Highlights of Final Regulations
The IRS recently published final regulations under Section 409A of the Internal Revenue Code (the “Final Regulations”). As interpreted by the Final Regulations, Section 409A applies to certain types of equity-based arrangements, such as most restricted or deferred stock units and other types of deferred equity arrangements, while also excluding from coverage many other types of equity-based arrangements, such as stock options and stock appreciations rights granted at fair market value (collectively referred to as “stock rights”) and restricted stock. In general, the Final Regulations retain many of the provisions relating to equity-based arrangements that were initially set forth in the proposed regulations with a number of helpful modifications. In particular, the Final Regulations:
- provide more flexibility in extending the exercise period of stock rights in certain circumstances;
- include a broader definition of “service recipient stock” (i.e., the classes and issuers of stock covered by stock rights that are not subject to Section 409A); and
- apply somewhat less stringent requirements for the “illiquid start up company” quasi-safe harbor for fair market value determinations.
The Final Regulations will become effective on January 1, 2008 but may be relied upon before that time.
Equity-Based Arrangements Subject to Section 409A
Under the Final Regulations, the following equity-based arrangements are subject to Section 409A:
- non-qualified stock options or stock appreciation rights that have an exercise price below fair market value at the date of grant or that provide a deferral feature;
- restricted stock units that are not paid upon vesting;
- deferred stock units that are not paid upon vesting; and
- options to acquire (or stock appreciation rights relating to) stock that does not constitute “service recipient stock” under Section 409A.
While there is no prohibition on granting equity-based awards that are subject to Section 409A, any such awards must be structured to comply with Section 409A in order to avoid adverse tax consequences and penalties.
Importantly, however, the following equity-based arrangements relating to service recipient stock are not subject to Section 409A:
- incentive stock options;
- Section 423 employee stock purchase plans;
- non-qualified stock options or stock appreciation rights with respect to service recipient stock that have an exercise price at least equal to the fair market value at date of grant and that do not provide any deferral feature;
- restricted stock, including restricted stock acquired upon the exercise of a so-called “California-style” stock option (as long as the stock option is otherwise excluded from coverage under Section 409A); and
- a promise to deliver stock in the future upon satisfaction of a vesting requirement (provided the delivery is made within the period required to meet the general exception to Section 409A for short-term deferrals).
Section 409A also does not apply to certain grandfathered arrangements. Generally, stock rights, including discounted stock rights or other equity-based arrangements that provide for the deferral of compensation, are not subject to Section 409A to the extent such awards were granted and vested before December 31, 2004, as long as such awards have not been materially modified since October 3, 2004.
Service Recipient Stock
The Final Regulations have clarified and somewhat expanded the definition of “service recipient stock.” Stock rights with respect to stock, other than service recipient stock, are subject to Section 409A.
Under the proposed regulations, service recipient stock meant, for any member of a group of corporations or entities treated as a single service recipient with a publicly traded corporation, only common stock that is readily tradable on an established securities market. For private companies, service recipient stock meant the class of common stock of the corporation having the greatest aggregate value.
Under the Final Regulations, service recipient stock means any class of stock of an “eligible issuer of service recipient stock” that is considered common stock for purposes of Section 305 of the Code other than: (i) classes of stock with preferences other than a liquidation preference, and (ii) classes of stock subject to a mandatory repurchase obligation (other than a right of first refusal) or a put or call right that is not a lapse restriction if the price of the stock upon exercise of the put or call is not based on the fair market value of the stock.
An “eligible issuer of service recipient stock” means the corporation that is the direct service recipient, as well as any entity in a chain of entities each of which has a controlling interest in the direct service recipient. Therefore, a service provider to a direct or indirect subsidiary of another corporation may be eligible to receive stock rights of any entity up the chain from the direct service recipient ending with the ultimate parent corporation. It is important to note, however, that a service provider to a parent service recipient may not receive stock rights with respect to a subsidiary corporation. This expansion of the definition of eligible issuer more closely fits common business practices and is therefore an important change in the Final Regulations.
A “controlling interest” generally means at least 50% ownership in an entity. If, however, there are legitimate business criteria, a controlling interest may mean 20% ownership in an entity. Determination of whether business criteria are legitimate will be based on a facts and circumstances test. The primary focus in determining whether the business criteria are legitimate will be on the connection between the service provider and the issuer of the stock right. Importantly, any grant in such a case must serve a legitimate non-tax business interest not related to avoiding the requirements of Section 409A.
The Final Regulations provide two useful examples of situations in which the legitimate business criteria requirements are met for granting stock rights when the ownership interest is only 20%.
- Stock of a corporation that owns an interest in a joint venture with an operating business may be used for grants of stock rights to employees of the joint venture who are former employees of the corporation if the corporation owns at least 20% of the joint venture.
- Similarly, stock of a corporate venturer could be used to grant stock rights to an employee of the joint venture if there is a reasonable expectation that the employee would in the future become an employee of the corporate venturer.
The Final Regulations retain the provision that, subject to otherwise satisfying the requirements for service recipient stock, and provided that there is no change to the terms of the stock right that would cause it to be deemed a modification of the original grant, stock rights may be substituted or assumed by reason of a corporate transaction and remain not subject to Section 409A.
As in the case of the proposed regulations, the Final Regulations provide that American Depositary Receipts may qualify as service recipient stock. The Final Regulations also permit mutual company units to constitute service recipient stock provided that the valuation of the units meets the criteria set forth in the Final Regulations.
The Final Regulations generally retain and expand on the guidance provided in the proposed regulations regarding the valuation of both publicly traded and private company stock. Valuation continues to be very important as stock rights granted with an exercise price below fair market value are subject to Section 409A.
Publicly Traded Stock
The following methods may be used to determine the fair market value of stock that is readily tradable on an established securities market:
- the price of 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 average of the high and low prices on the trading day before or the trading day of the grant;
- any other reasonable method using actual transactions in the service recipient stock as reported by the market; and
- the average of selling prices on all trading days during a specified period that is within 30 days before or 30 days after the applicable valuation date, or the weighted average of such prices over the specified period based on the trading volume of the stock during the specified period. To use this method, the program under which the stock right is granted must irrevocably specify the commitment to grant the stock right including the designation of the recipient of the stock right, the number and class of shares of stock that are subject to the stock right, and the method for determining the exercise price including the period over which the averaging will occur, before the beginning of the specified averaging period. If required under applicable foreign law, a specific price averaging method and period may be used provided that the averaging period does not exceed 30 days.
Private Company Stock
The Final Regulations generally follow the proposed regulations regarding valuation of private company stock. Accordingly, a valuation of stock based upon a reasonable application of a reasonable valuation method is treated as reflecting the fair market value of the stock. The determination of whether a method is reasonable is based on the facts and circumstances as of the valuation date. Factors that should be considered in making such a determination include, as applicable:
- the value of tangible and intangible assets of the company;
- the present value of anticipated future cash flows of the company;
- the market value of stock or equity interests in similar companies engaged in substantially similar trades or businesses, the value of which can be readily determined through nondiscretionary, objective means;
- recent arm’s-length transactions involving the sale or transfer of the company’s stock; and
- other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the company, its stockholders or its creditors.
To be considered reasonable, the valuation method must take into consideration all available material information regarding the value of the company. A previously calculated value is not reasonable as of a later date if it fails to reflect information available after the date of the calculation that may materially affect the value of the company. Consistent use of a valuation method to determine the value of a company’s stock or assets for other purposes, including for purposes unrelated to compensation, is also a factor supporting the reasonableness of the valuation method.
With some clarification, the Final Regulations include three methods of valuation contained in the proposed regulations which are presumptively reasonable:
- a valuation determined by an independent appraisal as of a date that is not more than 12 months before the relevant transaction to which the valuation is applied (e.g., the date of grant);
- a valuation based upon a formula that will not lapse provided that the stock is valued in the same manner for all purposes relating to the transfer of any shares of such class of stock to the issuer or any person who owns 10% or more of the total combined voting power of all classes of stock of the issuer; and
- a valuation of illiquid stock of a start-up company (a company that has been in business less than 10 years) that is not subject to any put or call right, that is made reasonably and in good faith and is evidenced by a written report that takes into account the relevant factors. The valuation must be performed by a person or persons qualified to perform such a valuation based on the person’s or persons’ significant experience (generally at least five years of experience in a relevant field), education or training. This method will not be presumptively reasonable if it may be reasonably anticipated at the time of the application of the valuation that the company will have a change in control within 90 days or that the company will make a public offering of securities within 180 days.
One significant difference from the proposed regulations is that the Final Regulations permit a different valuation method to be used for each separate action for which a valuation is relevant, provided that a single valuation method is used for each separate action and, once used, may not be altered retroactively. For example, one valuation method may be used to establish the exercise price of a stock option, and a different valuation method may be used to determine the value at the date of the repurchase of stock pursuant to a put or call right. A method may not be changed retroactively. However, if after the date of grant but prior to the date of exercise or transfer, the stock to which the stock right relates becomes readily tradable on an established securities market, the company must use a valuation method for readily tradable stock to determine the payment at the date of exercise or the purchase of the stock, as applicable.
Modifications of Stock Rights
Under the Final Regulations, any material modification of the terms of a stock right is considered the granting of a new stock right that could become subject to Section 409A. A modification (other than vesting acceleration) that gives the holder additional rights is generally treated as a new grant that must satisfy the requirements to be excluded from Section 409A on the date of modification. In this regard, if a stock right was originally not subject to Section 409A (e.g., an incentive stock option), but is materially modified, it could become subject to Section 409A at that time. The following are considered material modifications:
- reduction in exercise price, other than pursuant to a proportionate adjustment to reflect a stock split, a stock dividend or other corporate transaction;
- addition of discretion to provide added benefits;
- changes in the terms of the underlying stock that increase the value of the stock; and
- increases in the number of shares subject to the stock right, other than pursuant to a proportionate adjustment to reflect a stock split, a stock dividend or other corporate transaction.
Under the proposed regulations, it was also considered a modification if the exercise period of a stock right was extended beyond a prescribed limited time period. The Final Regulations provide that an extension of the exercise period of a stock right will not be considered a modification that can cause the stock right to be subject to Section 409A as long as the extension does not exceed the earlier of the balance of the original term of the stock right and the 10th anniversary of the original grant date. This is welcome relief as it is not uncommon to extend the exercise period of stock rights in connection with termination of employment or cessation of service as a director. In addition, the Final Regulations provide that any extension of a stock right at a time when the fair market value of the underlying stock exceeds the exercise price (e.g., an underwater option), regardless of the duration of the extension, is not a modification that can cause the stock right to become subject to Section 409A. Similarly, it is not a modification that could cause the stock right to be subject to Section 409A if it is extended past its expiration date because the holder cannot exercise without either violating applicable law (including certain foreign laws) or jeopardizing the ability of the company to continue as a going concern (as long as the extension is for no longer than 30 days past the date on which the holder may exercise the stock right without violating applicable law or jeopardizing the company’s ability to continue as a going concern). The Final Regulations also generally give broad relief for extensions of stock rights that occurred before April 10, 2007.
In addition, the following changes to an existing stock right will not be considered a modification to a stock right not otherwise subject to Section 409A:
- reduction of the exercise period;
- addition of an ability to tender previously owned stock to pay the exercise price;
- addition of a provision allowing shares to be withheld to pay the exercise price or to satisfy tax withholding;
- exercise of discretion previously reserved to permit transferability;
- acceleration or delay of vesting or exercisability; and
- substitution or assumption of a stock right by reason of a corporate transaction, generally as long as the substitution or assumption complies with the rules for substituting or assuming incentive stock options. Notably, adjustments to stock rights to reflect an extraordinary dividend (e.g., in connection with a leveraged recapitalization or otherwise) will not constitute a material modification so long as the aggregate spread and the ratio of the exercise price to fair market value of the shares subject to the stock grant after the modification is no greater than such spread and ratio before the modification.
The Final Regulations continue to provide relief for certain “inadvertent changes” to stock rights. If there is an inadvertent change to an existing stock right, the change will not be considered a material modification if it is rescinded by the earlier of the date the stock right is exercised or the last day of the calendar year during which the change is made.
Compliance with Section 409A
If a stock right or other equity award is subject to Section 409A (e.g., a discounted stock option or a deferred stock unit that is not paid upon vesting), then it must be structured to comply with Section 409A in order to avoid the Section 409A penalties. Generally, in such a case any election pertaining to the timing or form of payment with respect to the award needs to be made in accordance with Section 409A’s election timing rules, and the provisions regarding the timing and form of payment of non-elective equity-based awards that are subject to Section 409A need to be specified in advance. For example, a discounted stock option must provide for a fixed exercise date, which may be designated as a particular year, a change in control, termination of employment, death, disability or the earliest of any of these events. In addition, once the fixed payment or exercise date is established, it can be changed only by complying with the restrictive Section 409A rules. Please see our Client Alert: Final Section 409A Regulations Require Prompt Action on Non-Qualified Deferred Compensation Arrangements for more information about Section 409A’s election rules.
The consequences of failing to comply with Section 409A’s requirements with respect to equity-based awards that are subject to Section 409A can be significant; the holder of such an award will be subject to tax when the award vests, which could be well in advance of the date such individual would receive a payment under such an award. In addition, the amount that is taxable under such an award will be subject to an additional 20% penalty tax, as well as interest. Further, Section 409A’s plan aggregation rules may cause other arrangements that otherwise comply with Section 409A to be subject to the penalties of Section 409A.
Other Issues Addressed in the Final Regulations
- Accumulated Dividends. The Final Regulations specify that a right to payment of accumulated dividend equivalents at the time of exercise of a stock right not otherwise subject to Section 409A is generally treated as a reduction in the exercise price of the stock right that will cause the stock right to be subject to Section 409A.
- Settlement of Stock Rights in Stock or Cash. Under the proposed regulations and earlier guidance, there was uncertainty regarding whether stock rights that could be settled for cash (e.g., cash-settled stock appreciation rights) would be subject to Section 409A. The Final Regulations specify that the application of Section 409A is generally not affected by the medium of a taxable payment. Accordingly, stock rights that are otherwise excluded from coverage under Section 409A will remain excluded regardless of whether the stock right is ultimately settled in cash or stock.
- Stock Option Gain Deferrals. The Final Regulations confirm that stock rights that provide for the potential to defer the payment of cash or securities upon the exercise of the stock right must comply with Section 409A and are not excluded from coverage, regardless of whether the other requirements for exclusion are satisfied.
- Electing Form of Bonus Payments. Some companies provide their employees with an opportunity to elect whether certain bonuses will be paid in cash or as an equity award (e.g., stock option or restricted stock). The Final Regulations provide that an election between compensation alternatives, none of which is subject to Section 409A (e.g., a choice between non-discounted stock options for service recipient stock with no deferral feature or restricted stock) will not be an election that is subject to Section 409A’s election timing rules. However, if an election includes an alternative that is subject to Section 409A (e.g., a choice that includes restricted stock units that are not paid upon vesting), the election would have to comply with Section 409A’s election timing rules.
- Arrangements Between Partnerships and Partners. The Final Regulations do not provide any additional guidance on the application of Section 409A for arrangements between partnerships and partners. Therefore, until further guidance is issued, partnership interests or an option to purchase partnership interests, granted in connection with the performance of services, may be treated under the same principles applicable to stock rights. In addition, until additional guidance is issued, it is permissible to continue to rely on prior guidance with respect to partnership arrangements, which specifically provides that the issuance of a profits interest in connection with the performance of services does not result in the deferral of compensation.
- Grant Date of an Option. The Final Regulations specify that the grant date of an option is the date when the granting company completes the necessary corporate action to create a legally binding right. A legally binding right is not complete until the date on which the number of shares, exercise price, class of underlying stock and identity of recipient are fixed or determinable. The determination of the grant date is relevant for ensuring that the exercise price is at least equal to the fair market value of the underlying stock on such date.
Corrective Action for Certain Stock Rights
Companies that conclude that they have outstanding stock rights that are subject to Section 409A because, for example, the stock right was granted with an exercise price below fair market value and is not grandfathered, continue to have some ability to correct such awards. Generally, such discounted stock rights can be corrected by increasing the exercise price before December 31, 2007. For stock rights granted to Section 16 officers and directors of publicly traded companies, however, the deadline for correction was December 31, 2006.