Proposed Section 409A Regulations Facilitate Common Pay Practices

Background

Section 409A regulates a broad range of group and individual arrangements that provide employees and consultants (hereinafter, “service providers”) a legally binding right to receive payments or benefits in a later tax year, including cash and equity incentives, severance rights and non-qualified retirement benefits. Violation of the documentary and operational requirements of Section 409A triggers a 20% federal additional tax on the service provider, in addition to other applicable taxes. The IRS’s proposed regulations do not meaningfully reduce Section 409A’s scope or complexity. Instead, the proposal incrementally expands certain Section 409A exemptions and payment timing grace periods while also increasing the scope of the income inclusion rules used to calculate Section 409A penalties.

Expanded Stock Option Exemptions

Generally, stock options granted to a service provider are exempt from Section 409A if the option’s exercise price is at least 100% of the fair market value of the underlying stock on the grant date. The proposed regulations would clarify the scope of the stock option exemption in a number of helpful ways.

• Grants to Prospective Hires. The exemption would expressly cover nonqualified stock options granted prior to a service provider’s start date as long as it is reasonably expected that service will commence within twelve months and the option is forfeited if service does not commence in that timeframe.
• Below FMV Repurchase Rights. The exemption would expressly cover stock options even if the stock acquired upon exercise of the option is subject to repurchase by the employer at a price that is less than the stock’s fair market value in the event that the optionee is terminated for cause or breaches a restrictive covenant.
• Delayed Settlement in M&A Context. Payment of deferred compensation in exchange for exempt stock options will not be considered violative of Section 409A if paid over the same time period (of up to five years) and on the same terms as payment of merger consideration to the selling stockholders. This enables inclusion of exempt stock options in a merger earnout or escrow. The IRS’s proposal does not address whether an unvested exempt stock option may be converted into an unvested cash-settled substitute award, which, by definition, will not be paid on the same conditions as applies to the selling stockholders.

Flexibility for Special Payment Situations

Generally, Section 409A imposes penalties in the event of any change to the payment schedule of nonqualified deferred compensation, subject to limited exceptions. The proposed regulations would provide latitude to revise or deviate from the payment schedule in certain circumstances where abuse is unlikely.

• Delayed Settlement for Securities Law Compliance. The proposed regulations would allow stock units and other equity incentive awards that are intended to be exempt from Section 409A as “short-term deferrals” (i.e., paid within 2½ months after the end of the year in which the payment is no longer subject to a substantial risk of forfeiture) to be settled after the timeframe set forth in the relevant award agreement if the delay is due to an inability to deliver shares in compliance with securities laws (such as the mandatory deferral of incentive compensation under the Dodd Frank Act) or other applicable law. The proposal does not address whether the lapse of a valid Form S-8 registration (due, for instance, to failure to keep financials current) would be sufficient to trigger this leniency.
• Delayed Settlement on Account of Death. The proposed regulations would allow nonqualified deferred compensation payable in connection with a service provider’s death to be paid at any time up to December 31st of the year after the death.
• Accelerated Settlement to Beneficiaries. The proposed regulations would permit an agreement providing for the payment of nonqualified deferred compensation to a beneficiary of a service provider (such as after the service provider’s death) to be amended to accelerate payment upon the beneficiary’s death, disability or unforeseeable emergency.

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