Stock Rights Under Final Section 409A Regulations
April 19, 2007
After much anticipation, on April 10, 2007, the Internal Revenue Service (IRS) issued final regulations under Section 409A of the Internal Revenue Code. Earlier this week, we provided a summary of the highlights of the final Section 409A regulations in a Client Alert that is accessible at http://www.wsgr.com/WSGR/Display.aspx?SectionName=publications/PDFSearch/clientalert_409Aregulations.htm.
This Client Alert focuses on how these final regulations impact stock rights (e.g., nonstatutory stock options (NSOs) and stock appreciation rights (SARs)). Additional Client Alerts will be provided over the next couple of weeks that will discuss additional Section 409A topics in greater detail.
Section 409A was added to the Internal Revenue Code in October 2004 by the American Jobs Creation Act. In December 2004, the IRS issued Notice 2005-1, setting forth initial guidance with respect to Section 409A. Proposed regulations under Section 409A were released in October 2005 and six additional notices providing transitional relief subsequently were issued.
Under Section 409A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan (as defined in the regulations) currently are includible in gross income unless such amounts are subject to a substantial risk of forfeiture. In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties. Certain states also have adopted similar tax provisions. (For example, California imposes an additional 20 percent state tax, interest, and penalties.)
Stock Rights in General
- What are stock rights under Section 409A?
A stock right means a NSO or a SAR.
- Are incentive stock options (ISOs) and employee stock purchase plans subject to Section 409A?
No. The final regulations generally exclude ISOs (within the meaning of Section 422 of the Internal Revenue Code) and options granted under an employee stock purchase plan (described in Section 423 of the Internal Revenue Code).
However, if an ISO later loses its ISO status, it may become subject to Section 409A. An option might, for instance, lose its ISO status and become subject to Section 409A if it is modified after it is granted (for example, if the post-termination exercise period of an ISO is extended).
- Are NSOs subject to Section 409A?
No, under the final regulations (as under the proposed regulations), NSOs generally will be exempt from Section 409A if:
- the shares covered by the option qualify as "service recipient stock" (see question 5 below);
- the exercise price of the option at least equals 100 percent of the fair market value of the covered shares on the date the option is granted;
- the option covers a fixed number of shares as of the date of grant;
- the option is subject to the typical tax treatment under Section 83 of the Internal Revenue Code (in other words, the option is a "garden variety" option); and
- the option does not provide for the deferral of compensation past the exercise date.
- Are SARs subject to Section 409A?
No, as with NSOs, SARs generally will be exempt from Section 409A if:
- the shares covered by the SAR qualify as service recipient stock;
- the exercise price of the SAR at least equals 100 percent of the fair market value of the covered shares on the date the SAR is granted;
- the SAR has the typical structure that provides for a payment equal to the amount of the excess of the fair market value of a share of stock on the date of exercise over the exercise price, multiplied by a fixed number of shares; and
- the SAR does not provide for the deferral of compensation past the exercise date.
- What is 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 common stock having the highest aggregate value of such corporation's issued and outstanding common stock.
The final regulations significantly expand the definition of service recipient stock. Under the final regulations, service recipient stock is common stock (as defined in Section 305 of the Internal Revenue Code) that does not have any distribution preferences (other than preferences with respect to stock dividends or liquidation distributions). This rule applies even if there is another class of publicly traded common stock that would qualify as service recipient stock. Service recipient stock also may include American depositary receipts and American depositary shares.
Only the corporation for which the recipient is providing direct services on the date of grant, or any corporation in a chain of a controlled group of corporations (beginning with the parent and ending with the corporation that is receiving services from the recipient), can issue stock rights. For example, a stock right reflecting the stock of a parent corporation may be granted to an employee of the parent's subsidiary. In certain circumstances, a joint venture can be considered to be part of a controlled group if there is a legitimate business reason for using its stock as compensation.
Under the final regulations (as under the proposed regulations), the stock of a corporation that is an investment vehicle cannot be service recipient stock. The final regulations also add an anti-abuse rule that provides that service recipient stock does not include stock of any corporation within a controlled group if a purpose of establishing the group, or a purpose of a significant transaction between two or more corporations within the group, is to provide deferred compensation not subject to Section 409A. If the primary source of income or value of an entity in a controlled group is from the provision of management service to other members of the controlled group and any stock rights are issued for such entity's stock, it will be presumed that the corporate structure was established for purposes of avoiding Section 409A.
- When does a stock right include a deferral feature?
A stock right includes a deferral feature (and thus is subject to Section 409A) to the extent that it provides a right other than the right to receive cash or stock on the date of exercise, and that this additional right would allow the deferral of compensation beyond the date of exercise. A deferral feature does not include the right to receive substantially nonvested stock upon exercise of the stock right or the right to pay the applicable exercise price with previously acquired shares.
In response to questions regarding the proper treatment of stock rights that include deferral features, the preamble to the final regulations provides that a stock right, regardless of whether the deferral feature is actually utilized, will be subject to Section 409A. Similarly, if a deferral feature is added to a preexisting stock right, the stock right will be treated as having included a deferral feature as of the original date of grant, which will generally result in a violation of Section 409A.
- Does the right to receive dividends subject a stock right to Section 409A?
Maybe. Under the final regulations (as under the proposed regulations), a right to receive dividends or other distributions that is contingent upon the exercise of a stock right generally will be treated as a reduction in the exercise price of the stock right, causing it to be deferred compensation under Section 409A. However, if the right to dividends or other distributions is not contingent upon, or otherwise payable on, the exercise of a stock right, the right to dividends or distributions will not cause the stock right to become subject to Section 409A. In that situation, the right to dividends or distributions will be treated as deferred compensation subject to Section 409A, but such a determination will not affect the underlying stock right.
- Does the exclusion of certain stock rights under Section 409A apply to tandem rights?
The exclusion of certain stock rights under Section 409A potentially applies to tandem rights (a stock right that combines a stock option with a SAR such that the exercise of one right terminates the other right), as well as the substitution of a stock option for a SAR, or vice versa, where all of the terms except the mode of payment upon exercise are similar.
- Is restricted stock subject to Section 409A?
Generally, no. The final regulations (as under the proposed regulations) provide that a grant of restricted stock generally will not constitute deferred compensation under Section 409A. The final regulations also clarify that a legally binding right to receive an award of stock in a future year, which will be subject to vesting conditions when granted, generally will not constitute deferred compensation.
- What is a modification of a stock right?
Under the final regulations, a stock right is modified if any change in the terms of the stock right (including any change to the plan under which the stock right was granted) may result in a reduction in the exercise price, regardless of whether the holder of the stock right actually benefits from the changed terms. An extension of the term of an underwater stock right (i.e., where the exercise price of the stock right equals or exceeds the fair market value of the underlying stock) also is considered a modification. Extensions of stock rights are discussed in greater detail in questions 15-18 below.
- What is not a modification of a stock right?
The final regulations provide that the following are not modifications of a stock right:
- shortening the exercise period of the stock right;
- adding the ability to use previously acquired stock to pay the exercise price;
- adding the ability to withhold stock to satisfy the exercise price and/or tax-withholding obligations;
- exercising discretion to allow transferability specifically permitted under the stock right;
- accelerating the vesting and exercisability of a stock right; and
- delaying the vesting and exercisability of a stock right.
If the vesting and exercisability of a stock right subject to Section 409A is either accelerated or delayed, it may constitute an impermissible acceleration of a payment date or a subsequent deferral under the final regulations.
- What is the result of a modification of a stock right?
The proposed and final regulations provide that a modification of a stock right is considered the grant of a new stock right. The stock right is analyzed as of the deemed new grant date to determine if it constitutes a deferral of compensation subject to Section 409A (see question 3 above).
- Can a modification of a stock right be rescinded?
Yes. The proposed and final regulations provide that a change to a stock right that would result in its modification may be corrected. The proposed regulations indicated that an inadvertent modification would need to be corrected by the date that the stock right is exercised or by December 31 of the calendar year during which the change occurred, whichever date is earlier. The final regulations allow for the rescision of a modification by the earlier of the date that the stock right is exercised or the last day of the holder's taxable year in which the modification originally occurred.
- What happens to stock rights that are assumed or substituted in a merger or acquisition?
Stock rights that are assumed or substituted in a corporate transaction, such as a merger or acquisition, will not be considered either modified (as to the form of payment) or the grant of a new stock right, so long as the requirements of Section 424 of the Internal Revenue Code are satisfied, except that the holder of the stock right need not be employed or otherwise provide services to the successor corporation.
- What is an extension of a stock right?
The final regulations provide that an extension of a stock right is:
- the provision of additional time to exercise the stock right beyond its original term;
- the conversion or exchange of a stock right for a legally binding right to compensation in a future taxable year; or
- the addition of any deferral feature beyond the exercise date, other than at a time when the stock right is underwater.
The final regulations give additional flexibility to extend stock rights. The proposed regulations provided that there was no extension of a stock right if it was extended to a date no later than: (a) the 15th day of the third month following the date on which the stock right otherwise would have expired, or (b) December 31 of the year in which the stock right otherwise would have expired. The final regulations provide that an extension does not occur:
- if the exercise period is not extended beyond the earlier of: (a) the stock right's original expiration date, or (b) the 10th anniversary of its original date of grant;
- if the exercise period is extended when the stock right is underwater. In this situation, the stock right is treated as having been modified rather than extended; or
- if the expiration of the stock right is tolled while the holder cannot exercise the stock right because the exercise would violate applicable law or would jeopardize the ability of the company to continue as a going concern, provided that the period is extended no more than 30 days after the exercise would no longer violate applicable law or would not jeopardize the ability of the service recipient to continue as a going concern.
- What is the result of an extension of a stock right?
The proposed and final regulations provide that if there is an extension of a stock right, the stock right is treated as having had an additional deferral feature from the date of grant. Consequently, since most stock rights may be exercised at any time, they would not comply with Section 409A's rigid restrictions on the payment of deferred compensation and would be subject to Section 409A's tax consequences (see the background section above).
- Can an extension be rescinded?
Yes. The final regulations provide that an extension can be rescinded in the same manner as a modification of a stock right, as discussed in question 13 above.
- What if a stock right was extended before April 10, 2007?
The final regulations provide a broad exemption from Section 409A for any extension of a stock right which occurred before April 10, 2007, and was made solely to provide the holder an additional period of time beyond its original term to exercise the stock right.
- How can a public company determine the fair market value of its stock?
The final regulations provide that a public company may base the fair market value of its stock on:
- 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 arithmetic mean of the high and low prices on the trading day before or the trading day of the grant (this factor was not in the proposed regulations); or
- any other reasonable method using actual transactions in the stock as reported by the market.
The proposed and final regulations provide that fair market value also may be determined using an average selling price during a specific period of time. Under the final regulations, the specific period of time in which the fair market value may be determined must be within 30 days before or 30 days after an applicable valuation date (instead of the date of grant, as was required by the proposed regulations). The final regulations require that the decision or commitment to base the fair market value on the average selling price method must be irrevocably made before the specific time period begins, and the company must designate at the same time the following items:
- the recipient of the stock right;
- the number and class of shares covered by the stock right; and
- the method that will be used to determine the exercise price (including the length of time that will be used to determine the average selling price).
Where foreign law requires that the exercise price of a stock right must be based upon a specific price averaging method and period that is different from the above averaging method (for example, as required in France for the preferential tax treatment of options), a stock right that is granted in accordance with such foreign law will be treated as meeting the above requirements if the period of time that is used for the averaging is less than 30 days.
- How can a private company determine the fair market value of its stock?
The proposed and final regulations require that a private company determine the fair market value of its stock by the reasonable application of a reasonable valuation method (as further explained below). Whether a valuation method is reasonable will depend on the facts and circumstances surrounding the valuation. To be considered reasonable, the method must take into consideration all available information material to the value of the company.
The final regulations set forth the following factors to be considered, as applicable, under a reasonable valuation method:
- the value of tangible and intangible assets;
- the present value of future cash flows (the final regulations have clarified that this should be anticipated future cash flows);
- the readily determinable market value of similar entities engaged in a substantially similar business;
- recent arm's length transactions involving the sale or transfer of such stock or equity interests (this factor was not in the proposed regulations); and
- other relevant factors such as control premiums or discounts for lack of marketability.
- Is there a presumption of reasonableness that applies to the valuation of private company stock?
Yes. Both the proposed and final regulations provide that the determination of the fair market value of a private company's stock will be presumed to be reasonable in any of the following situations:
- if an independent appraiser determines the fair market value of the stock and the appraisal is used to value the stock within 12 months of the valuation;
- where the valuation is based on a buy-back formula that is applicable for both compensatory and noncompensatory purposes and would be treated as fair market value under Section 83 of the Internal Revenue Code (subject to certain rules); or
- if the valuation is of illiquid stock of a start-up corporation and is made reasonably, in good faith, evidenced by a written report, and takes into account the relevant valuation factors described above.
- Can the presumption of reasonableness be rebutted?
The IRS may rebut the presumption if it can show that the method or its use was grossly unreasonable.
- When is stock considered issued by an illiquid start-up corporation?
The final regulations provide that stock is considered issued by an illiquid start-up corporation if the following requirements are met:
- the company has not conducted (directly or indirectly through a predecessor) a trade or business for a period of 10 years or more;
- the company does not have a class of securities that are traded on an established securities market;
- the stock is not subject to a put, call, or other rights or obligations to purchase such stock (other than a right of first refusal or other lapse restriction, such as the right to purchase unvested stock at its original cost);
- the company is not reasonably expected to undergo a change in control within 90 days or conduct a public offering within 180 days of the date the valuation is used (under the proposed regulations, the company could not reasonably expect to undergo such events within 12 months of the date the valuation was used); and
- the valuation is performed by a person or persons that the corporation reasonably determines is qualified to perform the valuation based on the person or persons' significant knowledge, experience, education, or training. The final regulations 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 corporation operates.
Modifications, Extensions, Substitutions, and Assumptions of Stock Rights
Modification of a Stock Right
Extension of a Stock Right
Valuation of Stock Subject to Stock Rights
Public Company Stock
Private Company Stock
As a result of the final regulations, companies should perform the following action items within the next several months:
- Review existing equity incentive plan documents and form equity award agreements and amend as necessary to ensure compliance with the final regulations
- Review outstanding equity awards to determine whether they are subject to Section 409A and amend as necessary to ensure compliance with the final regulations.
- Assess whether the company's method for valuing the fair market value of its common stock complies with the final regulations.
For More Information
This Client Alert is intended only as a general summary of the impact of the final Section 409A regulations on stock rights. We strongly advise you to seek professional assistance with respect to your specific issues.
If you have any questions regarding this Client Alert, please contact Scott McCall at (650) 320-4547, Heather Aune at (858) 350-2213, or Thuy Le at (650) 849-3329, the principal authors of this alert, or any other member of the Employee Benefits & Compensation practice at Wilson Sonsini Goodrich & Rosati:
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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.