(From the April 16, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
IRS Issues Final 409A Regulations
The Internal Revenue Service released final regulations under IRC § 409A on April 10, 2007. These regulations implement the rules for unfunded, nonqualified deferred compensation plans that were enacted as part of the American Jobs Creation Act of 2004. The statute generally applies to deferred compensation accrued or vested after December 31, 2004. The regulations become effective as of January 1, 2008. During the interim, taxpayers must operate in good faith compliance with the statute and Notice 2005-1. Compliance with either the proposed or final regulations is not required, but constitutes good faith compliance. The preamble to the final regulations and previous IRS guidance address the meaning of "good faith compliance" and a number of transitional issues.
The basic elements of IRC § 409A are rules governing elective deferrals of compensation, the form and timing of distributions, and the use of rabbi trusts as funding vehicles. If a deferred compensation plan complies with all of the applicable requirements, its tax treatment is the same as in the past: The deferred amounts are taxed on actual or constructive receipt if the services are performed for a taxable entity (see Revenue Ruling 60-31) or upon vesting if the service recipient is tax-exempt (see IRC § 457(f)). However, if the plan does not comply in form or operation, deferrals are included in taxable income immediately and an additional tax of 20 percent and an interest rate tax apply. For years after the initial inclusion, increases in the value of the deferral are similarly taxed.
The regulations define "deferred compensation" very broadly, as any arrangement under which compensation for current services is payable in a later year, then carve out exceptions for many common programs, such as qualified plans, short-term deferrals, stock options, welfare benefits, certain types of separation pay and some foreign plans. This broad definition with specific exemptions means that employers may set up plans that inadvertently do not comply and therefore need to consider the effect of these rules.
It is important to become familiar with the new rules. During the remaining months of 2007, all deferred compensation, stock option, separation pay and similar plans need to be reviewed to determine, first, whether they are subject to IRC § 409A; second, whether they have met the standards for good faith compliance since the beginning of 2005; and, third, how they must be amended to comply in the future.
This article concentrates on the exemptions from IRC § 409A. A future installment will deal with the substantive rules for compliant plans. This discussion is merely an overview. Many exceptions, qualifications and special rules not discussed may affect any particular situation.
Compensation Covered by Other Code Provisions
IRC § 409A does not apply to qualified plans and similar arrangements (section 403(b) plans, section 408(k) simplified employee pensions, section 408(p) SIMPLE plans and section 457(b) eligible deferred compensation plans), incentive stock options, section 423 employee stock purchase plans, property transferred in connection with the performance of services and taxed under IRC § 83, secular trusts (taxable under section 402(b)) or secular annuities (taxable under IRC § 403(c)). A promise to make a future transfer to any such arrangement is, however, a deferred compensation plan subject to IRC § 409A.
Partial Exemption for Section 457(f) Plans
While section 457(b) plans are exempt from IRC § 409A, section 457(f) plans (unfunded deferred compensation plans of tax-exempt organizations) are not. They must comply with both IRC § 457(f) and IRC § 409A. However, because these amounts are taxed when vested under IRC § 457, only earnings credits need to comply with IRC § 409A.
IRC § 409A does not apply to "any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan". To fall within this exception, death or disability benefits must be payable only upon those events. A distribution upon death or disability under an ordinary deferred compensation plan does not qualify. Also exempt are nontaxable welfare benefits, such as retiree health coverage exempt under IRC § 105(b). However, if health benefits would be taxable (perhaps due to application of the discrimination rules on self-funded plans), amounts would be subject to the rules and currently taxable unless they can comply with the requirements of IRC § 409A.
IRC § 409A does not apply to payments made during "the short term deferral period": 2½ months after the end of the year of the later of the employer's or the employee's taxable year in which amounts accrue or, if later, become vested. This exception is useful in a wide variety of circumstances. For instance, IRC § 409A does not allow distributions of deferred compensation on account of an initial public offering (IPO). However, arrangements to pay such amounts can be designed to vest only upon the occurrence of an IPO with payment within 2½ months after the end of the year in which vesting occurs. Under this design, amounts will not be paid if an IPO does not occur and employees who leave before an IPO will not receive payment.
The short-term deferral exclusion is available only if the plan specifies that payment will be made within the requisite period or if it specifies no distribution date at all and payment is in fact made by the deadline. Not specifying a distribution date is risky; if the payment is late for any reason, it will violate IRC § 409A unless the delay is due to unforeseeable impracticality or because payment would jeopardize the business as a going concern. On the other hand, specifying the deadline has a noteworthy advantage. Under the regulations' rules regarding time of payment, payment at any time during the year in which the distribution was supposed to be made will be sufficient to avoid the application of IRC § 409A. This result depends on plan specifics regarding the payment date and taxpayers should review annual bonus plans intended to comply with these rules to ensure that the language specifies only one year in which payments can be made. To do this, the plan will need to state that payment may not be made before the beginning of the specified year. For example, if a bonus plan states that bonuses for 2008 will be paid between January 1 and March 15, 2009, they may actually be paid at any time during 2009. If it says only that they will be paid by March 15, 2009, and it is possible that payment might be made before the end of 2008, payment after March 15th will result in an IRC § 409A violation.
Stock Options and Stock Appreciation Rights
The legislative history of IRC § 409A indicates that it was not intended to apply to stock options. Indeed, applying its distribution rules would destroy one of the key features of an option, namely, the holder's ability to select the time of exercise. To avoid the application of IRC § 409A, an option must --
Stock appreciation rights (SARs) are exempted in accordance with the same principles: The stock used for measuring the value of the SAR must be common stock of the service recipient, the value of the right must be limited to the increase in the fair market value of the stock from the date of grant, and there must be no possibility of further deferral after the SAR is exercised. The key issues, then, are --
Common stock is generally defined in the same manner as under IRC § 305. Any class of common stock may qualify, including stock with a liquidation (but not with a dividend) preference. It therefore will be possible to create special classes of common stock for use only in option grants to employees, as long as the creation of the class is not intended to circumvent these rules. In general, any common stock class must appreciate or depreciate in value with the value of the service recipient's enterprise.
The service recipient includes both the entity to which services are rendered directly and all entities above it in a chain of controlled entitles. The standard of "control" for this purpose is 50 percent, relaxed to 20 percent if there are "legitimate business criteria" for granting particular individual options on the less-than-50 percent controlling entity's stock. Business criteria must be evaluated case-by-case, with the principal consideration being the existence of a nexus between the issuer of the stock and the recipient of the option. Note that options on stock of a subsidiary or brother sister corporation of the service recipient do not qualify for exemption from IRC § 409A.
For stock that is readily tradable on an established securities market, fair market value is the current price. More specifically, the value may be "based upon the last sale before or the first sale after the grant, the closing price on the trading day before or the trading day of the grant, the arithmetic mean of the high and low prices on the trading day before or the trading day of the grant, or any other reasonable method using actual transactions in such stock as reported by such market". In lieu of using the price on a single day, prices may be averaged over a period of up to 30 days before or after the date of grant, except that the employer must be irrevocably bound to grant the option before the averaging period begins. An exception applies if foreign law requires that compensatory options be priced using a specific averaging period, as long as that period does not exceed 30 days.
The value of nonpublic stock must be determined "by the reasonable application of a reasonable valuation method" based on facts and circumstances. An independent appraisal is not required. In addition, the stock price can be fixed by a formula generally applied to all transactions in the stock (with some exceptions). In the case of illiquid stock of a corporation that has been in business for less than ten years, has no publicly traded class of stock, and does not anticipate a change of control within 90 days or an initial public offering within 180 days, a valuation performed by someone reasonably qualified by reason of "significant knowledge, experience, education, or training" can be used.
While the final regulations do not adopt the good faith standard applicable to incentive stock, in many cases reasonable application of a reasonable method will have the same result. Note, that the valuation method and not the value is what is being evaluated to determine if the exercise price reflects the fair market value of the stock on the date of grant. That said, it is conceivable that a company that simultaneously issues ISOs and nonqualified options could discover that the exercise price of the ISOs is defensible as having been made in good faith, while the nonqualified options are subject to IRC § 409A, because the valuation method was determined not to be reasonable or was not reasonably applied.
As a general rule, modifying the terms of an option after its issuance is treated as the grant of a new option, which must again meet the standards for exemption from IRC § 409A as of the new grant date. However, the terms of an options whose exercise price is currently above the fair market value of the stock can be changed and, as long as any modified exercise price is not less than the current fair market value of the stock and the other rules exempting stock options from IRC § 409A are met, the options can continue to be exempt. For in-the-money options, only specified changes are allowed. The most important is that the exercise period may be extended, though not beyond the earlier of ten years from the date of grant or the latest expiration date originally permitted under the terms of the plan.
Options may also be modified to reflect stock splits and changes brought about by corporate mergers, acquisitions and split-ups. The rules are generally the same as those for similar modifications to incentive stock options.
Payments on severance from employment are deferred compensation, but the regulations provide a limited exemption for payments on account of involuntary termination or termination of employment for good reason.
The conditions for an exempt separation pay plan are these:
There are also exemptions for collectively bargained plans and separation payments mandated by foreign law, as well as certain exemptions for taxable expense reimbursements paid after separation from service (e.g., for medical overage, education expenses, outplacement fees, moving expenses including loss on the sale of a residence) and exemptions for certain in-kind benefits (e.g., personal use of corporate vehicles, aircraft or office space). Finally, there is a de minimis exception for separation pay that does not exceed the current IRC § 402(g) limit ($15,500 in 2007).
The regulations provide some relief for U.S. citizens or permanent residents who participate in deferred compensation plans established by foreign employers. There is an exclusion for participants in unfunded broad-based foreign retirement plans. The exclusion for U.S. persons applies only if the individuals do not simultaneously participate in a U.S. qualified plan, do not make elective deferrals under the foreign plan, and do not receive contributions or benefits in excess of the maximum amount that IRC § 415 allows for qualified plans.
For non-U.S. persons with U.S. source income, additional exemptions apply. First, income excluded from U.S. taxation by treaty is also excluded from IRC § 409A. Second, if a nonresident alien's deferred compensation would have been exempt from U.S. taxation if paid when earned, it will not subsequently be taxed by IRC § 409A, even if he becomes a U.S. person. (A more limited version of this exemption is available for U.S. expatriates whose deferrals would have been exempt under IRC § 911 if received when they were earned.) Third, de minimis deferrals by nonresident aliens, up to the IRC § 402(g) maximum limit, are exempted from IRC § 409A.
Finally, benefits that were accrued and vested before January 1, 2005, are exempt from IRC § 409A. The terms of the pre-2005 plans under which they were deferred may be followed, so long as they are not materially modified after October 3, 2004. Earnings credited to grandfathered deferrals are also grandfathered, except in the unlikely event that the right to them did not vest until after 2004.
Benefits are considered vested for purposes of the grandfather rule only if they are not subject to a substantial risk of forfeiture and do not require any performance of future services. The regulations state explicitly that the possibility that a stock option's exercise period will be shortened by termination of employment does not, in itself, prevent it from being vested before 2005.
A prohibited modification is "a plan amendment or the exercise of discretion under the terms of the plan that materially enhances an existing benefit or right or adds a new material benefit or right even if the enhanced or added benefit would be permitted under IRC § 409A. For example, the addition of a right to a payment upon an unforeseeable emergency of an amount earned and vested before January 1, 2005, would be considered a material modification." The elimination of a right is not a material modification. Also specifically permitted are the establishment of a rabbi trust to fund benefits, changes to the method of determining earnings credited under an account balance-type plan, an amendment to allow elections between equivalent forms of annuity (to the extent permitted for plans subject to IRC § 409A), the addition of de minimis cashout features (likewise to the extent permitted by IRC § 409A) and certain other changes. Amendments that inadvertently make a prohibited modification to a grandfathered plan may be freely rescinded during the same taxable year of the service provider, unless they are utilized before the rescission.
Having reviewed what is not within the scope of IRC § 409A, we will, in the next installment, look at the substantive restrictions on plans that do have to comply with the section.
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