On September 29, 2005, the IRS issued its long-awaited proposed regulations under Code Section 409A (the "Proposed Regulations").  As outlined in prior legal updates (Deferred Compensation Plans To Undergo Major Changes Under American Jobs Creation Act of 2004, October 2004, and Deferred Compensation Update: IRS Issues Initial Guidance, Notice 2005-1, January 2005), Section 409A of the Internal Revenue Code, adopted as part of the American Jobs Creation Act of 2004, enacts a major overhaul to the tax treatment of deferred compensation. 

Section 409A generally regulates: 

• the date by which deferred compensation elections must be made; 
• the permissible dates on which deferred compensation may be paid to employees and other service providers; and 
•  timing rules for changing distribution elections.

If the requirements of Section 409A are not met with respect to any deferred compensation arrangement, all amounts deferred under the arrangement with respect to an individual will be includable in the individual’s gross income, and an excise tax of 20% of the deferred compensation will be imposed on the individual.  The inclusion of income and the 20% excise tax are imposed as soon as the amounts under the deferred compensation arrangement are no longer subject to a "substantial risk of forfeiture" (i.e. vested).

The Proposed Regulations generally follow and add detail to prior guidance announced by the IRS under Notice 2005-1.  A few of the more notable items that the Proposed Regulations discuss in detail include the following:

• Many, but not all deadlines are extended until December 31, 2006;
• Greater detail on what requirements must be satisfied to exempt stock options from Section 409A.

What Arrangements are Subject to Section 409A?

Much of the discussion under Code Section 409A has been, and continues to be, what arrangements and plans are considered "deferred compensation" that is regulated under Code Section 409A.  In general, "deferred compensation" for this purpose arises whenever a service provider (including an employee, partner, independent contractor or director) has a "legally binding right" to compensation in a future taxable year.  A "legally binding right" simply means that the service recipient (e.g., the employer) cannot unilaterally reduce or terminate the arrangement. 

Due to the breadth of this definition, many arrangements that were not generally considered deferred compensation are swept into the rules under Section 409A, such as employment agreements, severance pay plans, stock options and stock appreciation rights, as well as deferred compensation plans, and supplemental retirement plans (SERPs).  The regulations, however, list a half-dozen or so exceptions to what will be considered deferred compensation subject to Section 409A.  Examples of arrangements that do not constitute deferred compensation include: tax-qualified pension plans, profit-sharing and 401(k) plans, 403(b) plans, 457(b) plans, any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan, as well as Archer Medical Savings Accounts, health savings accounts, and any other medical or health expense reimbursement arrangement that meets the requirements of the Code for exclusion from income.

Stock Option Plans and Stock Appreciation Rights

Another very important exclusion from the application of Section 409A is the stock option exclusion, which will apply only if the option meets certain requirements.  The reason the stock option exception is so critical is that if a stock option does not meet the requirements of the exception, it will be treated as a deferred compensation arrangement, and will violate Section 409A simply by virtue of allowing the option holder to decide when to exercise the option, a feature that, of course, exists in virtually every stock option!

In order to avoid violating Section 409A, a stock option (i) has to qualify as an incentive stock option, or an option under an employee stock purchase plan under Code Section 423, or (ii) the exercise price of the option (or stock appreciation right) must not be less than the fair market value of the underlying stock on the date of the grant of the option.  Of course, to qualify as an incentive stock option, the option exercise price must also not be less than fair market value.

This means that the valuation of the underlying stock at the time of the option grant for non-qualified and incentive stock options is of major importance.  For public company stock, establishing that the exercise price of the option is no less than the fair market value of the stock on the date of the option grant can be accomplished by any reasonable method that is based on actual transactions on the market and consistently applied.

For incentive and non-qualified stock options granted by non-public companies, however, the problem is more acute.  Under Notice 2005-1, the prior IRS guidance on Section 409A, the IRS advised taxpayers that stock value should be established by "a reasonable valuation method".  After receiving many comments from taxpayers and practitioners that more guidance on valuation was needed, the IRS has responded in the Proposed Regulations with additional detail as to how to establish fair market value of stock in order to avoid having non-qualified stock options of non-public companies characterized as deferred compensation subject to Section 409A.  For incentive stock options, the IRS previously issued regulations that the use of an independent and well-qualified expert to perform the valuation will generally satisfy the requirement to determine the value of the stock in "good faith."

Factors Establishing a Reasonable Valuation Method for Non-Public Stock

Although the Proposed Regulations continue to require that stock not readily tradable on an established securities market be determined using a "reasonable valuation method", the Proposed Regulations also add that in determining the reasonableness of a valuation method, the IRS will consider the following factors:

(i) the value of the company’s tangible and intangible assets;

(ii) the present value of the company’s future cash flows;

(iii) the market value of stock or equity interests in substantially similar businesses the value of which can be readily determined by objective means (such as through trading prices on an established securities market or an amount paid in an arm’s length private transaction);

(iv) the effects of any control premiums and/or discounts for lack of marketability;

(v) whether the proposed valuation method is used for other material purposes by the company, its stockholders, or creditors; and

(vi) whether the valuation method is used for purposes unrelated to the compensation of employees or other "service providers".

In addition to considering the factors referred to above in performing the valuation, the Proposed Regulations provide that a valuation method will not be considered reasonable if it fails to take into account all information material to the company’s valuation, including after-acquired information with material effects on the company’s current value.  Nor will a valuation be considered valid if it is more than twelve months old.

Establishing a Presumption that Valuation Method is Reasonable

In addition to enumerating factors that will tend to establish that a reasonable valuation method has been used, the Proposed Regulations also describe three alternative valuation methods that if used consistently for all equity-based compensation arrangements will be presumed to result in a reasonable valuation that can be rebutted by the IRS only upon a showing either that the valuation method or its application was grossly unreasonable.  These methods are:

(i) Independent Appraiser.  A valuation by an independent appraiser that meets the requirements for valuing employer securities held by tax-qualified employee stock ownership plans that is conducted no more than 12 months prior to the relevant transaction date.

(ii) Formula Price.  A formula-based valuation based on a non-lapse restriction that meets the requirements of Treas. Regs. Section 1.83-5(a); provided that the valuation is used consistently and performed in the same manner for all compensatory and non-compensatory purposes (e.g., regulatory filings, loan covenants, stock repurchases, and other third-party arrangements) and is used consistently. [fn1]

(iii) Reasonable Valuation of Start-Up Corporation.  A valuation of the "illiquid stock of a start-up corporation" that is made reasonably and in good faith by a person with significant knowledge and experience or training in making similar valuations and is evidenced by a written report that takes into account the relevant factors described above.  The Proposed Regulations provide that a "start-up corporation" is a company that has no trade or business that it or any predecessor-in-interest has conducted for more than 10 years.  "Illiquid stock" means that no class of the corporation’s securities is traded on an established securities market, nor is any stock of such corporation subject to a put or call right or obligation (other than a right of first refusal from a unrelated third-party or a "lapse" right or obligation under the Code Section 83 regulations).  This valuation method is not available for stock if the company or the employee or other service provider reasonably anticipate that, as of the valuation date, the company will undergo a "change of control" or make a public offering of its securities within 12 months.

Whichever (if any) of the three methods that a corporation uses to establish a presumption regarding the value of the company’s stock, the Proposed Regulations specify that the company must consistently use the valuation method it has chosen.  Consistency for this purpose means that the valuation method is used for all equity compensation arrangements including stock rights (for determining the exercise price) and stock appreciation rights and stock options paid in stock subject to put or call rights providing for the potential sale of such stock by the employee or other service provider or other obligation of the company or any other person to repurchase such stock.  A company may prospectively change the valuation method it uses for future equity compensation awards including stock rights.

While incentive stock options are expressly excluded from Code Section 409A’s definition of "nonqualified deferred compensation," they cannot completely avoid its impact.  In order for a stock option to qualify as an incentive stock option under Code Section 422, its exercise price on the date of grant must be equal to or greater than the fair market value of the underlying stock; a stock option that fails to satisfy this requirement (or the other requirements imposed by Code Section 422) is by definition a non-qualified stock option and therefore potentially subject to Code Section 409A.

As with non-qualified stock options, the valuation process is the key to determining whether Code Section 409A will be applicable to incentive stock options issued by closely-held companies.  An inaccurate valuation is not necessarily fatal to an incentive stock option’s qualification under Code Section 422 as long as it was the product of a good-faith attempt to ascertain the value of the underlying stock; the presence (or absence) of "good faith" is determined based on the relevant facts and circumstances.  Where a closely-held company is involved, the IRS has indicated that the use of an independent and well-qualified expert to perform the valuation will generally satisfy the "good faith" requirement and preserve an option’s status as an incentive stock option.

Effective Dates of Proposed Regulations

Section 409A applies to compensation that is deferred after December 31, 2004, and with respect to compensation deferred before January 1, 2005, if the plan under which such amounts were deferred is materially modified after October 3, 2004.  An amount is considered deferred before January 1, 2005 if before that date the service provider has earned and is vested in such amount.

Although the Proposed Regulations are not effective until January 1, 2007, in the meantime, deferred compensation arrangements must be operated in good faith compliance with Section 409A.  Because compliance with the Proposed Regulations will be deemed to be good faith for purposes of Section 409A, many employers may decide to follow the Proposed Regulations before their formal effective date of January 1, 2007.  The Proposed Regulations extend many of the deadlines that were originally set to expire at the end of this year, to December 31, 2006, including:

(i) Fixing Non-Compliant Stock Options.  The Proposed Regulations afford employers the opportunity to replace a non-conforming (i.e. a discount) stock option, under which the exercise price was less than the fair market value of the stock on the date of the option grant, with a new option whose exercise price is not less than the fair market value of the option on the date of the original grant, as long as the new option replaces the original option before December 31, 2006.  This extended effective date is relevant for any stock option, or the portion of any stock option, that was not granted and vested as of December 31, 2004, or that has been materially modified after October 3, 2004.  Material modifications for this purpose include any reduction of the exercise price of an option (unless the reduction does not result n a discount option at the time of amendment) or any extension or renewal of the exercise period, other than an extension to the end of the calendar year in which the option was originally scheduled to expire or to a date that is not more than the later of (i) two months and fifteen days after the date the option was originally scheduled to expire, or (ii) the end of the calendar year in which the modification was made.  An acceleration of vesting is not considered a material modification for this purpose.

Note:  If the employer wishes to compensate option holders for the lost discount resulting from fixing a non-compliant stock option, any such amount must be paid before December 31, 2005, unless it is subject to vesting.

(ii) Amending Deferred Compensation Plans and Elections to Conform to Section 409A.  The date by which a plan needs to be amended to meet the requirements of Section 409A is extended to December 31, 2006, as long as in the interim the plan is operated in good faith compliance with Code Section 409A.  In addition, distribution elections with respect to amounts subject to Code Section 409A may be changed prior to December 31, 2006 to change the time or form of benefit comply with Code Section 409A; provided that a service provider cannot change a payment election to cause amounts to be paid in 2006 that otherwise would not have been so paid, nor cause amounts that would otherwise have been paid in 2006 not to be paid in 2006.

Items to Consider Before December 31, 2005

The Proposed Regulations did not extend all deadlines to December 31, 2006.  Deadlines that remain at the end of 2005, and that require a decision before the end of 2005, are the following:

(i) Whether to terminate the pre-2005 portion of a Plan and distribute such amounts to participants by the end of 2005.

As mentioned above, the restrictions of Section 409A will not ordinarily apply to amounts under a deferred compensation plan that were earned and vested under the plan before 2005.  Such amounts, plus any earnings on such amounts, are sometimes referred to as "grandfathered amounts" or the "grandfathered portion" of a plan.

Code Section 409A will, however, apply to grandfathered amounts if any material amendment is made to the plan that affect such amounts.  A material amendment is basically any amendment or discretionary action on the part of the service recipient (e.g., employer) that could be viewed as beneficial to participants in the plan, including a termination of the plan and distribution of all amounts under the plan to participants. 

For example, if an employer terminated a deferred compensation plan after 2005 and distributed all amounts to participants under the plan, that action would (with some narrow exceptions discussed below) subject the grandfathered amounts to Code Section 409A, even though the grandfathered portion of the Plan would not otherwise be subject to Code Section 409A.  The IRS position is that the termination of the grandfathered portion of a plan followed by a distribution of its assets is a material modification that "undoes" its grandfathered status and causes it to be subject to Code Section 409A. 

As transition relief, the IRS will permit the termination of a deferred compensation plan with respect to the grandfathered amounts, as long as such termination, plus the distribution to participants of all grandfathered amounts occurs by December 31, 2005.  Terminating a deferred compensation plan in 2005 will cause participants to be subjected to income tax in 2005 on their entire grandfathered amounts, instead of at the later dates that were elected by the participants in their deferral elections, but will avoid the imposition of penalties under Code Section 409A.

An employer who chooses not to proceed with this option will not have the ability after December 31, 2005 to terminate the grandfathered portion of a plan and distribute amounts to participants without violating Code Section 409A, unless the termination is conducted (i) within 12 months of a dissolution of the company or with the approval of a bankruptcy court, (ii) within 30 days preceding or 12 months following a change in control, but only if all substantially similar arrangements of the service recipient are also terminated, or (iii) so that (A) all similar arrangements sponsored by the company are terminated, (B) no payments other than those otherwise permitted by the plan have been made within 12 months of the termination of the arrangements, (C) all payments are made within 24 months of the termination of the arrangements, and (D) the service recipient does not adopt a similar arrangement at any time within five years following the date of termination of the arrangements.

(ii) Whether to Permit Participants to Terminate Participation in Plan and/or Cancel Deferral Elections.

A service recipient, such as an employer, can also permit participants to elect on an individual-by-individual basis whether to terminate their participation in a deferred compensation plan and receive a distribution of all or any portion of their account balances under the plan in 2005 (i.e., grandfathered and non-grandfathered amounts) and/or to cancel any current deferral elections in effect for the remainder of 2005.  This is a one-time opportunity for participants in deferred compensation plans to choose to receive a distribution of all or a portion of their account balances under a plan and/or to undo their remaining 2005 elections under the plan.  The advantage to doing this is that such amounts will not be subject to Code Section 409A; the disadvantage is that the participant will be taxable on the entire distribution in 2005.

As mentioned above, the Proposed Regulations extend until December 31, 2006 the ability to cure discounted stock options by increasing the exercise price to the fair market value at the date of the option grant.  If the employer wishes to compensate option holders for the lost discount resulting from fixing a non-compliant stock option, however, any such amount must be paid to the option holder before December 31, 2005, unless it is subject to vesting.

(iii) Participants Must Elect to Defer Amounts Earned in 2006 No Later Than December 31, 2005.

Elections to defer amounts to be earned in 2006 must generally be made by the end of 2005.  Taking advantage of either, or both, of the transition provisions discussed in sections (i) and (ii) above, will not preclude a participant from making new deferral elections with respect to amounts earned in 2006 or later.

1:    We expect that this will not be used frequently given the obligation to apply the formula valuation for all other purposes.