On April 10, 2007 the U.S. Treasury Department and the Internal Revenue Service (IRS) issued final regulations under Section 409A of the Internal Revenue Code. The final regulations are effective January 1, 2008, and taxpayers may rely on them for all periods. In addition, IRS Notice 2007-34 addresses how these regulations impact split-dollar life insurance arrangements. Taxpayers have until December 31, 2007, to make any necessary amendments to plans to comply with the final regulations — the IRS has stated that this deadline will not be extended. Set forth below is a summary of the key changes made in the final regulations along with some surprises and opportunities.
Stock Options and Stock Appreciation Rights. The final regulations significantly liberalize the stock option and stock appreciation rights exemption provided in the proposed regulations. All references to stock options below also include stock appreciation rights.
- - Can Subsidiary Stock be Used for Exempt Stock Options? The proposed regulations did not allow employers to grant exempt options using stock of a non-public subsidiary held by a publicly held corporation. This restriction cast significant doubt on the continuing viability of stock options based on subsidiary stock. In response to comments, the final regulations provide that employers may use stock of the service recipient (i.e., the corporation receiving the services from the employee) or any entity up the corporate chain, but not down the chain or sideways (a brother-sister corporation). When going “up” the corporate chain, there generally must be at least a 50 percent ownership interest, although it is possible to reduce that percentage to 20 percent based on legitimate business concerns. These rules also apply to private companies.
- - What Kind of Stock Works? The proposed regulations provided that stock options would be exempt from 409A only to the extent they were granted on common stock that had the highest aggregate value of any class of common stock (so-called “service recipient stock”). The final regulations generally provide that any class of common stock may be used, regardless of whether another class of common stock that could qualify as service recipient stock is publicly traded or has a higher aggregate value outstanding. Common stock that has a preference as to dividends (other than a liquidation preference), however, may not be used with an exempt stock option.
- - How Do You Determine the Stock’s Fair Market Value for the Exercise Price or Strike Price? The proposed regulations provided a limited safe harbor for illiquid start-up companies in existence for less than 10 years. This safe harbor was of limited usefulness because an initial public offering (IPO) or liquidity event within one year of the option grant made the safe harbor unavailable. In addition, it was unclear who could perform the valuation other than an appraiser. The final regulations expand eligibility to use the illiquid start-up company safe harbor by (1) reducing the look-back period from one year to six months in the case of an IPO and to three months in the case of a change in control, and (2) providing guidance as to who can perform the valuation other than an appraiser (i.e., would a reasonable person, knowing the facts, select the individual to determine value for a sale of stock), which includes a person with more than five years of experience in the field of private equity. For public companies that want to use their average stock price over a period of up to 30 days, the commitment to grant the stock right must be irrevocable before the beginning of the specified period (subject to a limited exemption to comply with non-U.S. law).
- - How do You Determine the Grant Date? The proposed regulations did not define what the “grant date” is for purposes of Section 409A. Failing to define a grant date was a significant omission in the proposed regulations given the draconian tax impact if an option is granted in the money (i.e., the stock’s fair market value exceeds the exercise price). The final regulations provide that the grant date is to be determined in the same manner as under the incentive stock option regulations. It is recommended that companies review their stock option granting practices in light of this grant date definition.
- - Extensions of Exercise Periods. The proposed regulations provided that an option extension lasting longer than December 31st of the year in which the option would have otherwise expired or, if longer, two and one-half months, would result in deferred compensation subject to Section 409A. This provision created significant problems—employers often provided longer extensions for legitimate business purposes, such as an exit incentive plan or an involuntary employment termination. The final regulations provide that an extended exercise period will not cause an option to be subject to Section 409A so long as the extension does not last longer than the original maximum term of the option or, if shorter, 10 years from the option grant date. The exercise period for underwater options may also be extended
- Severance. There are also several helpful changes in the final regulations with respect to severance:
- - The proposed regulations suggested that severance arrangements could be treated as deferred compensation subject to the Section 409A distribution restrictions. This created significant issues for public companies because payments of 409A deferred compensation cannot commence until six months after a separation for service by so-called “specified employees.” This situation was particularly difficult in situations where the termination was initiated by the employee for “good reason” in one year, but the event giving the employee good reason to quit occurred in an earlier year; in those fact patterns, it would be difficult to impossible to characterize the resulting payments as short-term deferrals exempt from Section 409A. The final regulations now provide that certain “good reason” terminations initiated by the employee will be treated as involuntary separations under certain circumstances. As a result, these severance payments will be eligible for the short-term deferral rule and can be paid immediately upon separation.
- - The proposed regulations provided an exemption from Section 409A for severance benefits equal to the lesser of two times the service provider’s annual compensation or two times the limit on compensation set forth in Section 401(a)(17). It was unclear under the proposed regulations whether this exemption could be used in combination with other exemptions. The final regulations clarify that this exemption applies to payments up to this limit even if the entire amount of the severance benefits exceeds the limit. Any amounts in excess of this limit will be subject to Section 409A unless another exemption is available, such as the exemption applicable to short-term deferrals.
- Revised Plan Aggregation Rules. The proposed regulations treated all similar types of deferred compensation for a single employee as a single plan. The importance of this aggregation rule is that a violation of Section 409A with respect to any aspect of a “plan” would result in triggering Section 409A penalties with respect to all benefits under the aggregated definition of a “plan.” In addition, this proposed plan aggregation rule impacted whether an employee was eligible for the special rule regarding initial deferral elections for participants who first become eligible for a particular type of plan. The proposed regulations only provided four types of plans under Section 409A: account balance plans, non-account balance plans, severance plans and “other” plans (generally, equity-based compensation arrangements). In response to comments that a Section 409A violation with respect to one arrangement might result in Section 409A penalties for other dissimilar arrangements, the final regulations include additional categories of plans, such as split-dollar life insurance arrangements, reimbursement plans and non-exempt stock rights. In addition, the final regulations also authorize employers to subdivide account balances into elective plans and non-elective plans, and amounts deferred under a foreign plan from any amounts deferred under a domestic plan.
- Initial Eligibility Elections. A couple of helpful new rules have been added in the initial deferral election rules. For example, in the context of rehires and transfers, the initial eligibility deferral election rules are applicable to an employee provided that the employee has not been an active participant—i.e., eligible to accrue benefits—in the plan (applying the plan aggregation rules) for at least 24 months. Also, a special initial eligibility rule applies to nonelective excess benefit plans whereby participants may make an initial deferral election immediately following the first year the service provider accrues a benefit under such plan.
- Separation from Service. Because of the importance of separation from service as a 409A distribution event, the final regulations allow plan sponsors to voluntarily adopt a “same-desk” type rule prohibiting nonqualified plan distributions in the event of certain asset sales. In addition, the final regulations permit certain flexibility for a plan to define a separation from service as including a change to a reduced level of bona fide services (i.e., a phased retirement) if the definition is specified no later than the time and form of payment are elected or otherwise specified.
- Delay for Specified Employees. Section 409A provides that with respect to a specified employee, a payment of nonqualified deferred compensation on account of separation from service may not occur before the date that is six months after the date of separation from service (or, if earlier, the date of death of the employee). The final regulations specifically allow the use of an “over-inclusive” list of specified employees provided that the alternative method is reasonably designed to include all specified employees. Lastly, the final regulations provide new rules for determining the list of specified employees in a variety of M&A situations such as the merger of two public companies, the acquisition of a private company by a public company, a spin-off of one public company from another public company and an IPO.
- Change in Control Distributions. The threshold for a change in the effective control of a corporation has been lowered from 35 percent under the proposed regulations to 30 percent under the final regulations. In addition, the final regulations clarify the rules under which a deferred compensation plan may be terminated and liquidated upon a change in control event. Specifically, only the plans covering the employees of the acquired company need to be terminated; the acquiror’s plans do not need to be terminated.
- Plan Terminations. The period of time during which a service recipient may not commence a new plan after terminating and liquidating a nonqualified deferred compensation plan following a change in control has been shortened from five years to three years.
- Split-Dollar Life Insurance. The preamble to the proposed regulations suggested that certain types of split-dollar life insurance could be considered to be deferred compensation subject to Section 409A. Notice 2007-34 confirms this statement in the preamble and provides guidance as to how covered split-dollar life insurance arrangements can qualify under (or become exempt from) Section 409A. The guidance allows for split-dollar life insurance arrangements entered into on or before September 17, 2003, to be amended as necessary to comply with Section 409A without resulting in a loss of grandfathered status. In addition, so-called non-equity arrangements only providing death benefits are exempt from Section 409A. However, other aspects of this guidance will be problematic and require careful consideration, including the allocation of earnings between grandfathered and nongrandfathered benefits and any future forgiveness of premium repayment obligations.
- Administrative Flexibility. The final regulations clarify that a payment will be considered made on a specified payment date if it is paid not earlier than 30 days before such date or if the payment or payments are made by the end of the calendar year in which the applicable payment date occurs or, if later, the 15th day of the third month following such payment date. Also, if an employer fails to make a payment on the specified payment date due to an oversight, the payment will be treated as made on the specified date if the employee makes reasonable, good faith efforts to collect the payment, generally through providing timely notice to the employer that the payment is due and unpaid.
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The final regulations do not address the calculation and timing of amounts required to be included in income under Section 409A, nor the reporting and withholding requirements applicable to service recipients providing nonqualified deferred compensation covered by Section 409A. The final regulations provide that taxpayers can continue to rely on the interim rules allowing partnerships to rely on the stock option exemption described above when issuing profits interests. The U.S. Treasury Department and the IRS intend to issue further guidance on these topics.
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As noted above, affected plans and arrangements are required to comply with documentation requirements established in the final regulations by December 31, 2007. In this regard, note that the final regulations indicate that a 409A “savings clause” will not work to prevent a non-compliant plan from violating 409A.