April 11, 2007
On April 10, the IRS issued long-awaited and often-delayed final regulations ("Regulations") interpreting the deferred compensation rules under Section 409A of the Internal Revenue Code ("Section 409A"). Section 409A imposes a number of requirements that deferred compensation arrangements must satisfy in order to avoid current taxation of participants (and a possible 20% "additional tax" and an interest charge).
The Regulations retain most of the rules from prior IRS guidance. However, some important differences include liberalizations of (i) the rules applicable to separation pay, including arrangements with "good reason" provisions; (ii) the rules applicable to stock options and other stock rights; (iii) the treatment of reimbursement and fringe benefit arrangements; and (iv) the determination of when an employee or other service provider has incurred a "separation from service" that is a distribution event under a plan. The IRS did not extend the December 31, 2007 deadline for amending arrangements to comply with Section 409A, and all arrangements subject to Section 409A must be brought into documentary compliance by year-end.
We describe below some of the key changes from prior IRS guidance. We are continuing to review the Regulations and expect to prepare additional client mailings that address key issues.
Separation Pay Arrangements
"Good Reason" Provisions
One of the main concerns expressed with respect to the prior IRS guidance was the effect of "good reason"/"constructive termination" provisions in employment agreements and other arrangements. Prior guidance suggested that severance/separation pay was not subject to a "substantial risk of forfeiture" if it could be paid in connection with a good reason termination of employment, regardless of the actual circumstances of the termination. The primary impact of this rule was that severance payable to an officer or other "specified employee" of a publicly-traded company generally would be subject to a six-month delay in payment following the employee’s termination of employment.
The Regulations significantly relax this rule by providing that where the right to a payment is contingent upon a voluntary separation from service following an occurrence that constitutes good reason for the employee to terminate employment, the right may be treated as payable only upon an involuntary separation from service where the good reason condition is such that the employee’s separation from service effectively is an involuntary separation. If treated as payable upon an involuntary separation from service, the payment can be made without the need for a six-month delay as long as the severance is paid in full by March 15 of the year following termination of employment or the severance otherwise is not subject to Section 409A as described below. The good reason condition must require actions by the employer resulting in a material negative change in the employment relationship, such as a material negative change in the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received. It also must not have avoidance of Section 409A as a principal purpose. Accordingly, severance provisions must be carefully drafted to satisfy the new relaxed standards.
The Regulations also provide a good reason "safe harbor." Payments under an arrangement with a good reason provision will be considered payable in connection with an involuntary termination of employment if a number of criteria are satisfied, including: (i) the employee must actually terminate employment within a limited period of time (not to exceed one year) following the initial existence of the good reason condition; (ii) the amount, time and form of payment must be identical to that available upon a "without cause" termination; (iii) the employee must be required to provide notice of the existence of the good reason provision within a period not to exceed 90 days of its initial existence, and the employer must be provided a 30-day "cure" period; and (iv) good reason must consist of one or more of six enumerated conditions arising without the consent of the employee.
General Separation Pay Rules
Reflecting the proposed rules, the Regulations generally provide an exemption from Section 409A coverage for separation pay made in connection with an involuntary separation from service or participation in a window program that does not exceed the lesser of two times (i) the employee’s annual compensation or (ii) the Code section 401(a)(17) limit for the year ($225,000 for 2007), and is paid in full no later than December 31 of the second year following separation from service. This results in a $450,000 limit for 2007 for employees whose average compensation exceeds $225,000. Under the proposed regulations, if separation pay was $1 over this threshold, the entire amount would have been subject to Section 409A. Under the Regulations, only the amount in excess of this limit will be subject to Section 409A. For example, this rule may allow severance payments to executives of up to $450,000 immediately upon termination of employment without regard to Section 409A (including, where applicable, the six-month delay applicable to officers of publicly-traded companies), and only severance in excess of this amount may be subject to Section 409A.
Stock Options and Stock Appreciation Rights
The Regulations include some important liberalizations of the rules for when stock options and stock appreciation rights ("SARs") are exempt from coverage under Section 409A.
Service Recipient Stock. An option or SAR will be exempt from Section 409A only if it is issued with respect to "service recipient stock." The Regulations make it much easier for stock to qualify for that status. First, any class of common stock can so qualify (under the proposed regulations, only the "best" class could qualify) as long as it does not have preferential distribution rights. Second, the Regulations permit the underlying stock to be stock of any corporation in a chain of organizations all of which have a controlling interest in another organization, beginning with the parent organization and ending with the organization for which the grantee was providing services as of the date of grant of the stock right. The Regulations provide guidance on what is a "controlling interest."
Extensions. Under the proposed regulations, any extension of the option or SAR term (other than de minimis extensions in connection with the service provider’s separation from service) would retroactively subject the option or SAR to Section 409A. Under the Regulations, an extension of any option/SAR that is not "in the money" as of the date of extension will not subject the option to Section 409A. The Regulations also provide that an option or SAR will not become subject to Section 409A if the exercise period is not extended beyond the earlier of the original maximum term of the option/SAR or 10 years from the original date of grant of the option/SAR.
Valuation. In order for a stock option or SAR to be exempt from Section 409A, the exercise price must at least equal the fair market value of the underlying stock as of the date of grant. For nonpublic companies, the Regulations include a presumption that a specified valuation of stock reflects the fair market value of the stock, rebuttable only by a showing that the valuation is grossly unreasonable. The presumption applies where the valuation is based upon an independent appraisal, a generally applicable repurchase formula or, in the case of illiquid stock of a start-up corporation, a valuation by a qualified individual or individuals applied at a time that the corporation did not otherwise anticipate a change in control event or public offering of the stock.
Reimbursements and Fringe Benefits
The Regulations clarify that a benefit that is nontaxable is not subject to Section 409A. They also provide that taxable reimbursements of medical expenses may be provided through the 18-month COBRA period without any restrictions.
In addition, the Regulations provide guidance on structuring taxable reimbursements or in-kind benefits to comply with Section 409A. A reimbursement plan must provide for the reimbursement of expenses incurred during an objectively prescribed period, where the amount of reimbursable expenses incurred or in-kind benefits available in one taxable year cannot affect the amount of reimbursable expenses or in-kind benefits available in a different taxable year. In addition, the reimbursement payment must be made by no later than the end of the service provider’s taxable year following the taxable year in which the expense is incurred. Such reimbursement or in-kind benefit rights may not be subject to liquidation or exchange for another benefit. In addition to other types of reimbursements, this special rule can be applied to taxable medical benefits following the end of the COBRA continuation period (with a special rule that there can be a limit on the amount of medical expenses that may be reimbursed under such arrangement over some or all of the period in which the arrangement is in effect).
Separation from Service
A service provider’s "separation from service" is one of the permissible payment events under Section 409A. The Regulations provide additional guidance on how to determine when a separation from service occurs. In general, an employee has a separation from service upon termination of employment, as determined under all the facts and circumstances. There is a termination if the service recipient and the employee reasonably anticipated either that no further services would be performed after a certain date or that the level of bona fide services the employee would perform after such date (whether as an employee or as an independent contractor) would permanently decrease to no more than 20 percent of the average level of bona fide services performed over the immediately preceding 36-month period. The Regulations include rebuttable presumptions to assist employers in applying this standard.
The Regulations also provide guidance on determining who is the service recipient/employer for purposes of whether a separation from service has occurred. In general, this is determined on a modified "controlled group" basis that treats entities that are 50% or more related as if they were a single entity (but the relation can be as low as 20% or as high as 80% if elected by the employer). The Regulations also provide guidance for determining whether a transfer of employment in connection with an asset sale or the sale of a subsidiary constitutes a separation from service.
In addition, distributions made in connection with a specified employee’s separation from service from a publicly-traded company are subject to a six-month delay under Section 409A. The Regulations simplify the test for determining who is a specified employee (generally the top 50 officers and certain shareholders) and permit employers significant flexibility in making this determination, especially following a spin-off, merger, IPO or other corporate transaction.
Effective Dates and Transition Rules
General Effective Date. Section 409A generally is applicable to compensation deferred on or after January 1, 2005. Amounts that were "earned and vested" as of December 31, 2004 generally are exempt from Section 409A absent a "material modification."
Pre-2008 Compliance. The Regulations are generally effective beginning January 1, 2008. For periods before January 1, 2008, the standards and transition rules set forth in prior IRS guidance apply. Pursuant to that guidance, Section 409A generally must be applied in a good faith manner (and following the Regulations would constitute good faith). The fact that an interpretation was different from the rule in the Regulations does not necessarily indicate a lack of good faith.
Plan Amendments. The Regulations provide that plans subject to Section 409A must be in writing. Plans generally must be amended no later than December 31, 2007 to comply with the Regulations. The preamble specifically notes that use of a general Section 409A "savings clause" is insufficient for Section 409A compliance.
The above is only a brief summary of some of the key provisions of the Regulations. Including the preamble, the Regulations tip the scales at 397 double-spaced pages. As noted above, we intend to provide additional guidance to clients further addressing important issues raised by the Regulations.
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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Chad Mead (214-698-3134, email@example.com),
Kimberly Woolley (415-393-8225, firstname.lastname@example.org), or
Jonathan Rosenblatt (650-849-5317, email@example.com).
© 2007 Gibson, Dunn & Crutcher LLP
The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.