The Internal Revenue Service (IRS) recently published proposed regulations under Internal Revenue Code Section 409A. The proposed regulations clarify 19 policy items addressed in the final regulations published in 2007 and also in proposed income inclusion regulations published in 2008. These clarifications generally are not surprising, and we do not expect that employers will need to take any immediate action in response to these proposed regulations. This blog will highlight some of the clarifications that we believe employers may find particularly interesting. In a future blog, we will describe a related set of proposed regulations that the IRS also published under Code Section 457 that affect only tax-exempt and governmental employers.
As background, Code Section 409A imposes strict rules regarding the timing of deferral elections and the timing of payment of nonqualified deferred compensation plans. Failure to comply with these requirements results in a plan participant having to recognize taxable income of the amounts deferred under the plan and having to pay an additional 20 percent tax plus a potential underpayment interest penalty. The IRS explained most of these requirements as well as applicable exceptions in final regulations that were published in 2007. The IRS also published proposed regulations in December 2008 to address how to calculate the amount that should be recognized as taxable income in the event of a Code Section 409A violation. The new proposed regulations clarify and expand upon these prior pieces of guidance.
When payment of deferred compensation is deemed to have been made.
The final Code Section 409A regulations used the term “payment” in several places, such as describing elections to change the time and form of payment and also when payment satisfied the short-term deferral exception. The proposed regulations add a rule to clarify when a payment has been made for all purposes under Code Section 409A. Specifically, a payment is deemed to have been made or received under Code Section 409A when a taxable benefit is actually or constructively received. As such, a payment may include a transfer of cash, any event that results in the inclusion of income under the economic benefit doctrine, a transfer of property that is includible in income under Code Section 83 and an event that triggers the inclusion of income under Code Section 457(f).
Correction of Unvested Amounts.
The prior proposed income inclusion regulations, as modified by subsequent guidance, indicated that if an arrangement violated Code Section 409A, but the amounts deferred were subject to a substantial risk of forfeiture, the arrangement could be corrected any time before the start of the year in which the compensation would vest. Correcting the arrangement before the year of vesting would avoid a Code Section 409A violation. While the IRS has published Code Section 409A correction programs, the relief offered is considered fairly narrow and so this ability to correct before the year of vesting was advantageous to employers and participants.
The IRS explained in the recent proposed regulations, however, that many employers were abusing this relief. As such, the proposed regulations significantly expand upon and clarify the scope of the anti-abuse rules in the proposed income inclusion regulations. These requirements include:
- There must be a reasonable good faith belief that the arrangement does not comply with Code Section 409A before the change. In other words, if an unvested arrangement probably complies with Code Section 409A, an employer and participant cannot change the time and form of payment simply because the arrangement is not yet vested.
- There must not be a pattern or practice of permitting similar failures.
- The correction method must be consistent with the methods described in the IRS correction procedures. This requirement is another way in which the IRS is trying to limit abuse in changing the time and form of payment under arrangements.
- The correction method must be consistently applied.
Equity award conversions upon change in control and similar transactions.
The final regulations provided that when an employee’s equity awards were cashed out in connection with a change in control, and payment to the employees were made on a schedule that matched the payment to shareholders, that generally would be compliant with Code Section 409A. It was never entirely clear, however, whether paying exempt awards (such as non-discounted stock options or stock appreciation rights) in this manner was permitted. The proposed regulations clarify that these exempt awards qualify for the same transaction-based compensation relief as other equity awards.
Other relief for equity-based awards.
The proposed regulations made other clarifications that employers should find helpful. One is that the proposed regulations clarify that if payment of an amount that otherwise qualifies for the short-term deferral exception (e.g., restricted stock units paid at vesting) is delayed because of the application of securities laws or other applicable laws, the payment should still qualify for the short-term deferral exception. The final regulations provided this relief for non-exempt awards to be treated as a timely payment, but it was never clear whether this relief applied to exempt amounts as well. Additionally, the proposed regulations state that a non-discounted stock option or stock appreciation right may be granted to an employee up to 12 months before being hired and still qualify for the stock right exception. Finally, the proposed regulations add that an employer may call a discounted stock option for less than the fair market value of the shares in certain circumstances (e.g., violation of a non-compete; termination for cause) without causing the stock right to lose its exemption.
One interesting question that the proposed regulations did not address was whether one type of equity-based award could be converted into another equity-based award. For example, occasionally, employers implement programs to exchange stock options for restricted stock or RSUs. Most commentators believe that if these programs are implemented in a non-abusive manner, they should not run afoul of Code Section 409A. Because the IRS expressed concern about potential abuse with respect to non-vested amounts in the income inclusion guidance, that might be an indication that employers should proceed with caution in the future with respect to these programs.
Separation from service and stock sales taxed as asset sales.
The final regulations stated that when a stock sale occurs, employees will not be considered to have separated from service when the sale closes. In contrast, an asset sale will be considered to result in a separation from service unless the target and acquirer agree otherwise. That left open the question of what happens upon the closing of a stock sale that is treated as a deemed asset sale under Code Section 338. The proposed regulations clarify that such a transaction is not considered a sale or disposition of assets for purposes of determining whether an employee has a separation from service.
Next steps for employers.
The proposed regulations made other clarifications too, none of which appear to be particularly surprising. We do not expect any of the clarifications in the proposed regulations to cause employers to worry or have to take urgent action to amend their plans. Of course, it is always prudent to periodically review nonqualified plan documentation and administration to make sure both are compliant with Code Section 409A. It always is easier to correct mistakes sooner rather than later.
In the meantime, the proposed regulations currently are not binding on employers or employees. They are proposed to apply on or after the date that new final regulations are published in the Federal Register. Employers and employees may rely on these new proposed regulations before that time.