This installment of the Mintz Levin Deferred Compensation Advisory Series focuses on what equity compensation arrangements are exempt from the deferred compensation rules of § 409A of the Internal Revenue Code of 1986 (the "Code"). As more fully described in our prior client advisories on deferred compensation, Code §409A was enacted under the American Jobs Creation Act of 2004, and it changed several tax rules governing deferred compensation. The enactment of Code § 409A has been followed by the issuance of interpretative guidance from the IRS and Treasury in the form of Notice 2005-1, issued in December 2004, and a set of proposed Treasury regulations (the "Proposed Rule"), issued in September 2005.

Notice 2005-1 provides that stock options, stock appreciation rights and other equity-based compensation will not be treated as deferred compensation subject to Code § 409A as long as such stock rights meet certain requirements. The Proposed Rule fleshes out many details of the equity compensation rules set out in Notice 2005-1,
and in some cases relaxes some of the limitations, particularly with respect to the treatment of stock appreciation rights, as described below. While the Proposed Rule does not yet have the force and effect of law, compliance with the Proposed Rule will be deemed to be "good faith compliance" with Code § 409A.

Sponsoring employers and recipients of equity compensation should take immediate notice of these deferred compensation rules so that they can determine whether or not their equity arrangements are subject to Code § 409A, and if so, what they should do about it.

Stock Options

Notice 2005-1 and the Proposed Rule provide that an option to purchase "service recipient stock" (as discussed below) shall not be treated as deferred compensation subject to Code § 409A if:

  • the option is granted at fair market value;
  • the number of shares subject to the option is fixed on the date of grant; and
  • the option does not include any deferral feature which delays the recognition of income beyond the date of exercise or disposition, or the date the stock acquired upon the exercise of the option first becomes substantially vested.

Notice 2005-1 and the Proposed Rule both specifically exempt "incentive stock options" granted under Code § 422 and options granted under an employee stock purchase plan described under Code § 423 from treatment as deferred compensation subject to Code §409A

NOTE
If an option is deemed to be deferred compensation, then in order to comply with the requirements of Code § 409A, the option must be structured to be exercisable only upon the occurrence of a permitted distribution event under Code § 409A, including a specified time or fixed schedule, separation of service, death, disability, a change in control or an unforeseeable emergency. This structure differs dramatically from a standard option where the option holder has discretion to exercise the option when he or she believes it to be the most economically advantageous time to do so. In addition, to be compliant with Code § 409A, if the option holder wishes to further delay an exercise date, the option holder must make the election to further defer at least 366 days in advance of the exercise date and the election to defer must be for at least 5 years.

Stock Appreciation Rights (SARs)

Notice 2005-1 provides that the only SARs exempted from the requirements of Code § 409A are SARs that are issued by publicly-traded corporations and are settled in the service recipient’s stock. The Proposed Rule dispenses with these limitations, and instead treats SARs similarly to stock options. Accordingly, the Proposed Rule provides that a SAR shall not be treated as deferred compensation subject to Code § 409A if:

  • the compensation payable upon the exercise of a SAR (whether in cash or service recipient stock) is not greater than the difference between the fair market value of the stock on the date of grant and the fair market value of the stock on the date of exercise with respect to the number of shares granted;
  • the SAR is granted with an exercise price that is at least fair market value on the date of grant; and
    • the SAR does not include any deferral feature which delays the recognition of income beyond the date of exercise.

    NOTE
    If a SAR is deemed to be deferred compensation, then in order to comply with the requirements of Code § 409A, the SAR must be structured much like a Code § 409A-covered option (as discussed above).

    Restricted Stock

    Notice 2005-1 and the Proposed Rule provide that restricted stock is generally not treated as deferred compensation. In contrast, the promise in one year to receive stock (whether or not the stock is restricted) in a future year may be considered deferred compensation subject to Code § 409A. However, the Proposed Rule provides that where a promise to transfer restricted stock and the right to retain the restricted stock are both subject to a substantial risk of forfeiture, the arrangement would generally satisfy the "short-term deferral rule" (i.e., payment of compensation within 2 ½ months following the end of the year in which the compensation is no longer subject to a substantial risk of forfeiture is not treated as deferred compensation) because payment would occur at the same time as the vesting of the right to the stock. For example, where an employee participates in a 2-year bonus program, such that if the employee continues in employment for 2 years, the employee is entitled to either an immediate $10,000 cash bonus or the grant of restricted stock with a $15,000 fair market value subject to an additional 3-year vesting requirement, the arrangement would constitute a short-term deferral because under either alternative, the payment would be received within the short-term deferral period.

    Dividends

    Under the Proposed Rule, if an option or SAR provides for the right to receive, on the date of exercise, an amount equal to all or part of the dividends declared and paid on the service recipient stock from the date of grant to the date of exercise, the right will have the effect of offsetting the exercise price of the option, or increasing the amount payable under a SAR. As a result, the option or SAR would be subject to the requirements of Code § 409A. However, if the right to receive dividends declared and paid on the underlying service recipient stock is explicitly set forth in a separate plan or arrangement, then while the separate plan or arrangement may be treated as a deferred compensation plan itself, the option or SAR will remain exempt from the requirements of Code § 409A.

    Service Recipient Stock

    In order to be exempted from the requirements of Code § 409A, an option or SAR must be granted with respect to "service recipient stock." The Proposed Rule provides that service recipient stock is limited to the common stock of a service recipient that is publicly-traded on an established securities market, or if not publicly-traded, then common stock that represents the class of outstanding common stock with the highest aggregate value (without regard to differences in voting rights). Service recipient stock may not include any stock (i) that includes any preferences as to liquidation or dividend rights or (ii) that is subject to a mandatory repurchase obligation or a put or call right that does not lapse and is based on a value other than the fair market value of the stock. American depositary receipts can also qualify as service recipient stock.

    NOTE
    As discussed below, options and SARs granted on or before October 3, 2004 that were vested before January 1, 2005 are "grandfathered" and are exempt from the requirements of Code § 409A (as long as they are not modified after October 3, 2004). However, even if not grandfathered, for options and SARs that were granted, but were not vested, before January 1, 2005, any class of common stock with respect to which the options or SARs were granted will be treated as "service recipient stock."

    The Proposed Rule also makes clear who is considered to be a "service recipient" for purposes granting options or SARs that are exempt from the requirements of Code § 409A. A service recipient includes the company for whom the services are provided and the members of the company’s tax controlled group (e.g., parent company, subsidiaries, and certain other affiliates), except for these purposes, a service recipient will be deemed a member of a company’s tax-controlled group if the common ownership between the members is at least 50%, instead of 80% (the normal common ownership threshold for members of a tax-controlled group). In addition, in limited circumstances, the common ownership threshold may be as low as 20% where the grant of a stock right from a company to a service provider is based on legitimate business criteria. For example, a grant of a stock right by a company to one of its former employees who is providing services to a joint venture in which the company owns at least 20% would be treated as "service recipient stock" for these purposes.

    NOTE
    In order for these lower thresholds (
    i.e., 50% and 20%) to be applicable, the stock right, or the plan or arrangement under which the stock right is granted, must specify that the lower thresholds shall apply for purposes of determining the members of a company’s tax-controlled group.

    The Proposed Rule also makes clear that when the stock underlying a stock right is substituted or assumed in connection with a corporate transaction, it will be treated as service recipient stock for purposes of replacement stock rights.

    Despite the foregoing rules, the stock of a company whose primary purpose is to serve as an investment vehicle with respect to the company’s interests in other entities shall not be deemed to be "service recipient stock," except as to stock rights granted to the company’s direct service providers.

    Fair Market Value

    Stock options and SARs may be exempt from Code § 409A only if they are granted at fair market value on the date of grant. For stock that is publicly-traded, fair market value may be determined on the basis of the last sale price before or the first sale price after the grant, the closing price on the date of grant or the immediately preceding trading day, or any other reasonable basis using actual transactions in the stock in the applicable securities market. It is also permissible to utilize an average selling price over a specified period within 30 days before or 30 days after the date of grant, provided (i) the commitment to grant the option or SAR based on such value must be irrevocable before the start of the specified period, and (ii) such valuation method must be consistently used for all grants under the same and similar programs.

    For stock that is not publicly-traded, fair market value may be determined by applying a reasonable valuation method, including the use of economic factors such as the present value of future cash flows, the market value of comparable businesses, the value of the company’s assets, and consideration of control premiums and minority discounts, etc. A valuation method will not be deemed reasonable unless all available information material to the corporation is considered and the valuation being used is not more than 12 months old. The Proposed Rule also provides for certain safe-harbor valuation methods for stock that is not publicly-traded, which methods will be presumed to be reasonable unless the IRS establishes that the valuation was grossly unreasonable. The safe-harbor valuation methods include:

    • a valuation by an independent appraisal that meets certain statutory standards required by the Code, and such appraisal is not completed more than 12 months prior to the date of grant;
    • a valuation formula that is used for all compensatory and non-compensatory valuations of the stock, including regulatory filings, loan covenants and other third party issuances and repurchases of stock; and
    • for an illiquid stock which is not subject to a put or call right or obligation that does not lapse (other than a right of first refusal) and is issued by a start-up corporation that has conducted business for less than 10 years, a written valuation report based on reasonable economic factors (as addressed above) and prepared by a person with significant knowledge and experience or training in performing similar valuations. Note, however, this valuation method will not be deemed reasonable if a change in control or an initial public offering of the stock is reasonably anticipated to occur within 12 months following the date that the valuation is being used.

    Modifications

    The Proposed Rule provides that any modification of an existing stock right will be deemed to be a grant of a new stock right, and the new grant may or may not be deemed deferred compensation, depending on whether or not its meets the exemption requirements described elsewhere in this advisory, including, among others, whether the new stock right is granted at fair market value.

    A modification of a stock right is any change in the terms of the stock right that results in a direct or indirect reduction in the exercise price, an additional deferral feature, or an increase in the value of the underlying stock, regardless of whether the holder actually benefits from the change in terms.

    The Proposed Rule provides that the following changes to a stock right will not be deemed to be a modification:

    • the shortening of the period during which a stock right can be exercised;
    • the inclusion of a provision that permits the use of previously acquired stock to pay the exercise price;
    • the inclusion of a provision that permits of use of shares to satisfy withholding requirements;
    • the acceleration of the vesting and exercisability of a stock right that is not subject to Code §409A;
    • the proportionate adjustment to the exercise price and the number of shares subject to a stock right to reflect a stock split or a stock dividend; and
    • the grantor’s exercise of discretion reserved under the stock right with respect to the transferability of the stock right.

    The Proposed Rule distinguishes between a "modification" and an "extension." The extension of the exercise period of a stock right is treated as having had an additional deferral feature from the date of grant, and as a result, the stock right would become subject to the requirements of Code § 409A. However, there is an exception to this general rule, which provides that an extension will not be treated as an additional deferral feature (subjecting the stock right to Code § 409A) if the extension does not go beyond the later of 2 ½ months following the date on which the stock right would have otherwise expired, or December 31st of the year in which the stock right would have otherwise expired.

    NOTE
    The modification and extension provisions in the Proposed Rule contain some ambiguities which can sometimes make it difficult to determine whether certain changes to an option would turn the option into a Code
    § 409A-covered option. Many in the tax community are expecting that the ambiguities will be corrected when the Treasury regulations are finalized.

    The Proposed Rule also provides that the substitution or assumption of a stock right in connection with a corporate transaction will generally not be treated as a new grant if the ratio of the exercise price to the fair market value of the stock after the substitution or assumption is not greater than the ratio of the exercise price to the fair market value of the stock before the substitution or assumption.

    For any stock right that is inadvertently modified or extended in such a manner that would otherwise cause the stock right to become covered by Code § 409A, the Proposed Rule provides that if the change is rescinded by the earlier of the date the stock right is exercised or the last day of the year in which the change is made, then the (rescinded) change will not be treated as a modification or extension of the stock right for purposes of Code § 409A.

    Grandfathered Stock Rights

    Stock rights that vested before January 1, 2005 are generally exempt from the requirements of Code § 409A so long as they were neither initially granted nor materially modified after October 3, 2004. It may be possible, however, to demonstrate that stock rights granted after October 3, 2004 that vested before January 1, 2005 are exempt from the requirements of Code § 409A if made as part of a historical pattern or practice of the issuer.

    Take Immediate Action

    If a stock right is subject to, but fails to satisfy, the requirements of Code § 409A, then the stock right may be subject to income tax on the date the stock right vests, plus a 20% excise tax and interest penalties. In light of these adverse tax consequences, sponsoring employers and recipients of equity compensation should review the terms of all their equity compensation plans and arrangements to determine whether or not they are exempt from the deferred compensation rules of Code § 409A.

    To the extent any such plans or arrangements are not exempt from Code § 409A, in order to avoid being subject to the requirements of Code § 409A altogether, employers have until December 31, 2005 to terminate such plans or arrangements, and recipients have until December 31, 2005 to exercise any such stock options and/or SARs.

    Any such plans or arrangements that are not terminated and/or exercised by the end of 2005 will be left with only two choices in order to avoid the penalties associated with not complying with Code §409A, including:

    1. Substitution. The Code §409A transition rules under Notice 2005-1 and the Proposed Rule provide that stock rights that are subject to Code §409A can be replaced with stock rights that are exempt from Code §409A before the end of 2006, as long as such replacement does not result in the exchange of cash or vested property in 2006.
    2. Amendment. Otherwise, the plans and arrangements will need to be amended by the end of 2006 to comply with the requirements of Code §409A.

    The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.