In June, the IRS released Revenue Ruling 2014-18 to clarify that stock options and stock-settled stock appreciation rights (SS-SARs) will not be considered nonqualified deferred compensation for purposes of Code Section 457A, provided the awards are settled in stock and designed to satisfy Code Section 409A’s “stock right” exemption.
Section 457A, which is separate from Section 409A, effectively eliminates the ability to defer compensation for taxpayers that provide services to “nonqualified entities.” Nonqualified entities are typically foreign companies in “tax-indifferent” jurisdictions (colloquially, tax havens) or domestic partnerships and other pass-through entities that are owned more than 20% by tax-exempt entities. Section 457A imposes tax on deferred compensation at vesting, rather than on payment as under Section 409A. Section 457A most commonly applies to hedge funds and U.S. citizens working outside the U.S. for a non-U.S. employer in a tax-indifferent jurisdiction.
Since Section 457A became effective in 2009, some compensation professionals have been concerned that Section 457A and its potential 20% penalty tax would apply to any stock option or SAR granted to a service provider of a nonqualified entity. This concern arose from the explicit language of the statute, which defines nonqualified deferred compensation by referring to the definition in Section 409A(d) but then adds “except that such term shall include any plan that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient.” The IRS previously tried to ally this concern in IRS Notice 2009-8, but now has used a more formal interpretation in Revenue Ruling 2014-18 to confirm that Section 457A does not apply to stock options and SARs that are stock-settled so long as they met the stock right exemption in Code Section 409A.
However, unlike Section 409A, Section 457A still applied to stock appreciation rights that are or may be settled in cash. Revenue Ruling 2014-18 applies retroactively.