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EBECatty

Deferral Feature in Exempt Stock Right?

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Say you have an exempt option or SAR. One of the requirements is that the stock right contains no feature for the deferral of compensation, which is defined as anything other than the right to receive payment upon exercise and would allow compensation to be "deferred beyond the date of exercise." 

The preamble says "if an arrangement provides for a potential to defer the payment of cash or property upon the exercise or exchange of a stock right beyond the year the right is exercised or beyond the original term of the stock right, the arrangement provides for a deferral feature and must comply with the requirements of section 409A from the time the legally binding right granted by the award arises." 

So if you exercise the option/SAR now, you can get paid any time during 2018. 

My question: What if someone exercises an option/SAR when it's administratively impossible to pay them in the same year, e.g., they send their exercise notice at 4:59 p.m. on December 31, 2018. Payment will have to be made in 2019. What's the cutoff? As soon as possible? If it's paid by March 15, 2019, is the payment "deferred" or can you use a short-term deferral like concept to say it's not? 

If the employee exercises on December 31, 2018, but payment is not made until, say, January 5,  2019, do you report it as 2018 income?

Appreciate any insights. 

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The question is whether the amount is constructively received in 2018.  Since (I assume) there is no practical way for the employer to process the payment in the one minute remaining before the close of business on December 31, 2018, it seems highly unlikely that it would be constructively received on that date.  Therefore, it would be taxable in 2019.

If the exercise then goes through the ordinary administrative processes for payment of an exercised SAR and is paid before March 15, 2019, there should be no issue with Code section 409A since the short-term deferral exception should apply.  Even if payment is deferred beyond that date, there are ways to self-correct the error.  Either way, the SAR should be taxable in 2019. 

If this is the final year for exercising the SAR, you may want to look closely at the plan document to see if the SAR is deemed exercised at any point in 2018 so that the employer can pay it out in that year without receiving an actual election.  Just a possibility but it depends on the plan design.

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You might want to look at the new tax law section on deferrals---there is a provision that allows deferrals again for limited purposes for stock plans but I believe it has to be an all-employee stock option plan which is becoming rarer today.

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Even before 409A, the issue of the date of inclusion in income of a stock option exercise, and the deadline for payroll tax deposits, was important and contentious. For an option, I believe it is the transfer of the stock that is going to govern the time of taxation, and, at least for a public company, that depends on the settlement date. Most publicly traded companies' shares settle T+2, so in your example of a 12/31 exercise, if that was, say, a Monday, I think you would be looking at Wednesday, Jan 2 as the date when the stock is actually owned by the option exerciser and includable on W-2 fo0r that year. You may want to search for a 2003 IRS Field Directive on the issue of timeliness of payroll deposits for NSO exercises (the directive told agents not to challenge taxpayers as long as withholding was made within 1 day of transfer and transfer was T+3 or sooner). For a private company, I do not know what the rule is. Probably the actual date of transfer on share ledger or delivery of share certificate. For an SAR, again don't know, but probably should be the same as for the underlying stock. Anyway, as long as paid by 3/15 of next year, I think you'd be OK for 409A under the "When a payment is treated as made upon the designated payment date" rule of 1.409A-3(d).

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Appreciate all the feedback. Thanks. 

It sounds like the consensus is that settling by the next March 15 should keep the 409A exemption. That was my tentative thought as well but I wanted to make sure I wasn't missing some other guidance on point. 

Taxation timing was a secondary thought but also appreciate the responses. 

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