The IRS has Issued Proposed Regulations on New Deferred Compensation Rules
The IRS has Issued Proposed Regulations
on "Deferred Compensation"
—Part One—
The IRS has just issued proposed regulations under new Code Section 409A. That Section made massive changes for 2005 in how "deferred compensation" plans or agreements can be designed and still accomplish their tax objective—to defer taxes until the funds are actually in an executive's hands. The basic premise of 409A is simple: in order for a person who performs services to successfully defer taxes on a value promised to be paid in the future, the promise as to when payment will occur must be designated or elected before the services to which the payment relates are rendered, and the payment time and manner must fall within certain parameters. After such an arrangement is established, the worker and business can have very limited ability to change the payment time or form (and therefore change when taxes will be due).
One of the hardest issues to deal with under the new Code Section is the number and types of plans subject to the new rules. Every stock option or other equity-based compensation scheme, phantom stock arrangement, nonqualified deferred compensation plan or arrangement (whatever it might be called; whether stand-alone or within an employment agreement), severance pay or retention plan, parachute agreement, long term bonus program, and even split dollar insurance arrangement, needs to be reviewed. It is rare to find one of any of these types of agreements that does not need some amendment—either to clearly exempt it from 409A or to adjust it to meet 409A's design requirements.
The stakes are high—if an arrangement is not adjusted to comply with 409A, a 20% excise tax, plus interest from the first date a value was not included in income, will be due.
Given the limited guidance previously available (these Regs. are the first official guidance since Notice 2005-1 was issued in late December, 2004), most employers have struggled with how to meet the original December 31, 2005 deadline for all plans to be updated in writing, as well as adjusted in operation.
In a multi-part Executive Compensation Advisory, of which this is Part One, we will outline some of the most important information in the new regulations.
Good News—More Time!
The original guidance (Notice 2005-1) included some very generous transition rules to assist employers in getting their plans redesigned to meet the new 409A requirements. With limited exceptions, the deadlines have all moved back from December 31, 2005 to December 31, 2006. By the end of 2006, businesses will need to identify all arrangements subject to the 409A rules, amend them to conform to the design requirements, communicate the changes and allow executive elections regarding payment timing and form.
Notice 2005-1 included a transition rule that allows an employer to terminate (or allow employee(s) to elect to terminate) an entire arrangement or the arrangement with respect to just particular employee(s), as long as the full amount due is paid and taxed to the worker in 2005. A number of employers have used this rule instead of completely restating an arrangement that would not work as intended under the new rules, or to avoid detailed analysis and change. If termination is a desirable option, you must use this option in 2005—this transition relief expires on December 31, 2005.
More Clarity On How Equity-Based Compensation Can Escape Redesign Due To 409A
Most employers do not want stock-based programs to be subject to 409A, because they prefer to give employees flexibility as to when to invest in and divest themselves of company stock or its equivalents. Notice 2005-1 made clear that stock options that allow the purchase of stock at a price that is not 100% of fair market value at grant will be subject to 409A and will need to be structured with much less employee tax-timing flexibility in the future. That has not changed. However, the Regs give much more detail about how other types of equity-based arrangements will be treated under 409A.
- Stock appreciation rights (SARs) are resurrected. SARs (with a limited exception for public company SARs settled in stock) were classified as deferred compensation in earlier guidance, which would have made their use impractical. Now SARs will not be considered deferred compensation, even if settled in cash, and even for a private company, as long as the measuring price is not (and can never be) less than fair market value of the related stock at the grant date.
- By extension of the new relief for SARs, the right to have shares withheld from those issued on exercise of a stock option to pay the exercise price (sometimes referred to as immaculate cashless exercise) should not cause an exempt stock option to become deferred compensation.
- The right to pay the exercise price of an option with previously-acquired shares does not turn a stock option that is otherwise exempt from 409A into deferred compensation.
- Private companies will have to give serious consideration to a time-consuming and expensive annual third-party appraisal before granting stock options or SARs, if they want to avoid tax risk under these rules. At a minimum, employers will need detailed documentation of how the "fair market value" was derived when granting stock rights based on that value. Formulas used to determine a stock's value will seldom be presumed to have derived true "fair market value."
- Determining a stock's fair market value by reference to average selling prices over a period of time will now be difficult, and averages for periods of more than 30 days are not allowed.
- Stock rights granted in preferred stock will always be subject to the deferred compensation rules.
- If stock acquired via an option is subject to a mandatory repurchase obligation or put/call rights at a price other then the then-fair market value, the stock option might be subject to the deferred compensation rules. Buy-sell restrictions on stock acquired through a stock option (not uncommon, especially in private companies) will need to be carefully analyzed.
- Stock options or SARs granted to employees of partnership or corporate subsidiaries or brother-sister organizations can be exempt from the deferred compensation rules, if the issuer of the stock and the entity for which the employee works have at least 50% common ownership. Under prior guidance, 80% common control was generally required.
- Stock options or SARs granted to employees of corporations that have as little as 20% common ownership with the issuing corporation will be exempt from the deferred compensation rules, which will allow greater flexibility in granting options and SARs to joint venture employees.
- Earlier guidance told us that modifying a stock right after grant could cause it to become deferred compensation. The regulations list a few exceptions: adding a feature to a stock option plan to allow already-owned stock to be used to pay the exercise price, to allow stock to be withheld to pay income or employment taxes on exercise, or to accelerate an exercise date for a stock right, will not be "modifications" to previously-issued options. But any modification to an option plan that provides a direct or indirect reduction in the exercise price, an additional deferral feature (such as a longer period to exercise than was allowed upon grant), etc., will generally cause options to be deferred compensation, retroactive to the date of grant.
- If you find you have "modified" a stock right in 2005 before this guidance came out, causing it to be subject to 409A, you can still rescind that action to salvage the treatment of the stock right as being outside the deferred compensation definition.
- A company may grant a participant the right to be paid dividends declared on stock for the period before an option is exercised, or before restricted stock is vested, without causing the option or restricted stock grant to become deferred compensation, if the dividend right is set forth in a separate arrangement and the dividend right arrangement meets the deferred compensation design requirements.
- Dividends related to stock rights or to unvested restricted stock can be paid annually without violating the 409A rules about payments being triggered only in one of six events. To be exempt, the dividends must be paid by the 15th day of the third month of the year after which they are credited.
More Relief For Separation Pay
- All collectively bargained separation pay arrangements are exempt from the 409A rules, provided the pay is triggered either by truly involuntary separations or pursuant to a bargained-for window separation program.
- Severance pay programs that are triggered only by involuntary separations, or pursuant to a voluntary "window" program, are exempt from the 409A rules if (A) the total payment is less than (1) two times the employee's annual compensation in the calendar year prior to the separation, or, if less (2) $420,000 (determined by reference to qualified plan compensation caps; to be indexed), and (B) all payments are completed no later than December 31 of the second year following separation.
- Separately-negotiated severance pay arrangements can allow the employee to elect between a lump sum and payments over time, if the election is made simultaneously with the right becoming legally binding. Similarly, window separation programs may give payment form/timing elections to employees as long as the election is made before the election to participate in the window program becomes irrevocable.
- Payment of medical costs or premiums on continued health insurance after separation (even if voluntary) will generally not be deferred compensation, provided the arrangement does not continue beyond December 31 of the second calendar year following separation. If such program extends longer, the program will need to be analyzed as deferred compensation, but may often meet 409A's design requirements.
Part Two of this Advisory will address other aspects of the Regs, including:
- When can an employee become a consultant without delaying the payment of deferred compensation until the consultancy ends?
- What time period should you consider in determining if a public company executive is a "key" employee?
- Do "wrap 401(k)" deferred compensation plans still work, or do the qualified and nonqualified plans' deferral elections need to be de-linked from each other?
- Can payments in installments ever be changed to a lump sum form?
- Can an employer terminate a deferred compensation plan?
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The primary author of this FBT client advisory is Debbie Reiss Hardesty, who can be reached at 502.568.0330 or at dreiss@fbtlaw.com.
This is intended as a source of information and is not intended to replace attorney-client consultation. This information is not intended as legal advice or as a substitute for the particularized advice for your situation and should not be relied upon as such, as the advice appropriate for you will be dependent upon the particular facts and circumstances.
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