Employee Benefits Law Alert: Equity Compensation Provisions in the Section 409A Proposed Regulations

Section 409A, which was added to the Internal Revenue Code in October 2004, imposes onerous penalties on nonqualified deferred compensation that fails to meet strict new rules. Although Congress enacted Section 409A in response to well-publicized abuses by highly paid public company executives, the broad scope of the legislation will have a wide-ranging impact on compensation generally, including conventional options granted to employees, officers, directors and consultants of public and private companies.

The Internal Revenue Service (IRS) has provided preliminary guidance regarding Section 409A in Notices 2005-1 and 2006-4, and in proposed regulations issued in September 2005. This Client Alert highlights the equity compensation provisions of the proposed regulations, and is one of a series of Client Alerts prepared by Stoel Rives LLP that explain the substantive provisions of the proposed regulations. Links to the other Client Alerts are provided at the end of this Alert.

Section 409A Overview

Section 409A operates by specifying the nonqualified deferred compensation arrangements that are subject to its rules and by setting out detailed rules that must be satisfied with respect to (1) the timing of elections to defer compensation and (2) the timing of distributions of amounts treated as deferred. To the extent these rules are not met, Section 409A taxes compensation earlier than pre-Section 409A rules (generally at the time of vesting rather than at the time of payment) and imposes an additional twenty percent penalty tax on the amount included in income and an additional interest charge on amounts deferred at the IRS's interest rate for underpayments, plus one percent.

As a result, Section 409A requires companies to determine whether a particular compensation arrangement is nonqualified deferred compensation covered by Section 409A, and if so, what deferral elections and distribution events must be followed to avoid the acceleration of tax and penalty taxes imposed on arrangements that do not comply with Section 409A.

Certain Stock Options and Stock Appreciation Rights Exempted

The IRS notices and the proposed regulations confirm that nonqualified stock options (NSOs) will not be treated as deferred compensation subject to Section 409A unless they are granted at a discount (i.e., have an exercise price that is less than the fair market value of the underlying stock as of the date the option is granted) or have other deferral features. Notice 2005-1 provided similar relief for stock appreciation rights (SARs) settled in publicly traded stock. The proposed regulations broaden the exemption for SARs, such that any nondiscounted SAR (including an SAR settled in cash or stock of a private company) will be treated as deferred compensation subject to Section 409A only if it has other deferral features. A grant of an incentive stock option (ISO) does not constitute a deferral of compensation, and therefore is not subject to Section 409A. To qualify as an ISO, however, the exercise price of an option generally must not be less than the fair market value of the underlying stock as of the date the option is granted, so stock valuation can be an issue for both ISOs and NSOs.

Dividend Equivalent Rights. Payments with respect to NSOs or SARs of amounts equal to dividends that would be paid on underlying shares of stock before the NSOs or SARs are exercised will cause the NSOs or SARs to lose their exemption if payment is tied to the exercise of the NSOs or SARs. The proposed regulations treat such an arrangement as an indirect reduction of the exercise price that creates a discounted NSO or SAR subject to Section 409A as of the original date of grant. Dividend equivalent rights should therefore be set forth in a separate written arrangement, and payment of accumulated dividends should be made other than upon exercise of the NSO or SAR, but in a manner that otherwise satisfies the requirements of Section 409A and the proposed regulations (e.g., by March 15th of the calendar year following the calendar year in which the dividend is declared).

Common Stock Required. For an NSO or SAR to be exempt from Section 409A, the underlying stock must be common stock of the service recipient that is readily tradable on an established market, or if there is no such market, then common stock that represents the highest-value class of outstanding common stock of the service recipient. Preferred stock may not be used.

Related Issuer. For an NSO or SAR to be exempt from Section 409A, it must be issued to employees or contractors of the corporation that issues the stock, or an affiliate to which the issuing corporation is related by at least an eighty percent interest. Employers may elect to use a fifty percent relationship test (and in some instances twenty percent) rather than eighty percent, but the election must be applied consistently to all compensatory stock plans of the company for a minimum of 12 months.

Valuation Methods. NSOs and SARs will qualify for the exemption from Section 409A coverage only if the exercise price is not less than the fair market value of the underlying common stock on the date of grant. Given the severe consequences that can apply to noncompliant nonqualified deferred compensation, determination of the fair market value of the underlying stock will be a crucial feature of any option or SAR grant.

• Publicly Traded Stock. Fair market value of publicly traded stock 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 grant date or the immediately preceding trading day, the average of the reported high and low sale prices for the grant date or the immediately preceding trading day, or any other reasonable basis using actual transactions in the stock in the applicable market. It is also permissible to use up to a 30-day average, provided the commitment to grant the NSO or SAR is irrevocable before the start of the averaging period and the valuation method is used consistently for all grants under the same program.

• Stock That is Not Publicly Traded. Pursuant to Notices 2005-1 and 2006-4, the determination of fair market value for options and SARs granted before the effective date of the Section 409A final regulations can be made using "any reasonable valuation method." The proposed regulations list the following factors that should be taken into account when determining fair market value of stock that is not publicly traded:
  • The value of the company's tangible and intangible assets,
  • The present value of future cash flows,
  • The market value of stock or equity interests in substantially similar companies,
  • Control premiums and discounts for lack of marketability, and
  • Whether the valuation method is used for other purposes that have a material effect on the employer, its shareholders or its creditors.

The proposed regulations also prescribe rules for determining when it is reasonable to rely on a valuation, including how recent the valuation must be and the impact of recent developments on the valuation. In addition, the proposed regulations designate three valuation methods that will be presumed to be reasonable. If one of the three methods is consistently applied, the valuation will be presumed to be fair market value, and the presumption may be rebutted by the IRS only by showing that the valuation is "grossly unreasonable."

• Stock in Start-up Companies. The regulations set out special rules for valuing stock in start-up companies—i.e., companies in business for no more than 10 years that have no publicly traded stock.

In light of the proposed regulations, a company granting NSOs or SARs should consider engaging an independent appraiser to determine valuation. If valuation is not obtained, the company should at least consider preparing a written internal report describing the process by which the fair market value of the underlying stock was determined and addressing as many of the factors set out in the proposed regulations as possible. In either event, if business circumstances can be expected to change in a manner that could materially affect value, causing the previous appraisal or memorandum to become "stale," the company should consider restricting NSO or SAR grants to limited periods during the year when the company has a relatively fresh valuation.

Repurchase Obligations and Put/Call Rights. An NSO or SAR subject to a mandatory repurchase obligation or a non-lapse put or call right that is based on a value other than the fair market value of the stock will be deemed to provide for the deferral of compensation, and therefore will not be exempt from Section 409A. Rights of first refusal and other rights that involve third parties (e.g., "tag-along" and "drag-along" rights) do not appear to be affected.

Modifications, Extensions and Renewals

General Rule. Modifications to the terms of an NSO or SAR generally will result in treatment as a new grant. The modified NSO or SAR might then be subject to Section 409A because, for example, the NSO or SAR was "in the money" when modified. On the other hand, extensions or renewals will result in the NSO or SAR being treated as though it were subject to Section 409A as of the original date of grant.

Planning Tip: As noted above, an extension granting the holder an additional period within which to exercise the NSO or SAR beyond the original exercise period generally will result in it being treated as subject to Section 409A as of the original date of grant. However, the proposed regulations provide an exception for any extension to no later than the 15th day of the third month following the date, or, if later, December 31 of the calendar year in which the NSO or SAR would otherwise have expired but for the extension. This exception will permit employers to amend an NSO or SAR to allow for exercise after a termination of employment if it is not already provided.

Repricings. A repriced NSO or SAR is treated as a new grant, but may still qualify for the exemption from Section 409A coverage if the exercise price is not less than fair market value at the time of the regrant. Multiple repricings, however, may indicate a floating or adjustable exercise price, with the result that the NSO or SAR would not qualify for the exemption.

Inadvertent Modifications. An inadvertent modification that would otherwise trigger the application of Section 409A to an NSO or SAR can be rescinded, if the rescission occurs before the earlier of (1) the date the NSO or SAR is exercised, or (2) the last day of the calendar year in which the modification occurs.

Restricted Stock and Restricted Stock Units

Restricted stock grants are not subject to Section 409A, whether or not an 83(b) election is made. Restricted stock units (RSUs) that entitle the employee to receive stock or cash following satisfaction of a vesting condition will not be subject to Section 409A if the stock is issued in compliance with the short-term deferral exception (i.e., issued either at the time of vesting or within 2½ months following the close of the year in which vesting occurs). If issuance of the stock or payment of the cash is to be deferred beyond the short-term deferral period, the arrangement must be structured to comply with Section 409A.

Planning Tip: If RSUs are contingent on the performance of services for at least 12 months, the proposed regulations consider an election to defer payment to be timely if made within 30 days after the date of grant, and at least 12 months remain before the end of the service vesting period.