You would like to encourage certain key employees to remain employed in your business by: (1) granting stock options at less than fair market value to give them an added incentive to help grow the company; (2) granting stock appreciation or phantom stock rights so as not to dilute the actual ownership of the company but still provide an incentive; or (3) giving your top executive a written employment agreement that provides for severance payments if the executive is terminated without cause.
New Internal Revenue Code section 409A could cause all three of these situations to result in immediate tax, penalties and interest if the arrangements are not handled properly. Careful planning and drafting, however, can ensure you avoid these potential traps and realize the benefits you are trying to achieve.
Code Section 409A was added to the Internal Revenue Code by the American Jobs Creation Act of 2004. The purpose of this section is to deal with perceived abuses in deferred compensation plans, such as some of the payments made to certain executives of Enron prior to its collapse.
While Code Section 409A applies to "deferred compensation plans," the definition of what constitutes a plan is very broad and, as such, applies to arrangements most of us would not generally consider to be deferred compensation plans. In fact, all three of the incentive options listed above could fall within the definition of a deferred compensation plan and, thus, would be subject to the new rules.
What does it take to comply with Code Section 409A? The plan or arrangement must meet the new rules -- in both form and operation -- with respect to (1) distributions, (2) acceleration of benefits and (3) deferral election. The new rules are complex, due in large part to the numerous definitions that fill dozens of pages. In addition, the rules are somewhat in flux, because the IRS hasn't finalized the existing regulations, and it's likely the IRS will issue more regulations. This article tries to summarize the rules as best as possible in the space available.
Under the distribution rules, deferred compensation may not be distributed earlier than: (1) the date of separation from service; (2) the date the participant becomes disabled (as defined in the law); (3) the participant's death (not defined); (4) a specified time or fixed schedule set forth under the plan at the date of the deferral of the compensation; (5) the date of a "change in ownership" of the employer (as defined in the regulations); or (6) the occurrence of an unforeseen emergency (as defined in the law). If the corporation is publicly traded and the participant is a "specified employee" (essentially, one of the top paid executives), there must be a six month delay for distributions based on separation from service (this is a direct result of the Enron situation).
The acceleration rules are met if the plan does not permit an acceleration of the time or schedule of any payment under the plan. There are limited exceptions to this rule, such as an order to comply with a domestic relations order.
Finally, the election rules are met if the plan provides that compensation for services performed during a taxable year must be deferred at the participant's election no later than the close of the preceding year.
Consequences for Failure to Comply With Code Section 409A
What happens if you don't comply? Each participant in the plan is taxed on the entire deferred compensation amount, plus interest, plus a 20% penalty. To say the least, this is not a result most executives would find appealing. Here's how this works: the executive would be required to include all compensation deferred under the plan for the taxable year in which the plan fails to meet the requirements and for all preceding taxable years to the extent that the amount payable under the plan is not subject to a substantial risk of forfeiture, and was not previously included in income. (Generally, amounts are subject to a substantial risk of forfeiture if the participant is required to perform some act or to refrain from performing some act in the future in order to receive the amount.) In addition, the participant is subject to a penalty equal to 20% of the amount required to be included in income, and interest at a rate equal to the Federal tax underpayment rate, plus one percent. The interest is calculated as if the deferred compensation were included in the recipient's income for the taxable year in which the compensation was first deferred.
Now, let's look at our three options for retaining key employees.
Section 409A does not apply to "incentive stock options" (an "ISO"). ISOs are options that meet certain requirements of the Code, and in particular, the requirement that the exercise price be no less than the fair market value of the stock at the date of granting the option. An option issued with an exercise price of less than fair market value is inherently not an ISO, although an option may also fail to be an ISO even if the exercise price is fair market value. That said, a non-ISO will not be deemed to be a deferred compensation plan under 409A so long as four conditions are met:
- The participant has the right to purchase "stock of a service recipient."
- The exercise price for the purchase of the stock can never be less than the fair market value of the stock on the date of the grant of the option, and the number of shares which the participant may purchase is fixed on the original date of the grant of the option. There are various (complicated) factors to be used in determining whether the exercise price is at fair market value, but if the stock is publicly traded you use the trading price.
- The transfer or exercise of the option is subject to tax under Code Section 83 and Treasury Regulations 1.83-7 (applicable to property received in exchange for services).
- The option does not include any feature for the deferral of compensation, other than the deferral of recognition of income until the later of (i) exercise, (ii) disposition of the option or (ii) vesting (as defined in Treasury Regulations).
Briefly stated, "stock of a service recipient" is stock that, as of the date of the grant of an option, is (a) common stock of the entity for which the services are to be performed by the executive (or a member of its controlled group), (b) readily tradable on an established securities market, or if it isn't traded, (c) the class of common stock having the greatest aggregate value of common stock of the corporation or its equivalent (but not including preferred stock).
Stock Appreciation Rights or Phantom Stock Plans
Code Section 409A will not apply to a right to compensation equal to the appreciation in value of a specified number of shares of stock of the service recipient occurring between the date of grant and the date of exercise of such right (i.e., a stock appreciation right or a phantom stock right, collectively an "SAR") if the following three conditions are met:
- Compensation payable under the SAR cannot be greater than (i) the difference between the fair market value of the stock on the date of grant of the SAR and (ii) the fair market value of the stock on the date the SAR is exercised, with respect to the number of shares fixed on or before the date of grant of the SAR;
- The SAR exercise price may never be less than the fair market value of the underlying stock on the date the right is granted; and
- The SAR does not include any feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the SAR.
The rules for determining the fair market value of stock under stock options apply for purposes of SARs to determine whether the SAR will be deemed to be a deferred compensation plan under Section 409A.
With respect to the severance arrangements under an employment agreement, the payments should be deemed to comply with 409A if the payments are required to be made on a specific date or pursuant to a schedule set forth in the employment agreement, and are paid within 2-1/2 months after the end of the tax year in which the severance occurs.
In our three scenarios, the companies can avoid any adverse tax consequences for their executives if the options and/or SARs are granted at fair market value and meet the other restrictions noted above, and if the severance arrangement in the employment agreement is carefully structured. The most important issue to remember, however, is that the deferred compensation plan rules contained in Section 409A will apply to many employment arrangements that are not typically thought to be deferred compensation plans. Consulting with a tax professional before putting signatures on the bottom line will help avoid having the people you are most trying to benefit be subject to acceleration of income tax, penalties and interest.
Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.