On April 10, 2007, the Internal Revenue Service (the “IRS”) issued long-awaited and much anticipated final regulations under Section 409A of the Internal Revenue Code (the “Final Regulations”). This Advisory provides a timely first look at some of the more important changes made by the Final Regulations to prior IRS guidance.

Background

In general, Section 409A provides that all amounts deferred under a non-qualified deferred compensation (“NQDC”) arrangement will be currently includable in gross income and result in the assessment of a 20% tax and interest on the service provider (e.g., the employee) to the extent not subject to a substantial risk of forfeiture, unless certain requirements are met. The requirements of Section 409A apply to a wide range of compensatory plans, not merely voluntary deferral arrangements, including supplemental retirement plans, split-dollar life insurance programs, severance plans, employment agreements, bonus incentives and various equity based alternatives. All such arrangements are required to have been operated in good faith compliance with Section 409A since January 1, 2005. Document compliance, however, is not required until December 31, 2007.

Over the coming weeks, we expect to provide a series of articles explaining the practical impact of the Final Regulations. For now, this Advisory highlights some of the more significant changes.

Stock Options and Stock Appreciation Rights

The Final Regulations provide clarity and relief in the Stock Rights area as follows:

 Service Recipient Stock. Generally, an option or SAR (“Stock Right”) will be exempt from Section 409A only if it is issued with respect to “service recipient stock”. The Final Regulations expand the definition of “service recipient stock” to include any class of common stock that does not have preferential distribution rights (other than a preference with respect to liquidation rights) regardless of whether there is another class of stock that is publicly traded or has a higher aggregate value outstanding.

Additionally, “service recipient stock” may include the stock of any corporation in a chain of organizations, all of which have a controlling interest in another organization, beginning with the parent and ending with organization for which the grantee was providing services on the date of grant.

  • Valuation. The Final Regulations retain the principle that for stock not readily tradable on an established securities market, a valuation based on a reasonable application of a reasonable valuation method is treated as reflecting the fair market value of the stock. The Final Regulations clarify that to meet this standard, a valuation determined by an independent appraiser is not necessary. The Final Regulations also preserve the three safe harbor valuation methods and their rebuttable presumptions of reasonableness, with minor changes, most notably to the methodology for illiquid stock of start-up corporations on the time periods in which the issuer could reasonably anticipate an IPO (180 days) or change in control (90 days) occurring following the valuation.

Public companies intending to use averaging for determining the exercise price must make an irrevocable commitment to grant the Stock Right with an exercise period set using such average selling price before the beginning of the specified averaging period. Additionally, the Final Regulations make clear that public or private companies can use different valuation methods for different purposes (for example, the employer can use one valuation method for establishing the exercise price and another valuation method for determining the repurchase price).

  • Option Extensions. Under the proposed regulations, an extension of the Stock Right’s exercise period (other than limited extensions typically in connection with the grantee’s separation from service) would retroactively subject the Stock Right to Section 409A. The Final Regulations have importantly provided that the extension of an option exercise period generally is not treated as an additional deferral feature or a modification of the Stock Right for Section 409A purposes if the exercise period is not extended beyond the earlier of the original maximum term of the Stock Right or 10 years from the original grant date. Moreover, the extension of an “underwater” Stock Right will not subject the Stock Right to Section 409A.
  • Partnership Interests. While not providing new guidance, the Final Regulations preserve the critically important treatment of partnership interests as provided in the prior guidance, namely that taxpayers may apply principles applicable to stock options as effective and applicable to equivalent rights with respect to partnership interests. Further, the issuance of profits interest may be treated under the same principles that apply to the issuance of stock, suggesting that a Section 83 analysis remains sound treatment to the grant of profits interests as Section 83 property.

Employment Agreements/ Separation Pay

  • “Good Reason” Terminations. A prominent concern with the prior guidance was the effect of “good reason”/constructive termination provisions in employment agreements and other arrangements. The prior guidance did not treat the right to payment upon a separation from service for good reason categorically as a right subject to a substantial risk of forfeiture.

That meant that neither the short-term deferral exemption nor the Two Time Exemption (as discussed in our Spring 2006 Employee Benefits & Executive Compensation Bulletin) for separation pay could apply. In addition, severance payable to a “specified employee” of a publicly traded company would be subject to a six-month delay upon the employee’s separation from service.

With great relief, the Final Regulations have established that a right to payment contingent upon a voluntary separation from service that constitutes “good reason” may be treated as payable upon an involuntary separation from service where the good reason condition is such that the employee’s separation effectively is an involuntary separation from service. To be treated as an involuntary separation from service, such good reason condition must require actions taken by the employer resulting in a material negative change in the employment relationship. The Final Regulations also provide a safe harbor for treating a “good reason” termination as an involuntary separation from service. The “good reason” safe harbor requires the satisfaction of a number of conditions, including (i) a time limitation on when a good reason termination can be triggered, (ii) good reason must consist of one or more of the six conditions listed in the Final Regulations, (iii) the employee must be required to provide notice to the employer of the existence of the good reason condition and the employer must have an opportunity to remedy the condition, and (iv) the amount, time and form of payment must be identical to any payments available upon an involuntary termination.

  • Involuntary Separation/Window Program. The Final Regulations clarify that severance pay upon an involuntary separation from service or participation in a window program may pour into the Two Times Exemption as a basket such that only the amount in excess of such exemption would be deemed deferred compensation subject to Section 409A.

For example, this rule allows severance payments of up to $450,000 (two times the Code Section 401(a)(17) limit for 2007) to be made immediately upon termination of an executive’s employment, without regard to Section 409A (and the six-month delay applicable to certain employees of publicly traded companies), and only the severance amounts in excess of the Two Times limit would be subject to Section 409A.

  • 280G Gross-Up. The Final Regulations provide that Code Section 280G tax grossup payments (and right to reimbursement of expenses incurred due to a tax audit or litigation) satisfy the fixed time and form requirements of Section 409A if the agreement provides that the tax gross-up payment will be made, and the payment is made, by the end of the employee’s taxable year following the year in which the related taxes are remitted to the taxing authority.
  • Reimbursements. The Final Regulations clarify that nontaxable fringe benefits and taxable reimbursements of medical expenses provided through the COBRA continuation coverage period are not subject to Section 409A. For reimbursement arrangements that are deferred compensation, the Final Regulations provide that these arrangements will satisfy the rules for a fixed schedule of payments if the provisions relating to eligible expenses and the time for reimbursement are objectively determinable, reimbursements in one year cannot affect the amount eligible for reimbursement in another year and reimbursements are made by the end of the year after the year in which the expense was incurred.

The Short Term Deferral Exception

The Final Regulations generally adopt the short-term deferral rule whereby payments made within 2 1/2 months after the end of the year in which such payments vest are not subject to Section 409A. The Final Regulations clarify that an arrangement provides for deferred payment if it provides for a payment that will be made or completed after a date or event that will or may occur later than the end of the 2 1/2 month period, either because of an affirmative election or a deferral condition inherent in the terms of the contract.

Thus, for example, if a bonus is subject to a substantial risk of forfeiture until competition of three years of service and is payable upon a separation of service following the three years of service, the right to the bonus is not a short-term deferral even if the employee separates from service immediately after vesting in the bonus.

Conversely, where a plan specifies no payment date or event, or specifies only the date on which the substantial risk of forfeiture lapses, the plan may qualify for the shortterm deferral rule if payment is made within the applicable short-term deferral period. However, such a plan would generally violate Section 409A if the payment was made after the short-term deferral period. The Final Regulations also note that a provision requiring payment be made prior to the end of the short-term deferral period may not work to except the payment from Section 409A if such payment could be made in more than one taxable year.

Conclusion

Notwithstanding the issuance of the Final Regulations, Section 409A compliance remains complicated and requires specialized expertise.