NSO Gain Deferrals into DCP - OK under 409A?

[Guest sjb]

I appears to me that (assuming the election timing and grandfathering provisions of 409A are followed as applicable), the new rules don't affect the practice the deferring gain on stock options into a NQDC. I think you just treat them as another source of participant elected deferred compensation and test them as to their election timing.

Am I missing anything? SB

[TCWalker]

Yes, I think the 409A problem is the election to defer needs to pre-date the performance and vesting service period, which arguably means pre-dating the grant date, which causes you to pre-dating any enforceable right to future compensation. It begs for relief, but none seen so far.

[Kirk Maldonado]

TCWalker:

It seems like your response contemplates that a future grant of a stock option. I interpreted the original posting as involving a situation where there is an existing (pre-2005) stock option that permits the gain to be transferred to a NQDC plan.

sjb:

Does such an arrangement really make sense any more? I see two major problems:

1. You are converting long-term capital gains (assuming that the person held the stock acquired upon the exercise of the stock option) into ordinary income (which is the way that all amounts distributed from NQDC plans are taxed); and, more importantly

2. The amounts deferred are subject to the claims of the employer's creditors until they are paid out. On the other hand, if the participant held the stock, then he or she could elect to sell the stock at any time. Accordingly, if the company becomes insolvent before the deferred compensation benefits are paid out, then the person has lost everything, whereas if the person held the stock, he or she could sell the stock as soon as the price started dropping.

Admittedly, the second factor is present whenever a participant contributes to a deferred compensation plan. But those contributions are usually made because the person believes that they will actually pay less in taxes by contributing those amounts to the NQDC plan when they are in a high income tax bracket and withdrawing them when they are in a lower tax bracket. Given the loss of long-term capital gains treatment, it seems like it would be hard to prove that this arrangement will save taxes in most cases.

[TCWalker]

Hi Kirk:

Yes, going forward, but not entirely. If you look at the transitional rule for pre-409A deferrals , Q&A 16(b), I read it as requiring a 12/31/04 existing deferral election and that it apply to legally entitled vested amounts. Since many SO gain deferral elections span future years and include unvested amounts as of 12/31/04 I deduce these elections may not work to defer gain that's unvested as of 12/31/04. Thus, you lose "grand-fathering" on the unvested part of this prior election and you'll need a 409A compliant election for the remainder - and I'm not seeing how the typical plan may comply.

So, it's going forward plus past grants where the amounts are unvested as of 12/31/04.

I'd like to be wrong on this one, you see it differently?

[Guest Harry O]

Kirk,

In most cases, deferral at ordinary tax rates still beats immediate tax with the prospect of LT capital gains. Anytime you can have pre-tax amounts compounding (i.e., the spread at exercise) versus after-tax amounts compounding (i.e., the spread at exercise minus taxes paid at exercise on spread), the pre-tax compounding overwhelms capital gains treatment under most reasonable assumptions.