- Section 409A Compliance Review: Stock Options and Other Equity-Based Compensation Plans
- June 6, 2007 | Author: David G. O'Leary
- Law Firm: Holland & Knight LLP - Chicago Office
On April 10, 2007, the Internal Revenue Service issued the long awaited Final Regulations under Section 409A of the Internal Revenue Code. Section 409A, which became effective January 1, 2005, may have a significant impact on stock option plans and other equity-based compensation plans and arrangements. It affects both public and private employers. It applies to agreements with a single employee as well as to plans and arrangements covering multiple employees, and it covers independent contactors as well as employees.
Although Section 409A became effective January 1, 2005, the IRS permitted employers and other plan sponsors to delay the amendment of the plan or arrangement until issuance of the Final Regulations, provided that they administer the plan or arrangement in good faith compliance with the requirements of Section 409A during the interim period. Now that the Final Regulations have been issued, all affected plans and agreements must be amended to conform to the requirements of Section 409A prior to December 31, 2007. The IRS has indicated this compliance date will not be extended.
Failure to comply with the requirements of 409A may result in substantial penalties for employees and other service providers who are parties to stock option plans and other equity- based deferred compensation plans and arrangements. Employees and other service providers may be liable for (a) income taxes on all amounts deferred in the current and prior years; (b) interest on the tax from the date the amount was first deferred or vested; and (c) additional penalties equal to 20 percent of the deferred amounts included in the employee or service provider’s income.
If, at any time during the taxable year, an equity-based deferred compensation plan fails to meet the requirements of Section 409A, or it is not operated in accordance with those requirements, all amounts deferred for the taxable year, and all preceding taxable years, are includable in gross income of the employee or service provider for such taxable year, to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. Such amounts are also subject to interest and an additional income tax. Interest is computed at the IRS underpayment rate, plus one percentage point. The additional income tax is equal to 20 percent of the compensation required to be included in gross income.
All Equity-Based Compensation Plans and Arrangements Should Be Reviewed Immediately
All stock option plans, stock appreciation rights plans (SARs), phantom stock plans, restricted stock plans and other equity-based plans and arrangements must be carefully reviewed to determine (a) if they are subject to the requirements of Section 409A and (b) if they are, what amendments are necessary. For those plans and arrangements that are subject to Section 409A, there is a transition period until December 31, 2007, which may provide plan sponsors with significant planning opportunities.
STEP ONE: Determine if the equity-based plans and arrangements are exempt from the requirements of 409A.
Amounts deferred under an equity based plan or arrangement will be subject to Section 409A unless: (a) the plan or arrangement qualifies under one of the statutory exemptions; (b) the amounts are subject to a substantial risk of forfeiture; or (c) the plan or arrangement is grandfathered.
1. Statutory exemptions.
Certain stock option plans and other equity compensation plans and arrangements are specifically exempt from the requirements of Section 409A. These exemptions are the following:
• Statutory stock options (ISOs) and employee stock purchase plans
This includes plans which provide for the grant of an incentive stock option, as described in Section 422 of the Code, and the grant of an option under an employee stock purchase plan described in Section 423 of the Code.
• Certain non-statutory stock options
A non-statutory stock option is exempt from 409A only if: (i) the exercise price is never less than the fair market value of the underlying stock on the date the option is granted; (ii) the receipt, transfer or exercise of the option is subject to tax under Section 83 of the Code; and (iii) the option does not include any separate feature for the deferral of compensation other than the deferral of the recognition of income of the option.
• Certain stock appreciation rights
The grant of stock appreciation rights is exempt from 409A only if: (i) the compensation payable under the stock appreciation right does not exceed the difference between the fair market value of the stock on the date of the grant and the fair market value of the stock on the date of exercise; (ii) the stock appreciation right exercise price does not exceed the fair market value of the underlying stock; and (iii) the stock appreciation right does not include any feature for the deferral of compensation other than the deferral of the recognition of income on the exercise of the stock appreciation right.
• Restricted property and stock plans covered by Code Section 83
Section 409A does not apply to restricted property and stock plans covered by Section 83 if (i) the restricted property is non-transferable and subject to a substantial risk of forfeiture and is, therefore, not currently includable in income under Section 83 by the service provider; or (ii) the restricted property is includable in income under Code Section 83 solely because a valid election was made by the service provider under Section 83(b).
Note: To be exempt, stock options and SARs must have an exercise price at least equal to the fair market value of the underlying stock on the grant date. An accurate determination of fair market value of stock is necessary when determining if stock options, stock appreciation rights and other equity-based compensation agreements are exempt from Section 409A. Section 409A has specific rules for determining fair market value. In general, if the stock is readily tradable on an established securities market, the fair market value of the stock may be determined with respect to actual transactions immediately before or after the grant or exercise, so long as the determination is made on a reasonable basis, consistently applied. In addition, an average price during a specified time period within 30 days before or after the grant or exercise can be used if the commitment to grant the stock right based on such valuation method is irrevocable before the beginning of the specified period and the valuation method is consistently applied. In the case of stock that is not readily tradable on an established securities market, the value must be determined by the reasonable application of a reasonable valuation method. The Final Regulations under Section 409A set forth several permissible valuation methods.
2. Benefits are subject to a substantial risk of forfeiture.
Equity-based compensation is subject to a substantial risk of forfeiture (and therefore not subject to Section 409A) if the service provider’s receipt of payment of an amount of compensation is conditioned upon (a) the performance of substantial future services by any person, or (b) the occurrence of a condition related to the purpose of the compensation, and the possibility of forfeiture is substantial. An amount will not be considered subject to a substantial risk of forfeiture beyond the time in which the service provider could have elected to receive the compensation. An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from performance of services (i.e., a non-compete agreement).
A substantial risk of forfeiture will be disregarded if it is used to manipulate the timing of the inclusion of income or if it is illusory. It will also be disregarded if the enforcement of the forfeiture is not likely to occur. This is a possible problem if the service provider is a substantial shareholder or exercises control over the service recipient.
Once the substantial risk of forfeiture lapses, the plan or arrangement is no longer exempt from 409A (unless one of the other Section 409A exemptions applies, such as short-term deferrals) and the documents and operations of the plan or arrangement must comply with the requirements of Section 409A.
For example, if a stock option plan provides that a participant will vest in his or her account at the rate of 0 percent for the first two years of employment and 25 percent per year thereafter, with 100 percent vesting after six years, the plan would be exempt from Section 409A for the first two years. However, in year three, the plan would have to comply with the requirements of Section 409A.
3. Benefits are grandfathered.
Stock options and other equity-based compensation in which the participant has a legally binding right to receive payments and which are fully vested and non-forfeitable on January 1, 2005, and earnings thereon, are “grandfathered” and not subject to Section 409A unless the plan or arrangement is materially modified after October 3, 2004. A plan is materially modified if a benefit or right existing on October 3, 2004, is enhanced or a new benefit or right is added. Amending a plan to conform to the requirements of Section 409A is not considered a material modification. However, amending a plan to add a provision permitted by Section 409A, such as permitting distributions upon a change in control, if the provision wasn’t previously in the plan, is considered a material modification.
For example, if in January 2003, a participant in a stock option plan was granted stock options to acquire 100 shares of the company’s stock at a price of $50 per share, the participant was fully vested in such right on December 31, 2004, and no material modification was made to the options, the value of such options (and any increase in value thereof) would be exempt from Section 409A.
STEP TWO: If plan or arrangement is not exempt from Section 409A, review for compliance with Section 409A.
Generally, Section 409A substantially limits the discretion of the employee or the plan sponsor as to the timing and methods of payments under stock options and other equity compensation plans and arrangements.
1. Determine if the underlying stock qualifies as “service recipient stock.”
Section 409A requires that the underlying stock qualify as “service recipient stock.” Generally, any class of common stock will qualify, even if there are transferability restrictions or buyback rights at fair market value. However, preferred stock and common stock with certain preferences, such as dividend rights, will not qualify. In general, service recipient stock includes stock of the employer and any company in an upward chain that has a controlling interest in the employer. As a result, grants of stock in brother-sister companies and grants of a subsidiary’s stock to employees of a parent company should be reviewed carefully.
2. Determine if the plan or arrangement permits exercise of options or distributions of benefits only upon the occurrence of a permitted “event.”
One of the most significant effects of 409A has to do with the time and form of payments. One of the most common provisions of stock option plans and other deferred compensation plans and agreements was to provide the service provider or the service recipient (sometimes both) with substantial discretion as to when and how the stock options would be exercised. This discretion has been substantially restricted.
Under Section 409A, at the time a stock option is granted or an amount is deferred, the plan documents must specify the amounts to be paid and the time and form of payment. Amounts may be paid or stock options exercised only upon the occurrence of one or more of the following “events,” and the “events” must be properly defined in the plan documents:
• Separation from service
Generally, an employee is deemed to have separated from service with the service recipient when the employee dies, retires or otherwise has a termination of employment with the service recipient. An independent contractor is deemed to have separated from service with the service recipient upon the expiration of the contract (or, if more than one contract, all contracts) under which services are performed for the service recipient if the expiration constitutes a good-faith and complete termination of the contractual relationship.
• The date an employee becomes disabled
An employee is considered disabled if the employee: (i) is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which can be expected to last for a continuous period of not less than 12 months; or (ii) is, by reason of any medically determinable physical or mental impairment which can be expected to result in death or which can be expected to last for a continuous period of not less than 12 months, receiving income replacement benefits for a period of not less than three months under an accident and health plan covering employees of the service recipient.
• A specified time or pursuant to a fixed schedule described in the plan
To qualify, the amounts must be paid or the options exercised at a specific time or pursuant to a fixed schedule that is objectively determinable at the time the amount is deferred or the stock option is granted. Any subsequent change in the fixed time or schedule will constitute a change in the time and form of payment, subject to the subsequent deferral election requirements.
• The death of the employee
The death of the employee is a distributable event.
• A change in control
The Regulations under Section 409A define what constitutes a change in ownership, a change in the effective control or a change in the ownership of the assets of a service recipient.
• The occurrence of an unforeseeable emergency
An “unforeseeable emergency” is a severe financial hardship to the employee resulting from an illness or accident of the employee or his immediate family. An “unforeseeable emergency” also includes loss of property due to casualties or similar extraordinary and unforeseeable circumstances arising as the result of events beyond the control of the employee. Amounts payable for an unforeseeable emergency must not exceed the amount necessary to satisfy such emergency, plus applicable taxes on such payment.
3. If the plan or arrangement involves a public company, make sure the plan provides that payments to “specified employees” will be delayed for six months.
A plan subject to 409A must prohibit payments on account of separation from service to a “specified employee” prior to a date that is six months after the date of such employee’s separation from service (or, if earlier, the date of death of the specified employee). A specified employee is generally defined to mean a key employee (as that term is defined under Section 416(i) of the Code) of a publicly-traded corporation. Section 416(i) of the Code provides that a key employee generally includes up to 50 officers of the employer having annual compensation greater than $130,000 (indexed, $145,000 for 2007), 5 percent owners and 1 percent owners having annual compensation greater than $150,000.
4. Determine if plan or arrangement permits an acceleration of the payment of benefits or the exercise of stock options.
Section 409A generally provides that no acceleration of the time or schedule of any payment or exercise of any option may be allowed, except (a) payments pursuant to a domestic relations order, as defined in Code Section 414(p)(1)(b); (b) payments pursuant to a certificate of divestiture, as defined in Code Section 1043(b)(2); (c) a de minimis amount if the payment is not greater than $10,000 and represents the payment of a participant’s entire benefit; (d) payments of FICA taxes on vested balances (e) payments made to avoid a non-allocation year under Code Section 409(p); and (f) payments linked to qualified plans.
If a plan or arrangement is terminated, acceleration of payments is permitted if: (a) all like plans or arrangements are terminated; (b) no payments are made for 12 months following the termination date; (c) all distributions occur within 24 months following plan termination; and (d) no similar type plan or arrangement is adopted for five years following the date of termination. Different requirements apply when a plan is terminated in connection with a change of control.
5. Review provisions pertaining to a delay in the payment of benefits or exercise of stock options.
Generally, under 409A, delay of payments or exercise of options is not permitted. However, if the payment would violate loan covenants or other contractual terms that would cause material harm to the service provider the payment may be delayed. Also, payments may be delayed in the event of bona fide disputes between the service provider and the service recipient or upon the dissolution or bankruptcy of the service recipient. In some instances, a delay based on the terms of an escrow or similar arrangement is permitted.
Also, if the period during which a stock option or stock appreciation right is exercisable is shortened due to a separation from service or other reason, the term may be extended to the earlier of the original maximum term of the option or 10 years from the original grant date.
6. Review provisions pertaining to a delay in the changes to the timing or form of benefit payments or exercise of stock options.
Generally, an election which changes either the time or form of distribution must meet all of the following requirements:
• the change must not take effect until at least 12 months after the date on which the election to make the change is made
• if the change relates to a distribution payable upon (a) the service provider’s separation from service, (b) a specified time or (c) a change of control, then the first payment with respect to which such election is made must be deferred for a period of at least five years from the date the payment otherwise would have been made
• if the change relates to a distribution which otherwise was to be paid at a specified time or pursuant to a fixed schedule, the election must be made at least 12 months before the date of the first scheduled payment
The discussion in this article is only a brief overview of the review process necessary to determine whether a stock option plan or other equity-based compensation plan or arrangement must be amended to conform to the provisions of Section 409A. The requirements of Section 409A are very complex and confusing. To receive further information, or to arrange for a more detailed review of your equity-based deferred compensation plans and arrangements, please contact your Holland & Knight attorney.