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On April 10, 2007, the Treasury Department and the Internal Revenue Service released final regulations providing additional guidance on deferred compensation arrangements under Internal Revenue Code (the “Code”) Section 409A. These long-awaited final regulations take effect as of January 1, 2008, but may be relied upon prior to that date and allow those affected by the statute to take steps to ensure that outstanding compensatory arrangements having deferred compensation implications comply with Section 409A before the compliance transition period ends on December 31, 2007.
Section 409A expansively defines deferred compensation as any arrangement that gives a service provider a legally binding right during one year to compensation that will or might be paid in a later year. This definition includes employment-related agreements providing for severance or other compensation amounts in the future, and can also include stock options and stock appreciation rights. The statute imposes strict requirements as to when elections (including the establishment of an arrangement) to defer compensation can be made, whether and how these elections can be changed once they are established, and on what events deferred payments may be made. Deferred compensation arrangements that fail to meet these requirements trigger income recognition in the year in which the service provider “vests” in the arrangement even if he or she has not received or directly benefited from the compensation, and significant tax penalties are imposed on the income required to be recognized.
Overall, while the final regulations made relatively few changes to the basic approach of the guidance previously issued, they do provide helpful clarification of certain deferred compensation issues and in several respects liberalize or simplify the guidance previously issued. The final regulations did not, however, address the mechanics of how the penalty provisions will apply to noncompliant arrangements, so we still have no clear guidance on how income subject to the Section 409A penalties is calculated or how the penalties themselves apply. The final regulations also do not address how Section 409A applies to partnership arrangements, or what Section 409A requires with respect to offshore trusts used to fund deferred compensation arrangements. We hope that guidance on these matters will be provided later this year.
In analyzing compensatory arrangements under Section 409A, we have found it a useful discipline to walk through the following steps:
If there is no aspect of the arrangement that carries over to a later year, then the arrangement should not be deferred compensation. If there is a later-year aspect, then further analysis should be done.
Possible exceptions include the “short-term deferral” rule, the “two times” exception with respect to severance pay, various exceptions applicable to reimbursement of expenses in connection with employment termination, and an exception for change-of-control related payments that mirror the structure of transaction payments to stockholders. These exceptions are all discussed in the “Frequently Asked Questions” summary attached.
If an arrangement qualifies for one of these exceptions, it either does not have to comply with Section 409A at all or it may be able to comply with less burdensome requirements.
Although the determination of whether a particular arrangement is subject to Section 409A is complex, it is often fairly simple to make an arrangement comply with the statute so that it will not be subject to its penalties or early income inclusion rule. For example, in many cases involving common severance arrangements, all that must be done to conform the arrangement to the statute’s requirements is provide that no amounts will be paid to a public company “key employee” until more than six months after his or her employment has terminated. Although it requires more involved structuring (and although we do not expect there will be much demand for such options), it is also possible to make discounted stock options comply with Section 409A. These issues are also discussed in more detail in the “Frequently Asked Questions” summary attached.
This Client Alert is intended to be a reference resource for clients and for corporate lawyers. It includes two attachments. Attachment 1 presents a Frequently Asked Questions summary, incorporating the guidance under the final regulations, of issues regarding Section 409A and its application to common compensatory arrangements. Attachment 2 suggests certain actions that clients should consider taking in 2007 to assure compliance of compensation arrangements with Section 409A before expiration of the transition period at the end of the year.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalty or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
Contacts
If you have any questions regarding the matters discussed in this Alert, please contact the Heller Ehrman attorney with whom you regularly work or one of the following members of our Compensation and Benefits or Tax Groups:
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London |
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Christopher Prout |
+44.0.20.7469.4277 |
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New York |
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Michael Faber |
+1.212.847.8602 |
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Seattle |
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Elizabeth Deckman |
+1.206.389.4231 |
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Silicon Valley |
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Renee Deming |
+1.650.233.8360 |
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Sharon J. Hendricks |
+1.650.233.8356 |
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Mark Windfeld-Hansen |
+1.650.233.8361 |
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