satisfy
the short-term deferral
rule. If both the promise to transfer the restricted stock and the
right to retain the stock are subject to a substantial
risk of
forfeiture, the arrangement will qualify as a short-term deferral
and will not have to satisfy the Section 409A rules.
Most other forms of equity compensation (including phantom stock and
restricted stock units) will be subject to Section 409A and generally
must satisfy the rules on timing of
deferral elections,
timing of distributions,
and
acceleration of benefits, unless the arrangement fits within the
short-term deferral rule. For example, under a phantom stock plan (a)
the time and form of payment must be fixed at the time the phantom stock
is awarded, (b) payment can be made only upon one of the permitted
Section 409A distribution
events, (c) payment generally cannot be accelerated, and (d) if the
recipient is a key employee of a public company payment following
separation from service may not commence until six months after separation.
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The Treasury Department and
IRS are currently working on finalizing regulations under Section 409A.
They have received a significant number of public comments on the
proposed regulations, including many requests to reconsider some of the
proposed rules on stock options and other forms of equity compensation.
However, it is not clear how the Treasury Department and IRS will
respond or when they might issue final regulations or other definitive
guidance. We will be monitoring the government’s progress and will
publish future alerts as warranted.
If you have any questions
regarding this alert or other Employee Benefits Law related issues, please
contact one of our Employee
Benefits attorneys.
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