On February 8, 2007, the Internal Revenue Service ("IRS") issued Announcement 2007-18 (the "Announcement")1 announcing a compliance resolution program (the "Program") that permits employers to pay the additional taxes arising under Section 409A of the Internal Revenue Code (the "Code") due to the exercise in 2006 of certain stock options and stock appreciation rights ("Stock Rights"). As will be discussed later in this Alert , the Announcement requires that the maximum amount of potential tax under Section 409A be paid to participate in the Program. In essence, the Program places the burden on the employer to pay the additional Section 409A taxes for the rank-and-file employees covered by the Program. By centralizing the collection of such taxes for those companies participating in the Program, the work of the IRS is significantly lessened. As is discussed below, however, participation in the Program will provide little or no benefit to many employers.
Section 409A generally
Section 885 of the American Jobs Creation Act of 2004 added Section 409A to the Code. Section 409A generally provides that, unless certain requirements2 are met, amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. Nonqualified deferred compensation plans that fail to comply with the requirements of Section 409A also subject the employee3 to a 20% additional tax on the "amount includible in income," in addition to regular income and employment taxes, plus a second additional tax4 equal to the interest on unpaid taxes from the year of initial deferral (or if later, the first year the deferred amount was not subject to a substantial risk of forfeiture), calculated at the underpayment rate plus 1%.
Application of Section 409A to discounted options
As we mentioned in prior Cooley Alerts,5 under Section 409A, any Stock Right having an exercise price or base price less than the fair market value of the underlying stock determined as of the grant date constitutes a deferred compensation arrangement. Many companies have determined or are in the process of determining that for financial statement purposes, some stock options have an exercise price that was less than the fair market value of the stock on the measurement date determined under GAAP. (We refer to such Stock Rights as "Discounted Options"6 in this Alert .) Because most Discounted Options do not comply with the strict distribution requirements under Section 409A, if the Discounted Option were to be deemed to have an exercise price that is less than the fair market value of the stock on the grant date for tax purposes, the holder of a Discounted Option would be potentially subject to 409A’s adverse tax treatment. However, the following Discounted Options (or applicable portion of such options) are generally not subject to adverse taxation under Section 409A:
- Options that were vested by December 31, 2004.
- Options that were exercised by December 31, 2005.
- Options that were "cured" of their Section 409A taint prior to being exercised.7
- Options that were exercised in good faith compliance with Section 409A.
Options that have an exercise price at least equal to the fair market value of the stock on the grant date of the option for tax purposes.
It is possible that some exercises of Discounted Options in 2006 qualify for none of the above exceptions to the application of adverse treatment under Section 409A ("Tainted 2006 Exercises") such that the employee will be liable for the additional Section 409A taxes with respect to Tainted 2006 Exercises.8
According to the Announcement, the IRS recognizes that many "rank-and-file employees" had Tainted 2006 Exercises without knowing (and without reason to believe) that the Stock Rights were actually Discounted Options subject to Section 409A. Even though it may be unfair to impose 409A’s adverse tax treatment on innocent employees, the Program does NOT reduce or abate the tax. Rather, the Program permits an employer to pay the additional taxes arising under Section 409A resulting from the exercise in calendar year 2006 of Discounted Options, when the exercise occurred in calendar year 2006. In addition, the Program permits an employer to avoid certain tax reporting requirements associated with the Tainted 2006 Exercises and allows the Section 409A taxes to be paid as late as June 30, 2007 rather than their normal due date, April 17, 2007.
1. Reporting. If an employer complies fully with the requirements of the Program (the "Program Requirements"), the employer will not be required to include the Section 409A inclusion amount with respect to the employees’ Tainted 2006 Exercises on the Form W-2 or on a corrected Form W-2 (i.e., Form W-2c) for 2006.9
View a description of the Program Requirements.
2. No Section 409A tax payments by the employee. If an employer complies fully with the Program Requirements, the employee will not be required to pay the Section 409A taxes on the employee’s Federal income tax return for 2006 with respect to the employee’s Tainted 2006 Exercises.
3. Employer payments treated as taxable compensation to employees. The payment of the Section 409A taxes due as part of the Program constitutes additional compensation income to the employee in the year paid.10 Such payments also constitute "wages" for Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and Federal income tax withholding purposes.
4. Not available for Section 16 persons. The Program is not available with respect to Tainted 2006 Exercises by an employee who is either (a) subject to the reporting requirements of Section 16 as of the date the employer provides the required notice or (b) who was subject to such reporting requirements on the date of grant of such Stock Right.
5. Relief for employer’s failure to comply with the program. An employee who receives the required notice from the employer (as described in the Announcement), and who either files a return or requests an extension of time to file a return, and who files a timely amended return or a return on extension after learning that he or she is not relieved of the duty to report and pay Section 409A taxes due to a failure by the employer to comply with the requirements for relief set forth in the Announcement, will be relieved from penalties11 for the failure to pay Section 409A taxes by April 17, 2007 arising from the Tainted 2006 Exercises, provided such Section 409A taxes are paid with the amended or filed return.
6. Caution. The Program only applies to Federal tax payment and reporting requirements. It is too soon to know what effect the Announcement will have on potential state tax payment and reporting requirements and securities law requirements.
What are the benefits and drawbacks of participation in the program?
As noted above, when one looks at both the employer taxes and the employee taxes, there is no net tax savings from participation in the Program, other than a slight delay in the due date for the payment of the Section 409A taxes. There is, however, a shifting of the burden of compliance from the employee to the employer. Furthermore, a participating employer is forced to expose any potential issues to the IRS, whether or not the employer believes that it has a reasonable position with respect to certain Tainted 2006 Exercises that no Section 409A taxes are due. We offer the included flow-chart below for consideration by an employer trying to decide whether or not to participate in the Program.
Alternative to participation in the program
In general, the effect of the Program can be achieved without participating in it, as follows:12
1. Payment of make-up bonuses. The employer pays cash bonuses to the employees to partially or fully offset the Section 409A tax cost to the affected employees resulting from Tainted 2006 Exercises. The employer maintains complete flexibility to determine the amount of any such bonuses and the recipients of such bonuses. In general, the employer would want to make such bonus payments before April 17, 2007 so that the employee would have the cash to pay the added taxes on April 17, 2007. Under the Program, the payments by the company could be delayed until June 30, 2007.
2. Reporting. If the applicable Form W-2s for 2006 did not report the Section 409A income associated with Tainted 2006 Exercises, then the employer files with the IRS and provides to the affected employees corrected Form W-2s on Form W-2c.
3. Available for Section 16 persons. While the Program is not available to Section 16 persons, the alternative to the Program could include Section 16 persons.
4. Make-up bonus treated as taxable compensation to employees. As noted above, the payments by the company of the employee’s 409A taxes is taxable compensation for the employee for 2007. Thus, the payment of cash bonuses has much of the same tax consequences for the employee as the employee would recognize under the Program.
5. No program requirements. No compliance with the Program is required.
1 The Announcement may be found at www.irs.gov/pub/irs-drop/a-07-18.pdf
2These include strict timing requirements relating to deferral elections and distribution alternatives, plus documentary requirements.
3 Note that these rules also apply to non-employee directors and independent contractors. References in this Alert to "employees" also include such non-employee directors and independent contractors.
4 This additional tax is pursuant to Code Section 409A(a)(1)(B)(ii).
6 Please note that Stock Rights may be subject to Section 409A for reasons other than being granted at a discount, such as: (1) a Stock Right that was with respect to stock that did not qualify as "service recipient stock" under 409A (e.g., nonstatutory stock options on preferred stock), and (2) a Stock Right that had been modified in a way that resulted in a Section 409A violation (e.g., extension of the post-termination exercise period beyond the period permitted under the Proposed Regulations). The Alert deals only with Discounted Options.
7 As stated in a prior Alert, Notice 2006-79 permits the employer to substitute for a Discounted Option a Stock Right that is not subject to Section 409A. In the case of Discounted Options granted to an employee who was subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934 ("Section 16") on the date of grant of the Discounted Option, the substitution was required to be completed by December 31, 2006. For other employees, the substitution must be completed by December 31, 2007. If the company and the employee utilize these corrective measures to exclude unexercised Stock Rights from coverage under Section 409A, then the amount is treated as always having been excluded from coverage under Section 409A.
8 Under Notice 2006-100, the "amount includible in income" as a result of a violation of Section 409A generally is determined as of December 31 of each year and, for Discounted Options, the amount includible equals the fair market value of the underlying stock as of December 31 less the sum of the exercise price and any amount paid for the Discounted Option. See Notice 2006-100. For Discounted Options exercised in 2006, the amount includible in income equals the excess of the fair market value of the stock on the date of exercise over the sum of the exercise price paid by the employee and any other amount paid by the employee for the Stock Right. See Announcement 2007-18, Section 4, C, ii, b.
9 The employer would normally be required to report the income associated with Tainted 2006 Exercises in box 12 of Form W-2 using code Z. If an employer has already properly reported such amount, the employer may provide a Form W-2c that does not report the Section 409A inclusion amount in box 12 of Form W-2c using Code Z, and such employer will not be subject to any penalties under Section 6721 or Section 6722 of the Code.
10 To comply with the Program Requirements, the employer must represent under penalty of perjury that the employer is treating such payment as additional compensation to the employee for the calendar year 2007.
11 Specifically, the relief is from penalties under Code Sections 6651(a)(2) and 6654, as applicable.
12 Note that this alternative only addresses the Federal tax payment and reporting requirements and does not address the impact the alternative may have on potential state tax payment and reporting requirements or other securities laws requirements.
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.