United States: Effect Of Final Code Section 409a Regulations On Equity Plans

Article by Jane Jeffries Jones and Bryan Tyson

Several weeks ago, the IRS and the Treasury Department issued much-anticipated final regulations¹ under Section 409A of the Internal Revenue Code of 1986, as amended (the "Code"), regarding the taxation of any plan or arrangement deemed to involve "deferred compensation." As a result, every employer should assess the impact of the final regulations not only on any traditional deferred compensation arrangements, but also on other compensatory arrangements, including equity-based plans and arrangements, since all such plans must be in documentary compliance with Section 409A by December 31, 2007. This client alert highlights key provisions of the Section 409A final regulations that impact equity-based plans.

Section 409A, which was enacted as part of the American Jobs Creation Act of 2004, establishes a new federal income taxation scheme for any plan or arrangement deemed to involve "deferred compensation." Section 409A may apply to many types of equity-based awards, including certain types of stock options, stock appreciation rights ("SARs"), restricted stock awards, restricted stock units, performance awards and phantom stock awards, and will have a significant impact on the design and operation of many types of equity arrangements. Section 409A applies to plans for not only employees, but also for directors, consultants and independent contractors, and applies to both public and private companies² (as well as any other business form), regardless of their size or the number of employees. The legislation applies to deferrals made after December 31, 2004. Deferrals before this time are not covered, as long as the awards were vested and earned on or before December 31, 2004 and as long as the plan or arrangement is not materially modified after October 3, 2004. Although, as noted above, companies have until December 31, 2007 to amend their plans and arrangements to comply with Section 409A, good faith operational compliance was required beginning January 1, 2005.

If compensation is considered deferred under an arrangement subject to Section 409A, it may not be distributed earlier than the following events: (i) separation from service (with "key employees" in publicly traded companies being subject to an additional six-month waiting period following separation); (ii) disability; (iii) death; (iv) a specified time (but not a specified event, such as purchase of a principal residence or a child attending college) or pursuant to a fixed schedule; (v) a change in ownership or effective control of the employer or in the ownership of a substantial portion of the employer's assets (as those terms are defined in the final regulations); or (vi) occurrence of an unforeseeable emergency. Awards covered by Section 409A also are subject to restrictions on acceleration.

Failure to satisfy Section 409A either in form or operation results in all compensation deferred under the plan for the current year and all preceding years (including earnings) being immediately includible in the participant's gross income to the extent vested. In addition, other related plans may also be considered in violation of Section 409A in certain circumstances. Interest also applies to all amounts previously deferred. A 20% excise tax applies to all amounts included in income. Only those plan participants with respect to whom the failure relates are subject to the tax treatment and penalties described above.

Given the complexity involved in complying with Section 409A, many employers have attempted to structure their equity plans so that they can rely on one of several exemptions from Section 409A. The final regulations continue to exempt certain types of equity awards from the reach of Section 409A. These include:

• Statutory options, such as incentive stock options ("ISOs") granted under Code Section 422, and purchase rights granted under a Code Section 423 employee stock purchase plan ("ESPP"), including discounted ESPP purchase rights. However, certain modifications to a statutory option may cause the option to become subject to Section 409A even if it initially was exempt from coverage, so employers must exercise caution when modifying option terms.

• Nonqualified stock options ("NQSOs") and SARs (collectively referred to as "stock rights" in the final regulations) granted with an option price or SAR "base" price that may never be less than the fair market value of the underlying common stock at the time of grant, as long as the number of shares subject to the stock right is fixed at the time of grant and the stock right provides for no further means of deferral other than timing of exercise (or disposition) of the award. (In addition, with respect to SARs, the amount payable cannot be greater than the spread between the fair market value of the stock at exercise and the SAR base price.) Discounted options and discounted SARs are subject to the provisions of Section 409A -- including distribution only upon the occurrence of one of the six triggers described above -- unless protected under certain grandfather provisions applicable to awards vested and earned as of December 31, 2004.

• Restricted stock awards, as long as the award does not permit any deferrals (other than deferrals of income based on the vesting schedule). However, a promise to transfer property (for instance, pursuant to a restricted stock unit) may be subject to Section 409A unless distribution of the stock or cash subject to the award occurs within a specific short-term deferral period permitted under Section 409A (described below).

As noted above, Section 409A and related guidance exempt "fair market value" options³ and SARs from Section 409A coverage. However, because of the new valuation burdens imposed by Section 409A, it is more critical than ever for companies to carefully establish -- and document -- that the option price or SAR base price is at least equal to the fair market value of the underlying stock. In order for the fair market value exclusion to apply, the stock right must specify that the exercise price (that is, the option price of an option or base price of an SAR) may never be less than the fair market value of the underlying stock on the grant date. The final regulations clarify some of the standards that apply in this context.4 Under the terms of the final regulations, the following principles apply:

• Publicly traded stock: Stock that is readily tradeable on an established securities market (that is, is regularly quoted by brokers or dealers making a market in the stock) can be valued based on the last sale before or first sale after grant, the closing price on the trading day before or trading day of grant, an average price over a specified time period within 30 days before or after grant (subject to certain new restrictions) "or any other reasonable basis using actual transactions" in the stock as reported by the particular market.

• Private company stock: For companies whose stock is not readily tradeable on an established securities market, generally, a valuation must be based upon a reasonable application of a reasonable valuation method (based on the particular facts and circumstances as of the valuation date). The final regulations clarify that the use of an independent appraiser is not required to meet this standard (although, as discussed below, the use of an independent appraiser puts the burden on the IRS to prove that a valuation was not reasonable). The final regulations identify certain specific factors that will be taken into account in determining whether a valuation method is reasonable and also provide three safe harbor valuation methods, which, if one is met, establish a presumption that the award price equals the fair market value of the underlying stock. The specific factors include (as applicable):

• Value of tangible and intangible assets;

• Present value of anticipated future cash flows;

• Recent arm's length transactions involving the sale of the employer's stock/equity interests;

• Control premiums;

• Illiquidity discounts; and

• Whether the valuation method is used for other purposes that have a material economic effect on the corporation, its shareholders or creditors.

A valuation method is not considered reasonable if it does not take into consideration "all available information material to the value of the corporation," and a valuation previously calculated is not reasonable if it does not reflect information available after the date of the valuation that may materially affect the value of the corporation or if the valuation is more than 12 months old. In addition, the employer's consistent use of a valuation method of its stock or assets for other purposes (e.g., unrelated to participant compensation) also supports reasonableness.

• Safe Harbors: Besides the general valuation guidance described above, the final regulations provide three safe harbors, which, if one is met, establish a "presumption of reasonableness," i.e., that the fair market value standard was met. These safe harbors are as follows:

• Use of an independent appraisal not more than 12 months old that meets taxqualified employee stock ownership plan ("ESOP") valuation requirements;

• Formula price: Use of a valuation repurchase formula that would be treated as fair market value under Code Section 83, if the method is consistently used for compensatory and non-compensatory purposes (e.g., loan covenants, regulatory filings, etc.) in all stock transfer situations involving the company or a 10% or greater shareholder (other than arm's length transfers involving the sale of all or substantially all of the company's stock to an unrelated purchaser); and

• Reasonable and good faith valuations of the illiquid stock of a start-up company (one that is less than 10 years old and not publicly traded) if: (i) the valuation is documented in a written report that takes into account the factors described above; (ii) the stock generally is not subject to puts/calls; (iii) a change in control is not reasonably anticipated within 90 days after the valuation event (date of grant, exercise, etc.) and an IPO is not reasonably anticipated within the 180 days after the valuation event; and (iv) the company reasonably determines that the person (or persons) performing the valuation is qualified based on his (or their) significant knowledge, experience, education or training.⁵

• The final regulations clarify that consistent use of the same valuation method (for instance, when setting fair market value at the time of SAR or option grant vs. When establishing the fair market value at the time of SAR exercise or when stock acquired upon option exercise is repurchased) is not required, as long as each valuation method complies with the final regulations. However, once the exercise price has been set, it may not be changed by the retroactive use of another method. If the service recipient stock becomes publicly held, one of the valuation methods required for publicly traded stock must be used.

Even if the original stock option (whether an ISO or a NQSO) or SAR grant is exempt from Section 409A coverage, if the option/SAR is later modified, extended or renewed, the altered award may become subject to Section 409A. In that case, compliance with Section 409A may not be possible since many of the requirements would not have been met at the time of grant (e.g., if the original award or plan did not specify that distribution may occur only upon the Section 409A-permitted events), with the result potentially being immediate taxation and a tax penalty. Under the final regulations, the following general principles apply:

• Modifications: A "modification" is any change in the terms of a stock right that may give the holder a direct or indirect reduction in the option/base price, even if the holder does not in fact benefit from the changed terms. Any modification of a stock right is treated as the grant of a new stock right, which may or may not be exempt from Section 409A depending upon its terms (e.g., if the option price is below the fair market value of the stock at the time of the modification).

• For instance, a change in stock price (other than changes due to certain corporate transactions, a stock split, a stock dividend or a similar event) generally is a modification which results in a new grant. However, as noted above, the new grant may still be exempt from Section 409A if it qualifies to be excluded under Section 409A (that is, the new stock right is a "fair market value" award and does not permit deferrals). Likewise, if a stock right is amended to increase the number of shares subject to the stock right, the increase is not a modification but is instead treated as a new grant (which may be exempt from Section 409A under the fair market value exception, depending upon the circumstances).

• Under the final regulations, a modification does not include shortening the exercise period, a change in award terms to permit transfer of the stock right, or a change to permit payment by share delivery (pre-owned stock) or to have shares withheld to facilitate payment of the exercise price or of employment or withholding taxes. Similarly, acceleration of vesting is not a modification (although acceleration of the time of payment of an award that is subject to Section 409A may be prohibited). Also, a change to a stock right is not treated as a modification (or extension) if the change is rescinded by the earlier of the date of exercise or the last day of the participant's taxable year during which the change occurred.

• Extensions and renewals: An extension refers to giving the participant an additional period of time to exercise a stock right beyond its original terms, the conversion or exchange of a stock right for a legally binding right to compensation in a future taxable year, or adding other deferral features. If the original award did not comply with Section 409A (for instance, by permitting distributions only upon the six specified triggers), the award may be subject to immediate taxation under Section 409A at the time of the extension. Many companies have a practice of amending options to extend the option exercise period, for instance, at the time of a participant's termination of service or due to a corporate transaction. Under the proposed regulations, this practice often could have resulted in adverse tax consequences. Fortunately, the final regulations offer more flexibility. Under the final regulations:

• It is not an extension if the exercise period of a stock right is extended to a date no later than the earlier of the original maximum term or the 10th anniversary of the original grant date.

• An extension does not occur if the exercise period of a stock right is extended when the stock right is underwater (although such a change is treated as a modification).

• An extension does not occur if the expiration of the stock right is tolled while exercise would violate applicable laws or jeopardize the company's ability to continue as a going concern.

The final regulations clarify that substitution and assumption of stock options and SARs made pursuant to a corporate transaction and in accordance with certain tax regulations applicable to ISOs (Treas. Reg. Section 1.424-1) are generally exempt from Section 409A (i.e., are not treated as a new grant). In addition, the final regulations clarify that substitution of an option for an SAR, or vice versa (or the exercise of an SAR or option in a tandem grant), does not affect whether the arrangement is exempt from Section 409A if the stock rights are identical in all respects except for the medium of payment (i.e., cash vs. stock). Thus, converting an option to a cash-only SAR (e.g., pursuant to a merger) should not have any adverse Section 409A effect as long as the original option was exempt.

The final regulations clarify that if an arrangement affords the potential to defer the payment of cash or property beyond the year the stock right is exercised (even if no deferral ever occurs), the entire arrangement is subject to Section 409A and resulting taxes.

Stock Right Terms

The final regulations include a number of definitions (similar in many respects to the Code provisions applicable to statutory options) that may impact grant practices. For instance, an option must be in writing, and an unreasonable delay in notifying a participant of an option grant may cause an option to be deemed granted on the later (notice) date.

The final regulations also affect dividends and dividend equivalents. With respect to options and SARs, a right to receive dividends or dividend equivalents that is directly or indirectly contingent upon exercise of the stock right is treated as an offset to the exercise price and thus would cause the stock right to be treated as a discount option/SAR subject to Section 409A. Dividends and dividend equivalent rights that are not contingent upon exercise of the stock right may, under certain circumstances, be subject to Section 409A, but the existence of such (non-contingent) rights will not automatically cause the stock right to be subject to Section 409A. In addition, dividend equivalents on other types of awards (e.g., restricted stock units) may be treated as deferred compensation and thus should be structured to comply with Section 409A.

In addition to the exception from Section 409A coverage for restricted stock and "fair market value" options and SARs, certain types of equity awards (such as restricted stock units) may avoid the reach of Section 409A if the award can be structured to comply with a separate "short-term deferral" exception. Under Section 409A, awards generally are exempt under this "short-term deferral" exception if the compensation is actually or constructively received by the participant by the later of (i) the 15th day of the third month following the end of the participant's first taxable year when the amount is no longer subject to a substantial risk of forfeiture, or (ii) the 15th day of the third month following the end of the company's first taxable year in which the amount is no longer subject to a substantial risk of forfeiture.

The final regulations provide additional guidance regarding the scope of the short-term deferral exception. For instance, the final regulations clarify that if a plan provides for payment either within the applicable 2 1/2-month period or an alternative date, and the alternate date could occur after the end of the 2 1/2-month periods (e.g., payment upon the later of March 15 of a year or separation from service), then the short-term deferral exception is not available, even if payment is in fact made within the 2 1/2-month periods. The final regulations also allow delayed payments after the applicable 2 1/2-month periods due to administrative impracticalities or if timely payment would have jeopardized the ability of the company to continue as a going concern.

In order to comply with Section 409A, certain provisions must be included in the terms of the plan and/or award. In those cases, it is not sufficient for the plan merely to comply with Section 409A in practice. For instance, for awards subject to Section 409A, the plan must provide that deferred compensation cannot be distributed earlier than the certain specific events described above, and the plan must also contain specific restrictions regarding initial and subsequent deferral elections. Plan terms must also address the six-month delay on distributions to "key employees" of public companies.

The final regulations clarify that "savings clauses" will be disregarded, so that if a plan contains noncompliant terms, it will be in violation of Section 409A. Thus, although a savings clause may be of some value, it will not, by itself, be sufficient to establish Section 409A compliance.

We recommend that companies consider a number of actions in order to comply with Section 409A and the final regulations. These include the following:

• Identify all equity-based plans or arrangements that are maintained by the company. Obtain copies of the current forms of such plans and arrangements, including award agreements, since modifications to not only the plan document but also award agreements may be required. Companies should review these plans and arrangements and their grant practices as soon as possible to determine whether any potentially problematic terms or practices exist that should be addressed -- such as granting below-market options or SARs or permitting option gain deferrals, deferrals on restricted stock awards or restricted stock units, or granting dividends or dividend equivalent rights.

• Companies granting stock options or SARs should confirm that such stock rights are granted with exercise prices at least equal to fair market value of the common stock at the time of grant and that their valuation procedures meet Section 409A standards. Companies also should be sure that they have adequate controls in place regarding their grant practices (for instance, not only with respect to establishing fair market value but also that such practices are not subject to manipulation and that the board takes appropriate action when granting stock-based awards so that the shares will be validly issued from a corporate law perspective). Many companies will need to improve board practices and documentation (e.g., board minutes) regarding fair market value determinations in order to be able to establish that the stock was reasonably valued if challenged.

• Once companies have identified plan or award agreement terms that need to be modified, they should be sure to provide ample time not only for internal preparation and review of the appropriate documentation but also for compensation committee, board and, where necessary, shareholder approval.

• Companies should consider how their equity plans are impacted by other compensatory arrangements, such as employment agreements, change in control agreements, and more traditional deferred compensation arrangements. Even if a company's equity plans comply with Section 409A, to the extent that their operation is impacted by other arrangements, those arrangements should be reviewed to ensure that they do not taint equity awards that may otherwise be exempted from Section 409A.

• Outstanding discounted options or SARs (which were not fully vested as of December 31, 2004) must be amended by December 31, 2007 in order to avoid taxation under Section 409A. Companies should review option and SAR grants to identify any discounted stock rights and begin the process of determining how to amend the options/SARs to make them Section 409A-compliant, keeping in mind that participant consent will be required in many cases.

If you have any questions regarding the final regulations, please contact either the Womble Carlyle attorney with whom you usually work or one of our Corporate and Securities or Employee Benefits attorneys.

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).