section 409a and section 162(m) – 2012 compliance … hogans-409a and 162m... · section 409a...

www.morganlewis.com © 2007 Morgan, Lewis & Bockius LLP

Section 409A and Section 162(m) –

2012 Compliance Update

Daniel L. Hogans

Morgan, Lewis & Bockius LLP

Washington, DC

Section 409A Background

• The American Jobs Creation Act of 2004 added section 409A to the Code, effective January 1, 2005

• Final regulations governing operational and documentary compliance became effective January 1, 2009

• Proposed regulations governing measurement and inclusion of income under section 409A have not yet been finalized

• Code “Y” reporting not yet implemented

• Code “Z” reporting is required for section 409A violations and certain corrections

Section 409A – Basic Provisions

• Section 409A provides strict timing rules for deferral

elections, distributions, and funding of nonqualified

deferred compensation.

• Code Section 409A applies to amounts "deferred" after

2004, amounts generally “grandfathered” if vested at

12/31/04 and not materially modified after October 3,

2004

• Noncompliance triggers inclusion of all amounts

deferred under plans of same type, included amounts

subject to a 20% additional tax, plus an additional

“interest tax”

Section 409A – Basic Provisions

• Broad applicability – starting point is any legally binding

right to taxable compensation in a future year

• Statutory exclusions for qualified retirement plans and

bona fide vacation, sick and compensatory time

arrangements as well as disability and death benefit

plans

• Relatively broad exclusions apply for “vest and pay”

(short-term deferral) arrangements, certain non-

discounted stock rights and limited involuntary

separation pay amounts

Equity Compensation Highlights

• Stock rights

• Relatively broad exclusion for non-discounted options and SARs

• Exclusion has detailed requirements

• Incentive stock options excluded (but watch out for changes

that could eliminate ISO status)

• Restricted stock

• Phantom stock and RSUs – vest and pay? Early vesting

(e.g., for retirement eligible, involuntary termination with

delayed settlement)?

Tax Issues for Performance Share Units

• Tax issues with respect to performance share

units

• Section 162(m)

• Section 409A

• Section 280G

• FICA tax

6

Short-Term Deferral Rule

•Amounts that are paid shortly after vesting are not

subject to section 409A – sometimes called the “vest

and pay” exception

•Important exception for bonus, phantom equity and

long-term incentive plans

•Includes an amount received by the service provider by

the later of

(i) 2 ½ months from the end of the service provider’s

taxable year when vesting occurred or

(ii) 2 ½ months after the end of the service recipient’s tax

year when vesting occurred


• Section 162(m)

• Section 162(m) limits the corporate tax deduction

with respect to compensation in excess of $1

million paid to the CEO and the next three

highest-paid officers (other than the CFO) of a

public company

• Exception for qualified performance-based

compensation

8


• Qualified performance-based compensation

• Preestablished objective performance goals

• Compensation Committee of two or more outside

directors

• Compensation Committee must certify results before

payment

• Shareholder-approved plan

• Plan contains per-person limit on amount or shares

payable

9


• Qualified performance-based compensation

• Performance goals must be set during first 90 days of

performance period (and before 25% of the

performance period has elapsed) and must not be

certain to be attained when set

• Any adjustment methodology must be hardwired

when the goals are set

• No guaranteed payment in the event of termination

other than death, disability, or change in control

10


• Continuing impact of Rev. Rul. 2008-13

• Amounts that may become payable on

involuntary termination or retirement without

regard to attainment of performance goal

generally cannot be performance-based

compensation

• Solution is “continued vesting” (full or partial)

subject to attainment of performance goal

• Impact of change in control


• Section 409A

• Performance unit grants should be drafted as short-

term deferral or Section 409A compliant

• If subject to Section 409A, watch for different timing or

form of payment based on different types of

termination

• If subject to Section 409A, six-month delay needs to

be included, and change-in-control provisions need to

comply with Section 409A change-in-control

requirements

12


• Section 409A

• Double-trigger vesting must be carefully drafted

(409A toggle issues?)

• In the event of a change in control, Section 409A

allows the company to terminate all aggregated

arrangements within 30 days before or 12 months

after the change in control – performance units are

generally non-elective account balance plans

• Limited flexibility to change once payment terms set

13


• Section 280G

• When performance share units fully vest upon a change in

control, full value of performance share units usually has to be

included as a parachute payment for purposes of the 280G

calculation

• In contrast, when awards that vest based only on continued

employment become fully vested upon a change in control,

280G regulations limit the “280G value” of the accelerated

vesting

• Consider truncated performance periods

14


• FICA tax

• Performance share units are subject to FICA tax

when there ceases to be a “substantial risk of

forfeiture”

• The FICA taxation date may be different from the

payment date

15

2012 Release Correction

• Agreements providing that deferred compensation payments will not be made until an employee signs and fails to revoke a release of claims must be reviewed for Section 409A compliance

• IRS has indicated that the mere possibility that the employee could influence payment timing based on delivery of the release could be viewed as causing the payment to become subject to Section 409A and violate Section 409A, or could be viewed as permitting impermissible payment delay if payment is subject to Section 409A


• Where a payment is intended to be a short-term deferral (i.e. it always pays on vesting), specify the maximum number of days the employee has to execute (and not revoke) the release

• Amounts may be paid upon execution of the release

• Release delivery should not allow for payment beyond the short-term deferral period

• The period the employee has to execute (and not revoke) the release should not extend the potential payment timing beyond March 15 of subsequent year (or 2-1/2 months after the end of employer’s fiscal year, if later)


• Where the payment is subject to Section 409A, specify the date on which the payment will be made (i.e., 60 days following termination of employment)

• Amounts forfeited if release is not irrevocable by specified date

• Amounts may be paid 30 days before specified date or until the end of the year of the specified date

• Where the payment is subject to Section 409A, alternatively, specify the period during which payment will be made (e.g., within 60 days following termination of employment) but specify that, where the period spans year-end, payment will always be made in the later year


• Late payment of such an amount is automatic

violation of section 409A if plan does not provide a

fixed date/year by which payments are to be made

• Accordingly, timely payment is critical

• Exclusion does not apply if amount is further

deferred

• Availability of election to defer does not disqualify

eligibility from exclusion if no election to defer is

made


• Generally, if one payment in a stream of payments is deferred

compensation all payments are deferred compensation

• However, if payments are designated as separate payments,

some may qualify as short-term deferrals while later payments

are deferred compensation

• Payments that may be made later than 2 ½ month window

(e.g., payments due upon separation from service or

discounted option exercise) are deferred compensation even if

ultimately paid during the window

Substantial Risk of Forfeiture

• Generally a requirement to perform substantial services

(e.g., 2 years)

• Or a requirement for an individual or corporate

performance goal to be satisfied

• Or a combination of service and performance

• Otherwise, the amount is forfeited if the service or

performance condition is not satisfied

• Addition of a substantial risk of forfeiture after the legally

binding right arises is generally disregarded unless

supported by reasonable compensation

Extending Vesting upon a Change in Control

• Extension of vesting otherwise due to occur

upon a Change in Control is permissible without

additional compensation under Treasury

Regulation section 1.409A-3(i)(5)(iv)(B)

• Extended vesting condition must otherwise

constitute a substantial risk of forfeiture

• What about situation where settlement is

scheduled for date after vesting?

Deferral Elections

• Deferral election must generally be irrevocable and must be made in the taxable year before the services are performed

• Includes election both as to the time and form of payment

• Elections for fiscal year-based compensation may be made by the last day of the prior fiscal year

• Elections may be made as late as 6 months before the end of the performance period for performance-based compensation, but specific requirements apply to meet the requirements to be treated as performance-based compensation

• Redeferral permitted, but must be for at least five years, with election at least 12 months before payment date

• To be used, deferral terms must be in the document and be section 409A compliant

Earn-out Relief Under Regulations

• Generally, section 409A rules prohibit rescheduling of payments except as specifically provided under the election provisions

• Special problems presented where transaction proceeds will be paid over time

• Regulations provide relief for deferred compensation denominated in employer stock to be paid on same schedule as transaction proceeds – see Treasury Regulation section 1.409A-3(i)(5)(iv)(A)

Permitted Distributions

• Must be paid upon one of the following

• Fixed date or schedule

• Death or disability

• Separation from Service

• Change of control

• Unforeseeable emergency

• Acceleration of payments generally prohibited

• Ability to terminate nonqualified deferred compensation plans restricted

• Ability to renegotiate payment timing VERY restricted

Definition of Change in Control

• Keys off of employer (or payor) corporation or any corporation up the chain, linked by majority ownership – note distinction from section 280G which looks to the controlled group in determining whether a change in control has occurred

• Change in Ownership – acquisition of more than 50%

• Change in Effective Ownership – acquisition of 30% or more or turnover of majority of board of directors within 12 months

• Change in Ownership of Substantial Portion of Assets – more than 40% within 12 months

• Note that Spin-offs and IPOs typically are not a CiC

Separation from Service

• Generally requires substantial, permanent reduction in service level with direct employer

• If there is continuity of employment with direct employer, there is generally no separation from service (but there may be a change in control)

• In asset sale transactions, default is that there would be a separation from service for transferring employees, but parties may agree to not treat as separation, but must be consistent – see Treasury Regulation section 1.409A-1(h)(4)

Six Month Delay Requirement

• Payments of deferred compensation to

“specified employees” on account of separation

from service must be delayed six months

• Specified employees are generally top fifty

officers at a public company

• Regulations specify how to combine or split

specified employee lists in connection with a

corporate transaction in Treasury Regulation

section 1.409A-1(i)(6)

Distributions on a Fixed Date or Fixed

Schedule

• Plans may specify the calendar year or years in which

the payments will be made, without specifying the date

• Fixed date or schedule may be triggered by event that

is subject to a substantial risk of forfeiture where date of

event is unknown

• e.g., payment due on sale of company will be paid in five

annual installments beginning in the year following the

change of control

Stock-Based Compensation

• Stock Options and SARs are not deferred

compensation subject to section 409A if:

• Exercise price can never be less than the fair

market value (FMV) of the underlying stock on the

grant date

• Stock right is granted on “service recipient stock”

• Stock right does not include any deferral feature

other than the deferral of income from the grant

date until the option exercise date

Modification of Stock Rights

• Modification generally results in a new grant

• Modification is any change in the terms of the stock right that may

give the holder:

• A direct or indirect reduction in the exercise price of the right

• Changes that would meet requirements under section 424 rules for

ISOs generally are not treated as new grants of rights

• Exercise period may be extended to the earlier of when the right

would have originally expired or 10 years from original grant

• Can extend term of underwater options (treated as new grant)

Extension of Stock Rights

• Extension beyond LESSER of original term or ten years is generally treated as an “additional deferral feature” for the ORIGINAL grant date

• Effect generally will be to cause automatic section 409A violation

• Most option extensions do not go beyond lesser of original term or ten years, and extensions within that time frame do not cause a violation or treatment as a new grant

• Exchange of option for legally binding right to compensation in a future year – the RSU exchange problem

Stock Right Exchange in Corporate

Transaction

• Must be pursuant to a qualifying corporate transaction

– typically, most merger, asset sale and other

transactions will meet this definition

• Must satisfy “spread” and “ratio” tests per

requirements under the regulations, though ratio test

is ambiguous

• Note that section 409A rules under ratio test do permit

deeper discount under option/SAR received

Exclusions for Separation Pay

• Involuntary separation and window programs, and

certain good reason separations, up to a limit:

• 2 x pay, capped at the 401(a)(17) limit and

• Paid within 2 years from year of separation

• Certain expense reimbursements and in-kind

benefits, so long as paid during above 2 year period

• De minimis amounts up to $15,500 (indexed)

• Short-term deferral amounts (you can “stack” the

exceptions)

Separation for Good Reason

• Final rules for separation for good reason

• May be treated as involuntary separation – affects both qualification as short-term deferral or involuntary separation pay

• The good reason condition must require actions taken by the employer resulting in a material negative change in the employment relationship

• Review existing programs for other factors supporting equivalence of good reason with involuntary termination

• Notice and cure

Change-in-Control Plan Termination

• Regulations provide special opportunities to

terminate arrangements pursuant to a change in

control

• Must terminate all plans of the same type for all

participants experiencing a change in control

• Note plan aggregation categories under

Treasury Regulation section 1.409A-1(c)

• Settlement in restricted property?

Arrangements to Watch For

• Identify Deferred Compensation Arrangements:

• Deferred compensation arrangements and supplemental retirement plans

• Severance promises, including in employment agreements

• Guaranteed bonuses

• Discounted stock options or SARs

• Phantom stock, restricted stock units and other equity rights

• Long-term incentive plans

• Annual bonus plans

• Split-dollar life insurance

• Taxable health benefit promises

• Etc.

Grandfather Rules

• Grandfathered arrangements (earned and vested at

1/1/2005)

• If arrangement is materially modified after October 3,

2004, it loses grandfather protection

• In general, a material modification exists only when a

right is added, not when one is taken away

• Certain additions are acceptable:

– More “real” investment alternatives

– Changes to stock rights that are not treated as new grants

or additional deferral features

Correction Opportunities

• Operational failures – Notice 2008-113

• Documentary failures – Notice 2010-6 and

Notice 2010-80

• Unvested amounts that will not vest until a later

year – Prop. Reg. § 1.409A-4

• Limitations – generally cannot correct beyond

two prior years

40

DISCLAIMER

• This communication is provided as a general informational service to clients

and friends of Morgan, Lewis & Bockius LLP. It should not be construed as,

and does not constitute, legal advice on any specific matter, nor does this

message create an attorney-client relationship.

• IRS Circular 230 Disclosure

To ensure compliance with requirements imposed by the IRS, we inform

you that any U.S. federal tax advice contained in this communication

(including any attachments) is not intended or written to be used, and

cannot be used, for the purpose of (i) avoiding penalties under the Internal

Revenue Code or (ii) promoting, marketing, or recommending to another

party any transaction or matter addressed herein. For information about why

we are required to include this legend, please see

http://www.morganlewis.com/circular230.

40

http://www.morganlewis.com/circular230

section 409a and section 162(m) – 2012 compliance … hogans-409a and 162m... · section 409a...

Documents