Guest Article

(From the November 21, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Application of New Deferred Compensation Rules to Equity Compensation

New tax rules under IRC § 409A dramatically change the operation and taxation of many common nonqualified deferred compensation arrangements. Deferred compensation plans must operate in good faith compliance with section 409A during the 2005 and 2006 transition period and must be formally amended by the end of 2006 or employees will become subject to taxation of their deferred compensation amounts in 2005 or, if later, when the amounts become vested. The amounts are also subject to an additional 20 percent excise tax and, in some cases, an underpayment interest penalty. To comply with the new rules, changes will likely need to be made to plan distribution rules and, in the case of plans that allow the employee to elect to receive amounts in the future, the deferral election rules.

This article provides general guidelines to help you identify plans that may be exempt from the rules and plans that may need to be amended to comply with the rules. In the case of a plan that needs to be amended, this article highlights some alternatives to consider that would allow plan participants to continue to defer compensation amounts without current taxation.

1. Does an arrangement provide for "deferred compensation"?

In general, deferred compensation exists if an employee has a legally binding right to receive compensation in a future year as a result of performing current services. For example, many employers have a severance policy that pays employees an amount (usually determined on years of service) in the event of a lay off. This arrangement constitutes deferred compensation as defined by the new rules. It does not matter whether the amounts are "vested" or not. The grant of an option to purchase property at a specified price for a stated time in exchange for services would also be deferred compensation under the new rules. In addition, a legally binding right can exist even if certain events are required to occur for payment to be made. For example, a legally binding right is created when an employer agrees in 2006 to pay employees employed on December 31, 2007, 1 percent of the employer's 2007 profit. The legally binding right exists in 2006 even though the recipients are not known until December 31, 2007 and the amount to be paid will not be known until after 2007.

The definition of deferred compensation arrangement is very broad for purposes of the new rules. However, many arrangements are excepted from the rules and will not be required to be changed.

2. Will the arrangement be paid so shortly after it is earned that is excepted from the definition of deferred compensation?

If amounts are paid within 2 ½ months after the end of the taxable year in which the amounts are vested or no longer subject to a risk of forfeiture, the arrangement meets the short-term deferral exception to the definition of deferred compensation and the payment is not subject to the new rules. The "year" for this purpose can be the employer or the employee's taxable year, whichever ends later.

An arrangement that does not specify a payment date can satisfy this exception by paying on or before the required 2 ½ month date. However, without a payment date specified in the arrangement, failure to pay by the short-term deferral date will result in a plan that is simultaneously subject to, and in violation of, the new distribution rules. This will result in immediate taxation and the 20% additional penalty. For this reason, we recommend that all arrangements state a payment date (e.g. a payment month or year).

Examples

Restricted Stock Units (RSUs) are granted in year 1 and vest after 3 years of service, upon death or in the event of a change in control. Once vested, RSUs are paid as soon as administratively practicable, but in no event later than 2½ months after the end of the year of vesting. This plan meets the short-term deferral exception and is not subject to the rules.

RSUs are granted in year 1, and vest ratably each year over 3 years of service, upon death, or upon a change in control. Once fully vested, RSUs are paid as soon as administratively practicable, but in no event later than the earlier of 2½ months after the end of the year in which the RSU grant is fully vested or upon the individual's separation from service. This plan does not meet the short-term deferral exception because the amounts that vest in the first 2 years are not paid within the required 2½ month period. This plan is a deferred compensation arrangement that must comply with the new rules.

3. Are all deferred amounts not yet paid to participants required to comply with the new rules?

No, amounts "fully earned and vested" before December 31, 2004 are grandfathered and not required to comply with the new rules if there has not been a material modification to the plan after October 3, 2004. Amounts are "fully earned and vested" if the payment is not subject to a substantial risk of forfeiture and not subject to the exercise of discretion in 2005 or later. Earnings on such grandfathered amounts are also not subject to the new rules.

4. What constitutes a material modification?

A plan is materially modified if there is an addition of, or material enhancement to, a benefit, right or feature to the obligation. This can occur by amendment or the exercise of discretion under the terms of the plan. Once materially modified, the plan must comply with section 409A even if it would have otherwise been grandfathered.

5. What arrangements meet the equity right exception and are not subject to the new rules?

An equity right (generally, option or stock appreciation right) is excepted from the rules, if it:

In addition, incentive stock options and stock purchased under and employee stock purchase plan are exempt from the rules.

6. What qualifies as "service recipient stock" for purposes of satisfying the equity right exception?

Service recipient stock is common stock of the employer or a related entity, without any liquidation or dividend preferences, that is not subject to a mandatory put, call or repurchase for any price other than fair market value (other than a lapse restriction). For related entities, the general rule is based on an 80 percent control test. The proposed regulations allow this general rule to be reduced to 50 percent control, or if there are legitimate business reasons, 20 percent control.

As proposed, the rules require that if there is a class of common stock that is readily tradable on an established market, that class of stock must be used for purposes of granting stock rights. If there is no class of common stock in the group of related entities that is readily traded on an established securities market, the class of common stock that has the greatest aggregate value, or stock with substantially similar rights to such common stock, is considered service recipient stock. Differences in voting rights are disregarded.

Stock rights granted on other classes of common stock are also considered granted on service recipient stock if the stock right was granted by December 31, 2004. In addition, the rules can apply to partnership interests for 2005 and 2006 if an 80 percent control test is met.

7. How is fair market value determined for purposes of satisfying the equity right exception?

For stock that is readily tradable on an established securities market (including over-the-counter), any reasonable, consistently applied method for deriving fair market value from actual transactions is acceptable. This includes the last sale price before grant, the first sale price after grant, the closing price on the trading day before or after grant, or an average price over a period of up to 30 days before or after grant if specified in advance. For stock that is not readily tradable on an established securities market, the proposed regulations require the use of a reasonable method based on reasonable assumptions, taking into account relevant facts and circumstances.

The proposed regulations also establish several safe harbors. Use of a safe harbor method on a consistent basis is presumed reasonable; to rebut the presumption the Commissioner must show that the valuation method or the application of the method was grossly unreasonable. Using a value determined under an independent appraisal that meets the requirements for valuing stock held by employee stock ownership plans that is issued no more than 12 months before the relevant transaction is one safe harbor. A non lapse formula-based valuation is a second safe harbor valuation, provided that the formula is used both for compensatory and noncompensatory purposes (including issuances to and repurchases from non-employee third parties). For illiquid stock of start-up companies (generally, those that have been in business for less than 10 years, have no publicly traded class of securities, and do not anticipate a change in control or a public offering within the next 12 months), a reasonable, good faith valuation evidenced by a written report issued by someone who is qualified, but not necessarily independent, will meet the safe harbor rules.

For equity rights granted in prior years, the employer will need to consider whether the exercise price was fair market value at grant and whether that determination can be documented. If so, the general standard on valuation may be satisfied, even if one of the safe harbors in the proposed regulations does not apply. In other cases, an employer will have to consider whether to adjust the exercise price to the fair market value at the date of grant or conform the arrangement to satisfy the section 409A rules.

8. For equity rights not exempted from the rules, how can modifications be made without the employee losing any value?

For equity rights granted at a discount (including options where the employer decides that the exercise price cannot be substantiated as fair market value at grant under a reasonable valuation method), the employer can increase the exercise price to the fair market value on the date of the initial grant in order to satisfy the equity right exception and not subject the rights to the new rules. Any price adjustment should consider accounting implications, including the adoption of FAS 123R.

To compensate employees for any lost discount, the following alternative adjustments are permissible as long as the right is not exercised before the exercise price is adjusted:

Alternatively, the existing equity right can be converted into an arrangement that complies with section 409A, including distributions only on permissible events. This distribution rule removes the participant's flexibility in choosing when to exercise the right and recognize income.

Cancellation of a deferral arrangement (including a discounted option) that does not comply with the new rules is permissible in 2005 without violating the strict restrictions imposed on cancellations in future years.

If an employer does not amend options with a discounted exercise price before December 31, 2005, it should freeze option exercises or advise affected employees not to exercise the options until the plan is compliant.

Transition relief does not extend beyond 2006. Therefore, employers should determine whether grants fit an exception, take action to bring the equity right into the exception or modify the grant to comply with the new rules by the end of 2006.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Bart Massey 202.220.2104, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Stephen LaGarde 202.879-5608, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2005, Deloitte.