Michael Shaff, Of Counsel with Stubbs Alderton & Markiles, LLP discusses the ins and outs of Section 409A, which regulates taxation of nonqualified compensation plans. Michael specializes in all aspects of federal and state taxation, including mergers and acquisitions, executive compensation, corporate, limited liability company and partnership taxation, tax controversies and real estate investment trusts.
1. General Rule. Section 409A calls for the annual taxation of a nonqualified deferred compensation plan that violates the provision of Section 409A. (IRC §409A(a)(1)(A).) Amounts deferred and subject to inclusion under Section 409A(a)(1)(A) are also subject to a penalty tax of 20% of the amount included (the additional 20% tax) in income. (IRC §409A(a)(1)(B); Prop. Reg. §1.409A-4.) As a general rule, for purposes of Section 409A, a deferred compensation plan is any written or oral, vested, legally binding right to receive compensation in a later year. (Treas. Reg. §1.409A-1(b)(1).)
2. When is deferred compensation not subject to tax under Section 409A? If the deferred income would not be included in income when paid, such as a right to receive a payment under a cafeteria plan, it is not subject to Section 409A. (Treas. Reg. §1.409A-1(b)(1).) Vested rights in a qualified defined benefit retirement plan (such as pension and profit-sharing plans, IRAs and government retirement plans) are outside the ambit of Section 409A.
In addition, as long as the deferred compensation is subject to a substantial risk of forfeiture, it is exempt from Section 409A. That rule can exempt from the scope of Section 409A income that is subject to vesting.
Also exempt from the inclusion rules of Section 409A are short term deferrals that meet either of (a) deferrals of up to 30 days in the case of the employer’s normal pay periods or (b) deferrals of up to 2 ½ months after the end of the taxable year.
Options, stock appreciation rights and other equity based deferred compensation are subject to additional tests for exemption from Section 409A. Nonqualified stock options do not result in current taxation under Section 409A if the exercise price may never be less than the fair market value of the stock on the date of option grant, the number of shares for which the option is exercisable is fixed at grant, the transfer or exercise of the option is subject to taxation under Section 83 and Regulation 1.83-7, and the option does not provide a feature for the deferral of income beyond the date of exercise or transfer or the date that the stock received on exercise become substantially vested under Regulation 1.83-3.
Stock appreciation rights must set the base for sharing in the appreciation in the value of the stock at the current fair market value on the date of issuance of the rights.
Section 409A effectively put an end to phantom stock and dividend equivalent rights as an effective form of deferred or incentive compensation. Section 409A would tax the annual appreciation on phantom stock and unpaid accruing dividend equivalent rights. (Treas. Reg. 1.409A-1(b)(5)(i)(D) and (E).)
Statutory options, even those issued under a Section 423 plan that are issued with an exercise price at less than the fair market value of the stock on the date of grant, do not create deferred compensation for purposes of Section 409A. (Treas. Reg. §1.409A-1(b)(5)(ii).) Stock options that qualify for incentive stock option treatment by definition are issued with an exercise price no higher than the stock value on the date of issuance of the option.
Publicly traded stock is easily valued based on one of several methods, the last sale before the option is granted, the closing price, the arithmetic mean of the high and low trading price or other method described in the plan, including a thirty day averaging method. (Treas. Reg. §1.409A-1(b)(5)(iv)(A).)
If the stock is not traded on an established securities exchange, the stock’s fair market value may be based on a reasonable valuation method, which may be based on “the value of tangible and intangible assets of the corporation, the present value of anticipated future cash-flows of the corporation, the market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation the stock of which is to be valued, the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm’s length private transaction), recent arm’s length transactions involving the sale or transfer of such stock or equity interests, 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 service recipient, its stockholders, or its creditors.” (Treas. Reg. §1.409A-1(b)(5)(iv)(B)(1).)
There is a presumption of reasonableness, which the Service may try to rebut with a showing that the method or application was grossly unreasonable (Treas. Reg. §1.409A-1(b)(5)(iv)(B)(2).), if the value of the stock on grant is based on an independent appraisal meeting the test for an independent appraiser for valuing employer securities to be purchased by an ESOP.
A value reached by agreement of the parties will not qualify for the presumption of reasonableness. Section 409A has its own set of option modification rules very similar to the ISO modification rules of Section 424(h). An option or other stock right deemed modified is treated as a newly issued right and must satisfy the requirements of Section 409A, including the requirement that the exercise price must not be less than the value of the underlying stock on the date of grant.
3. Substantial Risk of Forfeiture. Compensation subject to a substantial risk of forfeiture is not treated as deferred compensation under Section 409A. Under the Section 409A regulations, compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. (Treas. Reg. §1.409A-1(d)(1).) The concept of “substantial risk of forfeiture” is borrowed from Section 83, but the definition is not identical. Not any substantial contingency will suffice; the only acceptable condition must be the performance of future service under the Section 409A regulation. A covenant not to compete would probably not qualify as a substantial risk of forfeiture for purposes of Section 409A as it requires the forbearance from services, not the performance of services.
4. Performance based compensation is not treated as deferred compensation subject to Section 409A. The term “performance-based compensation” means compensation the amount of which, or entitlement to which, depends on the satisfaction of pre-established organizational or individual performance criteria that relate to a performance period of at least 12 consecutive months. Performance criteria are pre-established if established in writing no later than 90 days after the service period begins, provided that the outcome is substantially uncertain when the criteria are established. However, performance-based compensation doesn’t include any amount or portion of any amount that will be paid regardless of performance or based upon a performance level that is substantially certain to be met when the criteria are established. (Treas. Reg. §1.409A-1(e)(1).)
5. Deferral Election. A service provider may elect to defer compensation without creating deferred compensation under Section 409A if the deferral election is made before the beginning of the year in which the services are performed. (Treas. Reg. §1.409A-2(a)(3).) In the first year that the service provider is eligible to elect to defer compensation, an effective deferral election may be made within the first thirty (30) days that the service provider is eligible to defer compensation. (Treas. Reg. §1.409A-2(a)(7).)
6. Corrections. There is an opportunity for correcting a “plan” subject to Section 409A by December 31, 2012 (IRS Notice 2010-6, 2010-3 IRB 275) for a plan provision that is eligible for correction under any other section of that Notice.