Employee Benefits Law Report

New IRS Equity-Based Compensation Audit Guide Highlights Importance of Documenting Compensation Practices

The IRS recently released an audit techniques guide (the “Guide”) to advise its internal auditors who are examining cases involving equity-based compensation (i.e., compensation based on the value of specified stock). Examples include stock transfers, stock options, stock warrants, restricted stock, restricted stock units, phantom stock plans and stock appreciation rights paid to an employee, director or independent contractor. The Guide provides a general discussion of potential tax issues that could arise with respect to these arrangements (e.g., disqualifying dispositions of incentive stock options, Code Section 83(b) elections for restricted stock). Interestingly, the Guide devotes a fair amount of detail to explaining where auditors may find these documents, encouraging them to review Securities and Exchange Commission (“SEC”) filings as well as internal documents. As such, the Guide serves as an important reminder to employers to be mindful that the IRS (or other third parties) someday could seek to review their corporate documents. That will be the focus of this blog.

SEC Documents.

The Guide advises auditors that a good place to start an examination is by reviewing SEC documents (at least with respect to publicly-held entities). In particular, the Guide explains that a public company’s annual report (Form 10-K), definitive proxy statement (DEF 14A), and Statement of Changes in Beneficial Ownership (Form 4) can be particularly pertinent. These documents will identify the types of plans an employer sponsors and provide compensation data under the plans for the named executive officers and the directors. The Guide directs the IRS auditors to compare the compensation data on the SEC forms with information reported on the individual’s Form W-2 or 1099-MISC, as applicable, and confirm that the appropriate amount of taxes has been withheld and paid. If the information on the tax documents and SEC forms do not reconcile, the Guide recommends that the auditor consider expanding the scope of the audit.

Internal Documents.

The Guide also instructs auditors to review an employer’s internal corporate documents, including employment contracts, Board of Director meeting minutes and Compensation Committee meeting minutes. The Guide adds that auditors should request reports “issued by the compensation committee and presented to the board of directors” because these reports may provide additional insight into equity compensation practices.

Employers should be aware of these instructions. Often times, it is easy for someone to prepare internal documents using jargon or short-hand that is familiar among people at the company but that may be difficult to explain to a third party or worse could be misleading. The Guide demonstrates that internal documents may not be restricted to internal personnel. Instead, the IRS very well could review these internal documents. As such, employees and advisers who prepare these documents should be mindful of both the information contained in the documents and how they present that information.

Key Takeaways for Employers.

While the IRS prepared the Guide to assist its internal auditors, the Guide also helps employers understand how the IRS could conduct a potential audit of equity-based compensation plans. One takeaway for employers is to review its compensation practices and make sure that as a matter of substance they comply with the applicable tax rules. The other takeaway is a matter of form or style. Specifically, when employees of a company or its outside advisers prepare internal documents or documents to be filed with the SEC, they should keep in mind that the IRS very possibly will review some or all of these documents (particularly the SEC filings). Thus, when preparing these documents, they should do so in a way that demonstrates compliance with the applicable tax rules and that avoid any ambiguities. Doing so will help make a potential audit less burdensome and less risky.

Bright lines getting blurrier: Recent Ohio Supreme Court decision changes factors for determining who is an Ohio resident for state tax purposes

Cunningham v. Testa, Slip Opinion No. 2015-2744 (July 8, 2015)

Recently, the Supreme Court of Ohio issued an opinion in Cunningham v. Testa which significantly alters the application of a statute for determining non-Ohio domicile for state tax purposes. Prior to the ruling, the statute seemed to set forth two factors which, when verified, would create an irrebuttable presumption of non-residency for state income tax purposes:

  1. too few contact periods; and
  2. an abode outside of Ohio.

Following this ruling, a taxpayer may now be forced to prove sufficient additional facts to show that he would legally be considered domiciled outside the state. The change represents a partial reversion back to a prior structure which existed at common law, a structure which was amended over 20 years ago due to its complexities. The case of Cunningham v. Testa casts serious doubt on the future validity of any bright-line test for determining Ohio domicile and will create uncertainty for taxpayers in the coming years.

The taxpayer, Kent Cunningham, owned homes in both Ohio and Tennessee for the entirety of the 2008 tax year. Also, Cunningham undisputedly had fewer than 182 contact periods with the state of Ohio for that year. He filed a Form IT-DA, an “Affidavit of Non-Ohio Domicile,” for the 2008 tax year. In the affidavit, he declared that he “was not domiciled in Ohio at any time during taxable year 2008” and affirmed that he “had fewer than 183 contact periods in Ohio during the taxable year.”

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Like old soldiers, Employee Plans Determination Letter Program fades away

The Internal Revenue Service (the “IRS”) issued Announcement 2015-19 on July 21, 2015, in which the agency announced that its long-standing and widely used retirement plan determination program for individually designed plans was being significantly curtailed. The IRS indicated that this curtailment, which has been rumored for months and now becomes official, is attributable to a need to more efficiently direct its limited resources in an era of budget cutbacks for the agency.

Under the announcement, and effective as of January 1, 2017, the currently-available staggered 5-year determination letter remedial amendment cycles for individually designed plans generally will be consigned to history. As of that date, the IRS no longer will accept determination letter applications based on the 5-year remedial amendment cycles. Sponsors of Cycle A plans will continue to be permitted to submit determination letter applications during the period beginning February 1, 2016, and ending January 31, 2017. Presumably, all pending applications filed in earlier cycles will be processed. After January 1, 2017, the scope of the determination letter program for individually designed plans will be limited to submissions related to qualification upon initial plan qualification (i.e., regardless of when the plan was adopted, any plan for which a Form 5300, Application for Determination for Employee Benefit Plan, has not been filed or for which such a Form 5300 has been filed but a determination letter was not issued) and qualification upon plan termination. Generally, effective July 21, 2015 and through December 31, 2016, the IRS no longer will accept off-cycle determination letter applications (except for determination letter applications for new plans and for terminating plans). In addition, the IRS indicated in Announcement 2015-19 that plan sponsors will be permitted to submit determination letter applications in other limited circumstances that will be determined by Department of the Treasury (the “Treasury”) and the IRS in the future. The Treasury and the IRS will identify those limited circumstances through periodic published guidance.

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The Supreme Court rescues Obamacare one more time

President Obama might want to invite Chief Justice John Roberts to the White House for a “thank you” dinner!

The United States Supreme Court today issued an opinion in King v. Burwell that upholds the Obama administration’s interpretation of language in the Affordable Care Act (the “ACA”) that concluded government subsidies to underwrite the cost of health care coverage are available to all qualifying Americans–and not just to those living in states that maintain their own heath care exchanges under the ACA.  In a 6-3 decision, Chef Justice Roberts authored the opinion of the court (just as he did in the Court’s landmark opinion in 2012 in National Federation of Independent Business v. Sebelius).  Specifically, the Court’s opinion upholds a ruling by the Internal Revenue Service that subsidies should be available both in states that have set up their own exchanges and in other states in which residents must purchase coverage through the federal government exchange.  Five other justices joined Chief Justice Roberts in his opinion, including Justices Anthony Kennedy, Ruth Bader Ginsburg, Stephen Breyer, Sonia Sotomayor and Elena Kagan.  Justice Antonin Scalia wrote a typically scathing dissent, and was joined in that dissent by Justices Clarence Thomas and Samuel Alito Jr.

The case centered on an interpretation of a phrase in the ACA that offers tax credits to individuals who purchase health care coverage on exchanges that are “established by the state.”  Chief Justice Roberts wrote that even though the language was problematic, the intent of Congress to provide the subsidies to all individuals was clear.  In perhaps the core (and ultimately most-quoted) statement in the opinion, Roberts wrote that “Congress passed the Affordable Care Act to improve health insurance markets, not to destroy them.  If at all possible we must interpret the Act in a way that is consistent with the former, and avoids the latter.”

In his dissent, Justice Scalia forcefully expressed his view that the actions of majority were not designed to interpret the ACA but rather to save it—a job he believes is rightfully reserved to the legislature.  Scalia closed his dissent with a statement that is sure to gain much notice and notoriety when he wrote that “We should start calling this law SCOTUScare.”

This case does not deal with complicated constitutional principles, and at the end of the day simply preserves the status quo.  Having said that, most observers believed that a contrary ruling would have dealt a devastating blow to the essential operations of the ACA.  While other legal challenges to the ACA are being litigated, none of those cases seem to present such an existential threat to the ACA.  Still, the challenges are not over.  The ACA surely will be a centerpiece issue during the 2016 presidential campaign, and legislative efforts to repeal, defund or revise all or parts of the ACA will continue.  Although the battlefield may have changed, the battles will continue.


IRS issues 409A guidance—need to correct before the year of vesting

The Office of Chief Counsel of the Internal Revenue Service (the “IRS”) recently confirmed that violations of Section 409A of the Internal Revenue Code (the “Code”) could be corrected without penalty in any taxable year before the taxable year in which an arrangement became vested. However, the IRS went on to clarify that the Code would require immediate recognition of taxable income of the amounts deferred and the assessment of an additional 20% tax if taxpayers waited until the taxable year of vesting to correct an error.

In Chief Counsel Advice 201518013 (the “CCA”),the IRS clarified what some perceived to be an ambiguity under previously issued proposed regulations describing Code Section 409A income inclusion issues. The proposed regulations explained that an employer generally could correct a Code Section 409A error before the arrangement vests without immediate income tax and additional taxes being imposed on the participant. Most practitioners agreed that an arrangement could be corrected without the risk of penalty so long as the compensation under the arrangement became vested no earlier than the taxable year after the taxable year of correction, and the IRS has confirmed that view in the CCA. What was less clear was whether a correction could be made without the risk of penalty if compensation became vested after the date of correction but still within the same taxable year in which the correction was made. In the CCA, the IRS explained that the correction technique works only when the compensation remains unvested throughout the entire taxable year in which the correction is made and vests no earlier than the taxable year after the taxable year of that correction.

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Supreme Court says give credit where credit is due

In Comptroller of Treasury of Maryland v. Wynne, 135 U.S. 1787 (2015), the Supreme Court held that Maryland’s tax scheme was unconstitutional because it discouraged interstate commerce in violation of the Dormant Commerce Clause of the U.S. Constitution. Maryland’s tax scheme gave taxpayers credit for taxes paid to other states against the Maryland state income tax, but did not provide a credit against the county income tax. Therefore, out-of-state income was subject to double taxation, a tax burden not imposed on in-state income.

The Dormant Commerce Clause only gives Congress the ability to regulate interstate commerce, not intrastate commerce. However, shouldn’t activity prohibited at the state level also be prohibited at the municipal level? In Ohio, municipalities are given authority to impose taxes on personal income of both residents and non-residents. In effect, personal income made by an Ohio resident living in one municipality and working in another is taxed twice. In wake of Wynne, Ohio residents should look to a number of Constitutional and fairness arguments to consider whether Ohio’s municipal tax scheme could also be unconstitutional.

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Protection of ERISA’s statute of limitations is narrowed by the Supreme Court

The United States Supreme Court yesterday issued a unanimous opinion in Tibble et al. v. Edison International et al. vacating a Ninth Circuit Court of Appeals ruling that claims by employees of Edison International against the company over allegedly imprudent 401(k) plan investments were time-barred under applicable ERISA statute of limitation rules. The issue before the Court was whether a fiduciary breach claim can be brought under ERISA based on such an allegedly imprudent retirement investment when that investment initially was selected outside of ERISA’s applicable six-year statute of limitations. Writing for the Court, Justice Stephen Breyer stated that since plan fiduciaries have a continuing duty to monitor plan investments, any claims falling within that duty’s statute of limitations would be valid.

In this case, individual beneficiaries of the Edison International 401(k) Plan filed a lawsuit on behalf of the 401(k) Plan and similarly situated beneficiaries against Edison International and other related parties. The petitioners sought to recover damages for losses suffered by the Plan in addition to other equitable relief based on alleged breaches of the respondents’ fiduciary duties. Specifically, the petitioners argued that the respondents violated their fiduciary duties with regard to mutual funds added to the Plan in 1999 and in 2002. The action was filed by the petitioners in 2007. The underlying fiduciary claim was that the respondents imprudently selected six higher priced retail-class mutual funds as plan investments when materially identical but lower priced institutional-class mutual funds were available. Since ERISA generally requires a breach of fiduciary duty complaint to be brought no more than six years after the date of the last action that constitutes a part of the breach, the lower courts ruled that the petitioners’ complaint with respect the 1999 funds was barred under ERISA’s statute of limitations because those funds were added to the 401(k) Plan more than six years before the complaint was filed (the lower courts concluded that the attendant circumstances had not changed enough to require that review of the selected mutual funds by the respondents). On the other hand, the lowers courts concluded that the respondents’ failed to satisfy their fiduciary obligations with respect to the selection of the three funds in 2002 (and that portion of the lower court opinions may yet prove to be problematic in other similar situations).  While the rulings of the lower courts with respect to the 1999 funds likely cheered plan sponsors temporarily, the Court did not embrace the position of the lower courts and instead vacated the previous rulings and remanded the case back for further examination of the proper application of fiduciary obligations to the facts at hand.

Justice Breyer notes that the District Court in this case allowed the petitioners to argue that the complaint was timely with respect to the funds added in 1999. The petitioners argued that the respondents should have commenced a review and conversion of the higher priced retail-class mutual funds to lower priced institutional-class mutual because the previously selected funds incurred significant changes within the 6-year statute of limitations period. The District Court concluded, and the Court of Appeals later agreed, that the petitioners failed to show that changing circumstances would have required a prudent fiduciary to undertake a review of the funds within the 6-year statute of limitations period.

Breyer began his review by focusing on the language contained in ERISA’s statute of limitations rule. In that regard, he stated that ERISA Section 1113 reads, in relevant part, that “[n]o action may be commenced with respect to a fiduciary’s breach of any responsibility, duty, or obligation” after the earlier of “six years after (A) the date of the last action which constituted a part of the breach or violation, or (B) in the case of an omission the latest date on which the fiduciary could have cured the breach or violation.” Breyer noted that both prongs of the rule require that a breach or violation occurs within the applicable 6-year period. The petitioners contend that the respondents breached the duty of prudence by offering higher priced retail-class mutual funds when the same investments were available as lower priced institutional-class mutual funds. While in Breyer’s view, the Ninth Circuit Court of Appeals correctly focused on whether the last action that constituted a part of the breach occurred within the relevant 6-year period, he wrote that the lower court inappropriately concluded that only a significant change in circumstances could cause a new breach of a fiduciary duty.

The Court ultimately concluded that the lower courts erred by applying a statute of limitations bar to such a claim of a breach of fiduciary duty without considering the nature of that duty. The opinion states that the lower courts failed to recognize that under applicable trust principles a fiduciary is required to conduct a regular review of plan investments with the nature and timing of the review contingent on the circumstances. Citing a by-now familiar standard, Breyer noted that an ERISA fiduciary must discharge his or her responsibility “with the care, skill, prudence, and diligence” that a prudent person “acting in a like capacity and familiar with such matters” would use. When examining the range of that fiduciary duty, courts often look to the law of trusts. The Court went on to note that under trust law a fiduciary has a continuing duty to monitor plan investments and to remove imprudent ones (this continuing duty is in addition to the trustee’s duty to exercise prudence in selecting investments).  Since under trust law a fiduciary has a continuing duty of some kind to monitor investments and to remove imprudent ones, a petitioner should be permitted to allege that a fiduciary breached the duty of prudence by failing to properly monitor investments. In such a case, Breyer concluded that “so long as the alleged breach of the continuing duty occurred within six years of suit, the claim is timely.”

The Court in this decision expressed no view on the scope of the respondents’ fiduciary duty in this case.[1]  In effect, the case has been remanded so that the Ninth Circuit Court of Appeals can consider claims by the petitioners that the respondents breached their duties within the relevant 6-year statute of limitations period.  Breyer noted that on remand the Court of Appeals may conclude that the respondents did indeed conduct the sort of review that a prudent fiduciary would have conducted absent a significant change in circumstances.  Either way, the Court may well see this case again.

[1] The respondents argued that the petitioners failed to raise in the lower courts a claim that the respondents committed new fiduciary breaches due to a failure to monitor their investments. Given its decision to remand the case back to the Ninth Circuit Court of Appeals, the Court opted to let the Ninth Circuit resolve this ancillary issue.



Public companies should review stock option plans to ensure they qualify for exception to $1 million deduction limit

The IRS and Treasury Department recently issued final regulations under Code Section 162(m) that, as the IRS describes it, “clarifies” stock and equity-based compensation plan drafting issues. Of course, whether something represents a clarification or a substantive change lies in the eye of the beholder (particularly if that beholder is a politician or regulator in need of political cover). In this case, however, the IRS generally is correct to describe the final regulations as clarifications. With respect to stock options and SARs, the new regulations reflect what were widely held opinions in the executive compensation community. With respect to restricted stock units (“RSUs”) and phantom stock granted by privately held companies that become publicly traded, the new regulations could be considered a more substantive change, but the IRS in effect has provided nearly four years’ worth of advanced notice of this change. The good news is that the new regulations should not affect most employers’ stock plans. Still, it would be wise for public companies to perform a review of these plans to confirm whether they qualify for the performance-based exception to the $1 million deduction limit under Code Section 162(m).

Code Section 162(m), generally

As background, Code Section 162(m) limits the deduction that a publicly traded company can take with respect to remuneration paid to its “covered employees”—its CEO and three most highly paid named executive officers (other than the CEO and CFO)—to the extent that such compensation exceeds $1 million. The deduction limit does not apply, however, to qualified performance-based compensation. Publicly traded companies often structure their equity based compensation plans in a manner to qualify the awards under those plans (options, SARs, RSUs, restricted stock, etc.) as performance-based compensation.

Options and SARs

In 2011, the IRS issued proposed regulations that “clarified” that the plan under which options and SARs were granted must specify the maximum number of shares relating to those awards that may be granted to any individual during a specified period. Most practitioners had long counseled their public company clients to put these individual limits in their plans to make sure these awards qualified as performance-based compensation under Code Section 162(m). Some commentators, however, argued that stating an aggregate share limit for all awards should be enough. The IRS rejected this view in the proposed regulations, stating that a per employee limit was necessary to assist a third party in determining the maximum amount of compensation that could be payable to any individual employee during a specified period.

The final regulations formally adopt this view. The one modification is that a plan may specify a maximum number of shares with respect to all types of awards (options, SARs, RSUs, restricted stock, performance shares) that may be granted to an employee during a specified period.

RSUs and phantom stock of private companies that become public

Additionally, the proposed regulations clarified that an existing limited transition period does not apply to grants of RSUs or phantom stock by a company that, at the time the grants are made, is not a publicly traded company in the event that the company later becomes a publicly traded company when the grants are still outstanding. This interpretation reversed a position taken by the IRS in previously issued private letter rulings. The transition period rule generally provides that compensation related to the exercise of stock options or SARs, or the substantial vesting of restricted stock, under a pre-existing plan will not be subject to the $1 million deduction limit for a limited grace period after the company becomes publicly traded. Many practitioners believed that this grace period would apply to phantom stock and RSUs as well, but the proposed regulations said that would not be the case. The final regulations adopt the interpretation of the proposed regulations. Commenters had requested that the relief extend to RSUs and phantom stock, but the IRS did not adopt these recommendations.

Effective dates

The per employee share limits portion of the proposed regulations were effective with respect to options and SARs granted on or after June 24, 2011. The final regulations state that this rule remains effective as of that date. The preamble explains that a transition period for that rule is not necessary because this interpretation did not represent a substantive change in the rules. On the other hand, the interpretation regarding RSUs and phantom stock awarded previously by privately held companies that become public companies will become effective on the date the final regulations are published in the Federal Register.

Again, because the final regulations confirm what the IRS has long been telling us about equity-based compensation awards, most publicly traded companies probably will not see much, if any, impact on their plans. Nevertheless, the publication of the final regulations represents a good opportunity to review these companies to make sure that the awards under their plans still qualify for the performance-based compensation exception to the $1 million deduction limit.

Ninth Circuit decision illustrates importance of clearly designating beneficiaries under a nonqualified plan

In a recent blog, we discussed the importance of clearly defining who is a “participant” in a nonqualified plan and who is a former participant or retiree. A more recent Ninth Circuit decision in E & J Gallo Winery v. Rogers highlights a related issue that faces tax-qualified and nonqualified plans alike—who is the beneficiary? While cases like this may not raise novel issues of law, they highlight a more mundane yet important issue of preparing plan documents clearly and in a manner that is consistent with their administration. Further, the Gallo decision highlights the importance of reminding plan participants to make sure that they have completed beneficiary designation forms and that those forms are up-to-date.

In the case, E & J Gallo Winery filed an interpleader action to determine the proper beneficiary under its Key Executive Profit Sharing Retirement Plan, a nonqualified deferred compensation plan (the “Plan”). Robert Rogers had accrued a benefit under the Plan before he died.  After his death, ambiguity arose as to who was Robert’s designated beneficiary entitled to receive his accrued benefit under the Plan. Michele McKenzie-Rogers, who was married to the deceased at the time of his death, had filed a motion for summary judgment arguing that she was the proper beneficiary under the Plan. The District Court denied this motion and instead held that Mark Rogers, Robert’s son from a prior marriage, was the proper beneficiary. McKenzie-Rogers appealed that decision, and upon hearing that appeal the Ninth Circuit affirmed the District Court’s decision.

The ambiguity arose over a letter that was sent by the Plan sponsor to Robert Rogers in 1988. The third paragraph of that letter explained to him that vesting, payment methods and “all other matters” under the Plan would be determined in accordance with the procedures set forth under Gallo’s tax-qualified plan document. According to McKenzie-Rogers, the “all other matters” language meant that the tax-qualified plan’s beneficiary rules, which paid benefits to the current surviving spouse, should apply to the nonqualified Plan as well. The District Court disagreed, holding that this interpretation was too broad, especially because the fourth paragraph in that letter clearly named Roger’s first wife as primary beneficiary and his son Mark as contingent beneficiary. However, Rogers’ first wife waived her rights as primary beneficiary under the Plan by signing a waiver and release in 1988. As a result of that waiver, the District Court concluded the participant’s son Mark became entitled to the benefits under the Plan as contingent beneficiary. Nothing in the Plan indicated that the participant’s subsequent re-marriage to McKenzie-Rogers canceled his prior beneficiary designations. Moreover, the Plan was exempt from ERISA’s spousal consent requirements (which, if applicable, automatically would have made McKenzie-Rogers the beneficiary when she married Rogers). The Ninth Circuit agreed with this analysis and affirmed the District Court’s decision.

Again, this decision provides two takeaway items for plan sponsors. One is to make sure that the plan document and communications with the participants clearly explain how participants may designate beneficiaries. The other is that plan sponsors should consider periodically sending reminders to participants to make sure that their beneficiary designation forms are up-to-date. Clear documentation and communication can help reduce ambiguity and help sponsors avoid this type of lawsuits in the future.

ERISA damages—two bites off the same apple are impermissible

The United States Court of Appeals for the Sixth Circuit issued an en banc decision in Rochow v. Life Insurance Company of North America on March 5, 2015 that deals with the ability of a participant in a plan covered by ERISA to recover benefits due from that plan while simultaneously pursuing “other appropriate equitable relief” based on that same asserted injury. In a decision likely to be applauded by many plan sponsors, the court’s en banc decision concluded that both forms of recovery are inappropriate when based on the same injury except in limited circumstances—circumstances that were not satisfied in this case.

The facts of the case involve a claim for long term disability benefits filed by Daniel Rochow under a policy issued by Life Insurance Company of North America (“LINA”). After LINA denied that claim and all administrative appeals also were unsuccessful, Rochow filed an action in the United States District Court for the Eastern District of Michigan. That complaint sought to recover benefits due to Rochow under the applicable disability policy under ERISA Section 502(a)(1)(B) and to seek appropriate equitable relief to redress an alleged fiduciary breach under ERISA Section 502(a)(3). Continue Reading