On June 22, 2016, the Internal Revenue Service and Treasury Department issued proposed regulations under Section 409A of the Internal Revenue Code (409A Proposed Regs). [Insert link]The government noted that the 409A Proposed Regs are intended to clarify and modify select provisions of the 409A final regulations(409A Final Regs).The preamble to the 409A Proposed Regs list 19 areas of clarification of or modification to the 409A Final Regs. This advisory contains a summary of the principal issues raised in the 409A Proposed Regs.
As noted in the preamble to the proposed regulations, the 409A Proposed Regs do not present any surprises. Nevertheless, sponsors of nonqualified deferred compensation plans and plan advisors should review the new guidance to ensure that they fully understand the positions being taken by potential IRS auditors.
Summary Highlights from the Proposed 409A Regulations
Short-Term Deferral Payment or Planned Payment Delays to Avoid Federal Securities Law and Other Violations. The 409A Final Regs provide that short-term deferral payments, which normally must be paid within the applicable 2-½ month period, can be delayed under some circumstances. Specifically, a delay is acceptable if the payment would be administratively impracticable, would jeopardize the employer’s ability to continue as a going concern, or would reasonably result in a violation of the excess compensation rules under Code Section 162(m). The 409A Proposed Regs make it clear that a delay of payment beyond the applicable 2-½ month period would also be justified if payment would violate federal securities laws or other applicable law, provided the payment is made as soon as reasonably practicable following the first day on which the employee anticipates or reasonably should anticipate that making the payment would not cause a violation. (Note that like the 409A Final Regs, the 409A Proposed Regs use the more precise terms of “service recipient” and “service provider” instead of employer and employee. To enhance readability, this article refers to employers and employees.)
Exemption for Certain Below-Market Stock Repurchases. The 409A Final Regs provide various exemptions for stock options and stock appreciation rights granted with respect to “service recipient stock.” The term “service recipient stock” means the class of stock, determined as of the date of grant, that is the employer’s common stock, excluding any stock that is subject to a mandatory repurchase obligation (other than a right of first refusal), or permanent put or call right, if the stock price under such right or obligation is based on a measure other than the fair market value of the stock. Under this definition, an arrangement between an employer and employee that entitled the employer to buy back its stock for a discounted price if the employee was terminated for cause, or violated a non-compete, would remove the arrangement from the stock right exemption under the 409A Final Regs. The 409A Proposed Regs provide that a stock’s price will still be deemed to be based on the stock’s fair market value if the amount payable upon an employee’s involuntary separation from service for cause, or the occurrence of a condition that is within the employee’s control (such as a violation of a covenant not to compete), is based on a measure that is less than the stock’s fair market value.
Clarification of Separation Pay Plan Exception. The 409A Final Regs exclude from the definition of deferred compensation certain separation pay plans, provided that the amount paid under the plan did not exceed twice the employee’s compensation, based on compensation received in the preceding taxable year. Technically, this meant that an individual who was hired and then terminated within the same taxable year would not have had any compensation related to the prior taxable year, and therefore would not fit the exemption. The 409A Proposed Regs clarify that the separation pay plan exception is available for employees whose employment begins and ends in the same taxable year. In that situation the rules look at the annualized compensation from the taxable year in which the employee separates from service.
Employment-related Legal Fees and Expenses. Under the 409A Final Regs, an arrangement does not provide for a deferral of compensation to the extent it provides for amounts to be paid as settlements or awards stemming from bona fide legal claims based on wrongful termination, employment discrimination, etc. The 409A Final Regs provide that an arrangement does not provide for a deferral of compensation to the extent that it provides for the payment or reimbursement of an employee’s reasonable attorney’s fees and other expenses incurred to enforce a claim by the employee against the employer with respect to the employment relationship.
Certain Transaction-Based Compensation. Under the 409A Final Regs, payments were treated as “transaction-based compensation” if the payments related to certain types of changes in control and were calculated by reference to the value of the employer’s stock. Transaction-based compensation was deemed to have been paid as of a designated date, or pursuant to a payment schedule, and therefore compliant with Section 409A, if the payments were made on the same schedule and under the same terms that applied to shareholders generally in connection with the change of control transaction, provided that all payments were made within five years. The 409A Proposed Regs clarify that the special rule for transaction-based compensation applies to statutory stock options and stock rights that did not otherwise provide for deferred compensation. As a result, in connection with a change of control event, the cashing out of stock options or other stock rights in a manner consistent with the transaction-based compensation rules will mean that the payments to the stock option or stock right holders will not constitute a deferral of compensation.
Plan Terminations. The 409A Final Regs provide for accelerated payments from a deferred compensation plan if the plan sponsor terminates and liquidates all plans that would be aggregated with the terminated plan (under the plan aggregation rules provided in the 409A Final Regs). Some commentators noted the language in the 409A Final Regs only required the termination of similarly categorized plans to the extent that a common employee participated in each of the plans. The 409A Proposed Regs clarify that the acceleration of a payment pursuant to the plan termination rules is permitted only if the employer terminates and liquidates all its plans of the same category, and not merely all plans in the same category in which a particular employee actually participates.
Effective Date. The 409A Proposed Regs will not be applicable until issued as final, but taxpayers may now rely on the 409A Proposed Regs and the IRS will not assert positions that are contrary to the position set forth in the 409A Proposed Regs. The preamble to the 409A Proposed Regs notes that certain aspects of the proposed rules were not intended as substantive changes, but rather clarifications, and to that end the IRS would view certain issues addressed in the 409A Proposed Regs as being part of the previously issued 409A Final Regs. These four special points of clarification include the following:
- That the transfer of restricted stock for which no Code Section 83(b) election was made, or the transfer of a stock option that does not have a readily ascertainable fair market value, would not constitute payment under a deferred compensation plan.
- A contribution to a Code Section 402(b) trust, which in intended to fund an obligation under a deferred compensation plan and which is includable in income under Code Section 402(b), would result in a payment under the plan.
- A stock purchase treated as a deemed asset sale under Code Section 338 will not be treated as a sale or other disposition of assets for purposes of determining whether an employee has experienced a separate from service as a result of an asset purchase transaction under the change in control rules.
- The exception to the prohibition on accelerated payments in connection with a termination or liquidation of a plan (as described above) will not apply if the employer terminates and liquidates only the plans of the same category in which a particular employee participates, rather than all the plans of the same category that the employer sponsors.
- Sponsors of nonqualified deferred compensation plans should verify that their plans have been operated in harmony with the four points raised in the immediately preceding section, which points represent areas that the IRS feels were sufficiently addressed in the 409A Final Regs, in spite of the fact that the points are further clarified as part of the 409 Proposed Regs.
- Plan sponsors should review the entire list of the 409A Proposed Regs, or work with a trusted advisor to do so, to make sure that existing plan designs are in compliance with the clarified interpretation of the IRS with respect to Section 409A.