WSGR ALERT

Highlights of the Final Section 409A Regulations

April 16, 2007

On April 10, 2007, the U.S. Treasury and Internal Revenue Service (IRS) issued their highly anticipated and long-delayed final regulations under Section 409A (http://www.treas.gov/press/releases/reports/td9321.pdf). For a discussion of the proposed regulations and other subsequently issued Section 409A guidance, please see our previous client alerts on this subject at http://www.wsgr.com/WSGR/Search.aspx?SearchString=409A.

This Client Alert highlights the most important changes and clarifications made by the final regulations. We will provide additional Client Alerts over the next few weeks to give more in-depth and detailed descriptions of the final regulations. The final regulations are more comprehensive than the lengthy proposed regulations and cover 397 pages. The proposed regulations were a mere 238 pages.

Background

Section 409A was enacted in October 2004 as part of the American Jobs Creation Act. In December 2004, the IRS issued Notice 2005-1, which provided some transition guidance for complying with Section 409A. Subsequently, in September 2005, the IRS issued proposed regulations under Section 409A. Since the issuance of the proposed regulations, the IRS issued a series of six additional notices providing further transitional guidance with respect to Section 409A. Under Section 409A, unless certain requirements are satisfied, amounts deferred under a non-qualified deferred compensation plan (which would include certain discount stock options and severance arrangements) currently are includable in gross income unless the amounts are subject to a substantial risk of forfeiture. Such deferred amounts also are subject to an additional 20 percent federal income tax (and in California, an additional 20 percent state tax).

Highlights of the Final Regulations

The following highlights the most important differences between the final regulations and the previously proposed regulations. Future Client Alerts will discuss each of these issues in significantly more detail.

1. Modification of Stock Rights

Proposed Regulations. Previously, if the exercise period of a stock right (which for Section 409A purposes includes stock options and stock appreciation rights) was extended, except for certain limited extensions following a separation from service, the stock right would be considered as having an additional deferral feature from its original date of grant. This could expose the "modified" stock right to the additional 20 percent income tax (and in California, an additional 20 percent state tax) under Section 409A.

Final Regulations. The final regulations provide flexibility by providing that the extension of a stock right's exercise period generally will not be treated as an additional deferral feature or a modification of the stock right for purposes of Section 409A if the exercise period is not extended beyond the original maximum term of the stock right, but no longer than 10 years from the original grant date of the stock right.

In addition, an extension of a stock right will not be considered an additional deferral feature for purposes of Section 409A if, at the time of the extension, the stock right is "underwater" (i.e., the exercise price exceeds the fair market value of the underlying stock).

The final regulations also provide that an extension granted before April 10, 2007, solely to give the holder an additional period of time to exercise a stock right is not considered as having an additional deferral feature from its original date of grant.

Importance of Change. The final regulations significantly improve the proposed regulations. The blanket exemption for any extension granted before April 10, 2007, and the longer permissible period for extensions made after that date provide greater flexibility to companies and more closely reflect practices prior to the proposed Section 409A regulations.

2. Definition of Service Recipient Stock

Proposed Regulations. In order to receive favorable treatment for fair market value stock rights under Section 409A, the stock underlying the stock right must be "service recipient stock." The proposed regulations defined service recipient stock very narrowly, as common stock of a corporation that is publicly traded or, if none, that class of issued and outstanding common stock having the greatest aggregate value. Under this definition, it was very difficult for the common stock of a publicly traded corporation's subsidiary to qualify as service recipient stock.

Final Regulations. Under the final regulations, service recipient stock will include any class of common stock within the meaning of Section 305 of the Internal Revenue Code, including a class of common stock that has liquidation preferences. Conveniently, this applies even if there is another class of publicly traded common stock that would qualify as service recipient stock (even if that class of stock is subject to transferability restrictions or buy-back rights).

Additionally, the final regulations provide that service recipient stock may include stock of any corporation in a chain of organizations that have a controlling interest in another organization under Section 414 of the Internal Revenue Code, beginning with the parent organization and ending with the organization for which the employee was providing services at the date of grant of the stock right. In other words, the service recipient stock does not have to be the stock of the ultimate parent corporation, but cannot be stock in an organization on the chain that is below the corporation for which the service provider renders services.

Importance of Change. The type of stock that may be granted pursuant to a stock right has been expanded significantly by the final regulations. In particular, the final regulations now will permit the grant of stock rights to purchase stock of a majority-owned subsidiary of a public company to employees of the subsidiary.

3. Valuation of Private Company Common Stock

Proposed Regulations. In order for stock rights to be excluded from Section 409A, they must have an exercise price that at least equals the fair market value of the underlying service recipient stock on the date the stock right is granted.

For purposes of valuing private company stock, 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. A valuation was presumed to reflect the fair market value of the stock if the valuation was based upon: (i) an independent appraisal; (ii) a generally applicable repurchase formula that would be treated as fair market value under Section 83 of the Internal Revenue Code; or (iii) in the case of illiquid stock of a start-up, a written valuation report by a qualified individual or individuals. In the last instance, the illiquid stock written report presumption could not be relied upon if the company reasonably anticipated that it would undergo a change in control or an initial public offering within 12 months after the valuation was applied.

The proposed regulations provided a list of factors to be considered in determining the fair market value of private company stock, including: (i) the value of tangible and intangible assets of the corporation; (ii) the present value of anticipated future cash-flows; (iii) the market value of stock in similar corporations engaged in substantially similar businesses; and (iv) other relevant factors, such as control premiums or minority discounts.

Final Regulations. The final regulations provide that a company may rely upon the start-up written report presumption if the company instead reasonably believes that it will not undergo: (i) a change in control within 90 days of the valuation, or (ii) an initial public offering within 180 days of the valuation.

The final regulations also provide guidance for purposes of determining who is qualified to value the illiquid stock of a start-up. The final regulations clarify that the applicable standard is whether a reasonable individual, when informed about the potential valuator's relevant knowledge, experience, education, and training, would reasonably rely on the advice of such person in deciding whether to accept an offer to purchase or sell the stock being valued. The final regulations also clarify that significant experience generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the company operates. In determining the fair market value of private company stock, any recent arm's length transactions involving the sale or transfer of shares of the stock also may be considered.

Importance of Change. A start-up private company now can rely on the written report presumption more effectively. The reduction from 12 months to 90 days for a change in control and to 180 days for an initial public offering provides a more practical time period given the rapid pace at which business and market conditions can change. The addition of recent arm's length sale transactions as one of the factors to consider in determining the fair market value of common stock should provide a more real-world basis for many private companies to value their stock.

4. Severance Pay Solely as a Result of an Involuntary Separation from Service

Proposed Regulations. The proposed regulations provided an exclusion from Section 409A for certain amounts paid solely because of an involuntary separation from service. The exclusion covers payments that were: (i) payable no later than December 31 of the second year following the separation from service, and (ii) limited to an amount that was generally the lesser of either two times the employee's annual compensation or two times the limit of compensation set forth in Section 401(a)(17) of the Internal Revenue Code ($220,000 in 2006 and $225,000 in 2007).

Final Regulations. The final regulations permit this involuntary separation from service exclusion from Section 409A to payments up to the limits described above, even if the total payment amount would exceed the applicable limit. In other words, if an involuntarily terminated employee is entitled to a payment that would qualify for the above exception except for the fact that the total payment amount would exceed the applicable dollar limit, only the excess over the limit will be subject to Section 409A. Consequently, "key employees" of public companies will be subject to the Section 409A mandated six-month delay rule only for amounts over the applicable dollar limit.

Importance of Change. The clarification that if all of the other requirements are met, at least a portion of the amounts owed to any involuntarily terminated key employee may be paid without imposing the six-month delay required by Section 409A should provide much greater flexibility in a public company's negotiation with, and termination of, key employees. In addition, the change also provides a real-world benefit of allowing at least a portion of the cash owed to the terminated employee to be paid right away, while the excess amounts would still be required to be paid after a six-month delay.

5. "Good Reason" Terminations

Proposed Regulations. The preamble to the proposed regulations raised concerns regarding whether severance payments paid in a voluntary "good reason" termination might be amounts subject to Section 409A.

Final Regulations. The final regulations provide that a separation from service for good reason may be treated as an involuntary separation of service in certain circumstances, and therefore may not be subject to the penalties of Section 409A. If properly structured, the amount payable on account of such a termination will be treated in the same manner as an amount payable on account of an actual involuntary separation from service.

In order to qualify as an involuntary separation from service, the good reason condition must: (i) not have been established in order to avoid the imposition of Section 409A, and (ii) require actions taken by the company resulting in a material negative change in the employment relationship, such as a material negative change in the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received. Additional factors that will be examined in order to determine if the condition is a legitimate good reason condition (as opposed to a condition with the principal purpose of avoiding Section 409A) include the extent to which the payments upon the separation of service for good reason are in the same amount and in the same form of payments to be made upon an actual involuntary termination from service, and whether the employee is required to give the company notice of the existence of the good reason condition and a reasonable opportunity to remedy the condition.

The final regulations provide a safe harbor under which a provision for payment upon a voluntary termination from service for good reason will be treated for Section 409A purposes as a payment upon an involuntary separation from service. The safe harbor applies only if all of the following are true:

  • The amount must be payable only if the employee separates from service within a pre-determined limited period of time (not to exceed two years) following the initial existence of the good reason condition;
  • The amount, timing, and form of payment upon a voluntary separation for good reason must be identical to the amount, timing, and form of payment for an involuntary termination from service;
  • The employee must be required to provide notice of the good reason condition within 90 days of the occurrence of the good reason event; and
  • The company must be given a period of at least 30 days to remedy the good reason condition.

For the purposes of the safe harbor, a good reason condition may consist of one or more of the following conditions arising without the consent of the employee:

  • A material diminution in the employee's base compensation;
  • A material diminution in the employee's authority, duties, or responsibilities;
  • A material diminution in the authority, duties, or responsibilities of the supervisor to whom the employee is required to report, including requirements that an employee report to a corporate officer or employee instead of reporting directly to the board of directors of a corporation (or similar entity, as applicable);
  • A material diminution in the budget over which the employee retains authority;
  • A material change in the geographic location at which the employee must perform the services; or
  • Any other action or inaction that constitutes a material breach of the terms of an applicable employment agreement.

Importance of Change. There previously was concern that employment agreements and change of control severance plans might have to be stripped of good reason protections. Thankfully, the regulations provide a framework to address these concerns and specifically provide a mechanism to ensure that arrangements that provide for good reason termination payments can be structured to comply with Section 409A. Existing plans and arrangements providing for severance payments in the event of good reason should be reviewed and revised as necessary to ensure compliance with the final regulations, although employers are not required to use only the safe harbor definition.

6. Tax Gross-Up Payments

Proposed Regulations. The proposed regulations were silent with respect to whether a contractual promise to pay certain tax gross-up payments would be considered deferred compensation subject to Section 409A.

Final Regulations. In the final regulations, a tax gross-up payment that provides an employee with the right to a payment of taxes otherwise payable by the employee, as well as any additional taxes resulting from such payment, is a right to deferred compensation that satisfies the fixed time and form of payment requirements of Section 409A. This is the case only if the arrangement provides that the tax gross-up payment will be made, and the payment actually is made by the end of the employee's taxable year following the taxable year in which the related taxes are remitted to the taxing authority.

Importance of Change. Previously, it was not clear whether such tax gross-up payments would be considered deferred compensation under Section 409A. The final regulations clarify that, although such amounts are deferred compensation, there exists a fairly easy and straightforward exception for such payments to comply with Section 409A. Existing plans and arrangements that provide for tax gross-up payments should be reviewed and revised as necessary to ensure compliance with the final regulations.

7. Requirement to Amend Plans to Comply with Section 409A before 12/31/07

Proposed Regulations. Previous IRS guidance required that plan documents comply with Section 409A by the end of 2005 (Notice 2005-1), then by the end of 2006 (in the proposed regulations), and then by the end of 2007 (Notice 2006-79).

Final Regulations. The final regulations require that all plans and other arrangements that provide for deferred compensation subject to Section 409A be amended to comply with Section 409A on or before December 31, 2007. In order to comply with Section 409A, certain provisions must be included in the written plan documents. Specifically, the final regulations require the documents to specify the time an amount is to be deferred, the amount to be paid (or the terms of an objective, nondiscretionary formula to calculate the payment amount), and the payment schedule or payment-triggering events that will result in a payment of the amount.

Importance of Change. Given the long delay in finalizing the regulations, the IRS has set a deadline of December 31, 2007, to allow companies to revise plans and arrangements to comply with these final regulations. To ensure compliance with this deadline, companies should complete an inventory of the plans and arrangements potentially subject to Section 409A well in advance of that date, and establish a schedule for revisions to ensure timely adoption of any required amendments.

8. Compensation Not Subject to Section 409A

Proposed Regulations. The proposed regulations did not address whether several different types of benefits and other forms of compensation also might be deferred compensation subject to Section 409A.

Final Regulations. The final regulations provide clarification on the types of compensation not considered to be nonqualified deferred compensation (and thus not subject to Section 409A). The forms of compensation not subject to Section 409A include the following:

  • Rights to a benefit that is excludable from income—for example, an arrangement to provide health coverage excludable from income under Section 105 of the Internal Revenue Code;
  • Taxable reimbursements of medical expenses over the period during which the employee would be entitled to continuation coverage under a group health plan (i.e., COBRA coverage) if such continued coverage was so elected and the applicable premiums were paid;
  • Reimbursement for certain expenses such as reasonable outplacement expenses and reasonable moving expenses (including reimbursement for a loss incurred as the result of a sale of a residence) for a limited period of time due to a separation from service;
  • A legally binding right to receive a nontaxable benefit (unless the employee may exchange or has exchanged such benefit for an amount to be includable in income);
  • Settlement awards (and applicable attorney fees) relating to a settlement or award resolving certain bona fide legal claims (the exemption does not allow settlements or awards to act as substitutes for, or to allow for, the restructuring of pre-existing deferred compensation subject to Section 409A); and
  • Rights to educational benefits, where the benefits consist solely of educational assistance provided for the education of the employee.

Importance of Change. The final regulations provide clarity that deferred compensation subject to Section 409A does not include many of these common benefit and payment arrangements.

9. Aggregation of Arrangements under Section 409A

Proposed Regulations. Under the proposed regulations, all amounts deferred with respect to an employee under all plans of a company falling within a particular category would be treated as deferred under a single plan. This meant that a Section 409A violation with respect to one plan (e.g., a stock option) could negatively affect all other arrangements of that same type. The enumerated categories included: (i) amounts deferred under account-balance plans; (ii) amounts deferred under non-account-balance plans; (iii) amounts deferred under separation pay plans providing payments solely due to an involuntary termination or participation in a window program; and (iv) amounts deferred under any other plan.

Final Regulations. In addition to the above categories, the final regulations also establish split-dollar life insurance arrangements, reimbursement plans, and stock rights that previously constituted nonqualified deferred compensation. Additionally, account-balance plans will be subdivided into categories for elective plans and non-elective plans.

Importance of Change. The aggregation rules of the proposed regulations required that if one arrangement was not in compliance with Section 409A, all of the plans and arrangements in the same aggregation pool also were treated as noncompliant with Section 409A. The addition of the new categories of plans under the final regulations provides much-needed relief from the possibility that otherwise-compliant arrangements might be dragged into noncompliance as a result of an aggregated noncompliant arrangement.

10. Issues Not Addressed in Final Regulations

Proposed Regulations. The proposed regulations reserved comment on several topics on which the IRS has provided transition guidance through various notices since the release of the proposed regulations.

Final Regulations. The final regulations also do not address every issue and still reserve comment on several key subjects. Specifically, the final regulations do not address the calculation or timing of amounts required to be included in income under Section 409A, and the application of Section 409A to partnership arrangements.

Importance of Change. Although the final regulations are very comprehensive and provide much-needed clarification and relief in several troublesome areas, they do not answer every question or concern raised by Section 409A. The IRS has promised additional guidance on such open issues in the future.

Additional Client Alerts

Over the next few weeks, we will provide detailed Client Alerts that address the following topics:

  • Stock Rights. This alert will include the application of Section 409A to the grant and pricing of stock rights, modifications of previously granted stock rights, and the application of Section 409A to restricted property (e.g., grants of restricted stock).
  • Separation Pay Arrangements. This alert will include additional details on topics such as timing and form of payment, delay for key employees, and involuntary terminations.
  • Deferred Compensation Plans. This alert will focus on the impact of the final regulations on the traditional deferred-compensation plans and the new rules and requirements that the final regulations impose with respect to such plans and arrangements.

Action Items

As a result of the final regulations, companies should perform the following action items within the next several months:

  • Review existing plans and arrangements that provide for good reason definitions or tax gross-up payments and revise as necessary to ensure compliance with the final regulations; and
  • Take inventory of the plans and arrangements potentially subject to Section 409A and draft a schedule for revisions to ensure timely adoption of any required amendments.

For More Information

If you have any questions regarding this Client Alert, please contact Ralph Barry at (858) 350-2344, or Jessica Bliss at (650) 849-3470, the principal authors of the alert, or any other member of the Employee Benefits & Compensation practice at Wilson Sonsini Goodrich & Rosati:

Name Phone E-mail
John Aguirre (650) 565-3603 jaguirre@wsgr.com
Heather Aune (858) 350-2213 haune@wsgr.com
Michael Baker (650) 565-3902 mbaker@wsgr.com
Melody Barker (415) 947-2029 mbarker@wsgr.com
Ralph Barry (858) 350-2344 rbarry@wsgr.com
Jessica Bliss (650) 849-3470 jbliss@wsgr.com
Madeleine Boshart (415) 947-2057 mboshart@wsgr.com
Jason Flaherty (650) 849-3268 jflaherty@wsgr.com
Jessica Janov (858) 350-2351 jjanov@wsgr.com
Thuy Le (650) 849-3329 tle@wsgr.com
John Ludlum (801) 993-6410 jludlum@wsgr.com
Scott McCall (650) 320-4547 smccall@wsgr.com
Cisco Palao-Ricketts (650) 565-3617 cpricketts@wsgr.com
Roger Stern (650) 320-4818 rstern@wsgr.com
David Thomas (650) 849-3261 dthomas@wsgr.com
Jackie Tokuda (650) 565-3904 jtokuda@wsgr.com
Michelle Wallin (650) 565-3620 mwallin@wsgr.com

Circular 230 Compliance: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this memorandum is not intended or written to be used, and cannot be used, for the purpose of (a) avoiding penalties under the Internal Revenue Code, or (b) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

Circular 230 Compliance: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this memorandum is not intended or written to be used, and cannot be used, for the purpose of (a) avoiding penalties under the Internal Revenue Code, or (b) promoting, marketing, or recommending to another party any transaction or matter addressed herein.