October 5, 2006
On October 4, the IRS issued long-expected guidance extending the transition relief under Section 409A of the Internal Revenue Code (the "Code"). As described below, subject to an exception for certain "in the money" stock options granted to Section 16 officers and directors of publicly-traded companies, Notice 2006-79 generally extends the key transition rules through December 31, 2007.
Effective Date/Good Faith Reliance. Section 409A applies to compensation deferred on or after January 1, 2005. Previous deferrals generally are "grandfathered" unless the arrangement is materially modified. For these purposes, deferred compensation amounts that were not earned and vested as of December 31, 2004 are not protected by the grandfathering rules. The IRS issued proposed regulations interpreting Section 409A in October 2005.
Final regulations interpreting Section 409A are expected by year-end, and those regulations are expected to be effective beginning on January 1, 2008. Pursuant to Notice 2006-79, a deferred compensation plan adopted on or before December 31, 2007 will be treated as complying with Code Section 409A if the plan is operated through December 31, 2007 in good faith compliance with the provisions of Section 409A, IRS Notice 2005-1 (the IRS’s initial limited scope guidance), and any other generally applicable IRS guidance with an effective date prior to January 1, 2008. If an issue is not addressed in IRS guidance, the plan must be operated in accordance with a reasonable, good faith interpretation of Section 409A and the terms of the plan. In addition, compliance with the proposed regulations or (once they are issued) the final regulations automatically constitutes reasonable, good faith reliance.
Plan Amendments. Plans must be amended by December 31, 2007 to conform to the provisions of Section 409A and the final regulations. Amending a plan by this date is a condition to the application of the reasonable, good faith reliance standard as well.
Changes in Payment Elections. With respect to deferrals subject to Section 409A, a plan may provide, or be amended to provide, for new payment elections on or before December 31, 2007, with respect to both the time and form of payment. However, (i) election changes cannot be made in 2006 to defer payments that otherwise would be made in 2006 or to accelerate payments into 2006, and (ii) election changes cannot be made in 2007 to defer payments that otherwise would be made in 2007 or to accelerate payments into 2007.
Mirror Elections under Qualified Plans. Elections as to the timing and form of payment under a nonqualified plan or arrangement may be controlled by payment elections made under a corresponding qualified plan through December 31, 2007 (e.g., a Code section 415 excess benefit plan), provided that the payment is in compliance with the terms of the plan or arrangement as of October 3, 2004.
Substitution of Non-Discounted Stock Options and Stock Appreciation Rights ("SARs")/Addition of Fixed Exercise Date. Options and SARs with an exercise price that is lower than 100% of the fair market value of the underlying stock on the date of grant (often called "discounted" or "in the money" stock options or SARs) that were not vested and exercisable as of December 31, 2004 generally are subject to Code section 409A. Subject to the exception noted below, Notice 2006-79 extends to December 31, 2007 the ability to cancel a discounted stock option or SAR and substitute a non-discounted option or SAR not subject to Code section 409A. (The revised exercise price is based on the fair market value of the stock on the original grant date, not the date of cancellation/regrant.) Subject to the same exception, Notice 2006-79 allows a corporation to "correct" a discount stock option grant by imposing a fixed exercise date, subject to the rules described above regarding changes in payment elections.
An important caveat is that the transition relief will not apply to discount options/SARs to the extent they are exercised before the Section 409A violation is corrected. For example, if discount options subject to Section 409A are exercised in 2006 before the Section 409A problem is corrected, those options will be subject to Section 409A. Another important condition is that cash or vested property may not be provided to the optionee in the year the discount option is corrected. For example, cash or vested property may not be provided in 2007 in connection with the cancellation and reissuance in 2007 of stock options with an increased exercise price.
In reaction to recent stock option "backdating" scandals, Notice 2006-79 includes an important exception. Transition relief is not extended (i.e., it expires on December 31, 2006) with respect to stock options/SARs that:
were granted with respect to stock of a corporation that as of the date of grant had issued any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934 (this will apply to most U.S. businesses with publicly traded stock);
were granted to a person who, as of the date of grant, was subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934 (this requirement will generally apply to all members of the board of directors and senior executive officers); and
with respect to the grant, the corporation either has reported or reasonably expects to report a financial expense due to the discount price of the grant that was not timely reported on financial statements or reports for the period in which the related expense should have been reported under generally accepted accounting principles. (Note: This will not necessarily cover all stock options that a company determines after-the-fact were granted with a discounted exercise price since if the additional financial expenses are concluded not to be material, the company will not be required to report restated financial results.)
Collectively Bargained Arrangements. Notice 2006-79 provides a new transition rule for collectively bargained arrangements. An arrangement maintained pursuant to one or more collective bargaining agreements in effect on October 3, 2004 is not required to comply with the provisions of Section 409A until the earlier of (i) the date on which the last of such collective bargaining agreements terminates (determined without regard to any extension of the CBA after October 3, 2004), or (ii) December 31, 2009.
Tax Reporting for 2006. It should be noted that Notice 2006-79 does not address tax reporting (Form W-2) issues for 2006. However, IRS guidance on this issue is expected later this year.
Conclusion. The extension of these transition rules is very helpful for employers in light of the long delay in the issuance of final regulations. Employers should have sufficient time after the final regulations are issued to make plan design decisions and amend their deferred compensation plans. We will provide a follow-up client mailing when the final regulations are finally issued.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or
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Charles F. Feldman (212-351-3908; email@example.com)
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David I. Schiller (214-698-3205, email@example.com),
Michael J. Collins (202-887-3551, firstname.lastname@example.org),
Sean Feller (213-229-7579, email@example.com),
Amber Busuttil Mullen (213-229-7023, firstname.lastname@example.org),
Jennifer Patel (202-887-3564, email@example.com) or
Chad Mead (214-698-3134, firstname.lastname@example.org).
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