Deferred compensation for executives under sec. 409A.

• Author: Singer, Stuart R.
• Position: Part 2

EXECUTIVE SUMMARY

* Virtually all stock option arrangements are potentially regulated by Sec. 409A.

* Sec. 409A provides an exclusive list of permitted distributions; everything else is prohibited.

* The Service has blanket authority to determine permitted accelerated distributions.

**********

This two-part article discusses how Sec. 409A and the current proposed regulations apply to deferred compensation arrangements. Part II covers the applicability of Sec. 409A to equity-based compensation arrangements, permitted distributions and the election to defer compensation.

Sec. 409A and the current proposed regulations impose a new set of roles for taxation of deferred compensation. Part I of this two-part article, in the July 2006 issue, discussed the introduction of Sec. 409A and the plans and types of deferred compensation subject to it. Part II, below, covers the applicability of Sec. 409A to equity-based compensation arrangements, permitted distributions and the election to defer compensation.

Stock

Options

One of the more difficult areas of Sec. 409A coverage is stock options. First, as might be expected, incentive stock options (ISOs) are generally not treated as deferral of compensation for Sec. 409A purposes, although the proposed regulations provide a warning for plans that permit such options to be extended or otherwise modified in a manner that produces a nonqualified stock option (NQSO) as the successor. Under Prop. Regs. Sec. 1.409A-1(b)(5), such a modification would generally be treated as the grant of a new option and would be governed under the rules applicable to NQSOs.

NQSOs may escape characterization as deferral of compensation under Sec. 409A if, under the plan:

* No options may ever be granted or modified with an exercise price less than the fair market value (FMV) as of the grant date (32);

* The number of shares that may be purchased by exercise of the options is fixed as of the grant date;

* Both the exercise and the transfer of such options are taxable; and

* There are no additional deferral features in the option agreement or plan providing any benefit other than the deferral of income recognition until exercise. (33)

SARs

The proposed regulations provide the same exemption rules for stock appreciation rights (SARs) as for NQSOs, generally not treating SARs as deferred compensation if:

* The value of the baseline stock used for measuring appreciation may never be less than the FMV on the grant date;

* Only such traded stock may be delivered in settlement of the right on exercise; and

* There are no additional deferral features other than the basic SARs.

Because private companies are covered by these rules, the proposed regulations contain detailed rules on how to determine the underlying stock's FMV and a definition of what constitutes such stock. (34) There are also special rules in Prop. Regs. Sec. 1.409A-1(b)(5)(iii) (D) designed to limit the potential abuse of granting options and SARs to employees in affiliated entities. (35)

Stock Valuation

The proposed regulations address the valuation of stock underlying options and SARs for Sec. 409A purposes. For stock that is "readily tradable on an established securities market" the value may, in general, be:

* The sale price of the last trade before the grant;

* The sale price of the first trade after the grant;

* The closing price on the day before the grant;

* The closing price on the day of the grant; or

* "Any other reasonable basis using actual transactions," as long as it is consistently applied. (36)

If certain other criteria are met, taxpayers may also use an average daily wading price over a fixed period during the 30 days before or after the grant date; this rule was apparently included to accommodate certain corporations subject to foreign laws. (37)

For stock that is not readily tradable, the corporation merely has to use a "reasonable application of a reasonable valuation method" (38) Whether or not a method is "reasonable" depends on the usual factors, i.e.:

* The value of the corporation's assets;

* The value of the corporation's discounted cashflow;

* The market value of stock or other equity of comparable corporations or other entities in businesses similar to those of the taxpayer; and

* Other factors, such as premiums for control and discounts for lack of marketability. (39)

In general, a valuation is not reasonable if it is more than 12 months old or, regardless of its age, it does not take into account material recent developments. The proposed regulations provide limited safe harbors for corporations that are not confident that their internal valuation skills are intrinsically reasonable, including the use of an independent appraiser (in much the same manner as an employee stock ownership trust making its annual valuation of employer securities). (40)

Determining Which Entity Issued the Underlying Stock

Treasury continues to be wary of arrangements under which a service provider could take advantage of the general exclusion for certain stock rights, by receiving stock of an entity related to the service recipient and then using that entity as an investment vehicle. Subject to that prohibition, a service provider can receive stock in any corporation that is a member of the group as the service recipient. For this purpose, a group is defined in the same manner as a "controlled group" under the qualified plan rules, except that a corporation can elect to use a 50% standard instead of 80%. (41)

Restricted Stock

Actual grants of restricted stock are generally not treated as a deferral of compensation, because such grants-due to the restriction--are not currently includible in income under Sec. 83. On the other hand, an award that is essentially a promise to make such a transfer at some point in the future (commonly known as a restricted stock unit), may constitute deferred compensation under Sec. 409A. (42) If the grant is a promise to deliver stock that itself is subject to a restriction that constitutes a "substantial risk of forfeiture" then such award will not be deferred compensation for Sec. 409A purposes, until and unless the restriction has been removed. (43)

Modification of Stock Options, SARs and Certain Other Rights

In general, any material modification of an equity-based right will be treated as the grant of a new right, to be assessed on its own terms, including the requirement that the grant be based on stock exercisable at a price no less than the FMV at the time of such modification. For this purpose, modifications include reduction of the exercise price, addition of other deferral elements and extension of the exercise period (with certain limited exceptions). A modification that actually restricts or reduces the benefits granted to the service provider will not ordinarily be treated as a material modification constituting treatment as a new grant. A modification that shortens the vesting period for exercise is not generally a material modification, although...