On June 21, 2016, the IRS issued proposed regulations to clarify or modify various aspects of the current Code Section 409A ("409A") regulations that were issued in final form in 2007. The proposed regulations cover numerous topics but do not introduce any seismic changes in the deferred compensation landscape.
However, they do address a number of equity compensation issues that are worthy of note, including the following:
- Flexibility for Payment Timing upon Death. Under current 409A regulations, death is a "permissible payment event" for awards subject to 409A (e.g., RSUs with a retirement-vesting feature), and the payment would generally be treated as being made on the date of death if it is made within a relatively limited period following the date of death, unless a specified year after death is designated under the plan terms as the payment period.
Yet, despite the administrative challenges of making a payment at the time of death (e.g., identifying and verifying beneficiaries, completing probate or taking such other steps as may be required by applicable estate laws), the final regulations did not provide any special dispensation from the general time period in which the payment is required to be made following an employee's death. In a helpful change, the proposed rules allow for an amount that becomes payable upon death to be paid at any time between the date of death and December 31 of the calendar year following the year in which the death occurs, regardless of the payment period set forth in the plan or award agreement.
In addition, a plan may allow a beneficiary to select the payment date within this period. The plan may be silent on the payment period following death, and a plan or agreement amendment is not required to be amended to rely on the new payment period. However, to the extent a company wishes to amend the terms of an outstanding award for purposes of contractual clarity, it is free to do so without violating rules that generally prohibit amendments to the time of payment under an outstanding award that is subject to 409A.
It is not clear under the proposed rules whether the new flexibility applies to payments of amounts under awards that are exempt from 409A (e.g., RSUs designed to pay out immediately upon vesting and within the "short-term deferral period" discussed below). This is something we hope will be clarified by the final regulations.
- Additional Exception to Short-Term Deferral Rule. Under the short-term deferral rule, an award such as an RSU is exempt from 409A if it is settled within 2.5 months following the end of the later of the employer or employee's tax year in which the award vests (i.e., by March 15 if employee and employer are both calendar year taxpayers).
Current rules provide certain narrow exceptions that will allow for payment after this short-term deferral period without violating 409A. The proposed rules create an additional exception, which is available if the issuer reasonably anticipates that making the payment would violate "Federal securities laws or other applicable law," provided that the payment is made as soon as practicable once the risk of such violation no longer applies. The change mirrors a similar exception that applies to awards subject to 409A under current rules. The new rule could prove helpful in circumstances where securities or other laws require a deferral of payment under an outstanding equity or cash incentive award (e.g., rules requiring mandatory deferrals of compensation at certain financial institutions) or prevent the legal issuance of shares due to lack of registration or other required approval.
Given the breadth of its wording, the exception could even prove helpful in a situation where a company is unable to timely deliver shares to a U.S. taxpayer employee working outside the U.S. due to its need to complete a local securities or exchange control filing or otherwise obtain local governmental approval.
- Permissible Delayed Cash-Out of Options and SARs in Connection with Transactions. Under the current 409A regulations, deferred compensation subject to 409A that is tied to the value of the employer’s stock can generally be paid on the same schedule and terms that the transaction consideration is paid to shareholders in connection with a change in control.
For example, this is helpful where part of the purchase price due to shareholders of an acquired company in a change of control is deferred pursuant to an earn-out provision or is subject to an indemnification hold-back, as it allows for treatment of acquired company equity award holders in a manner consistent with that of acquired company shareholders. The proposed rules confirm that the ability to delay payment in certain change of control transactions applies to the payment of stock options (including incentive stock options) and stock appreciation rights that are “cashed out” in connection with a transaction.
However, the proposed regulations do not address the conversion of such stock rights into another form of compensation such as cash or RSUs that vest or are paid over the original vesting schedule – a practice that is not uncommon.
- Transfer of Unvested Restricted Stock as Payment of Deferred Compensation. Grants of restricted stock awards are generally exempt from 409A. However, the proposed regulations clarify that the grant of unvested restricted stock to satisfy a deferred compensation obligation (e.g., a deferral of a cash bonus) will not be respected as a 409A-compliant payment of the deferred amount unless the employee makes a Code Section 83(b) election to be taxed on the restricted stock at grant or the grant is made in accordance with 409A's subsequent deferral election rules.
- Grants to Prospective Employees. Due to the definition of "eligible issuer of service recipient stock" under the current 409A regulations, stock options or stock appreciation rights granted to prospective employees that are effective prior to commencement of employment would not be exempt from 409A. The proposed 409A amendments modify this definition, with the result that it will be possible to grant stock options or appreciation rights that are exempt from 409A to individuals before they commence employment, provided that it is reasonably anticipated that the individual will begin providing services, and the individual actually does begin providing services, within 12 months after the date of grant.
Although the prevalence of stock options has decreased in recent years, many companies continue to grant options to executives and other senior employees and this new ability to grant 409A-exempt stock options to prospective employees may help with executive or other new hire negotiations.
That said, many plans preclude the grant of equity awards unless the individual is an employee or other service provider on the date of the grant, and therefore, the plan terms will need to be reviewed before making any grants to take advantage of this relaxed rule.
The proposed rules are subject to comment for 90 days following their publication in the Federal Register (i.e., until September 20, 2016). Taxpayers may rely on the proposed rules before they are published as final regulations, and the IRS will not assert positions contrary to those set forth in the proposed regulations - at least until final regulations are published.