Final 409A Deferred Compensation Regulations

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1 April 2007 Bulletin If you have questions or would like additional information on the material covered in this Bulletin, please contact one of the authors: Jeffrey G. Aromatorio Russell J. Boehner Dennis R. Bonessa Dodi Walker Gross Jeffrey L. London (Chicago) John D. Martini (Philadelphia) David N. Pardys (Philadelphia) Cher E. Wynkoop Mary Lou Zwick (Chicago) or the Reed Smith attorney with whom you regularly work. This bulletin is presented for informational purposes and is not intended to constitute legal advice. Reed Smith LLP All Rights Reserved. Reed Smith refers to Reed Smith LLP, a limited liability partnership formed in the state of Delaware. Final 409A Deferred Compensation Regulations Overview Section 409A was added to the Internal Revenue Code of 1986, as amended (the Code ), by the American Jobs Creation Act of Section 409A made significant changes to the tax rules governing nonqualified deferred compensation plans and is generally applicable to amounts deferred after Dec. 31, Shortly after Section 409A was enacted, the Internal Revenue Service issued Notice , which set forth initial guidance with respect to Section 409A. In October 2005, the IRS issued long-awaited proposed regulations under Section 409A. On April 10, 2007, the IRS finalized the proposed regulations. The final regulations do not substantially change the proposed regulations, but do provide some modifications and clarifications to the proposed regulations. As under the proposed regulations, key points of the final regulations are as follows: They adopt a broad definition of a nonqualified deferred compensation plan to include any plan, agreement or arrangement between an employee (or other service provider) and an employer (or other service recipient) in which there is a legally binding right to compensation that, under the terms of the plan, is or may be payable in a later taxable year; and They affect not only traditional deferred compensation programs, but also other compensation arrangements that have the effect of deferring compensation into a future taxable year. Essentially, if the requirements of Section 409A are not met with respect to a particular deferred compensation arrangement, the amounts deferred will be subject to both ordinary income tax and a 20 percent excise tax when the deferred amounts are no longer subject to a substantial risk of forfeiture. This memorandum provides an overview of the key provisions of Section 409A and the final regulations as they relate, in particular, to equity and severance arrangements, the transition rules and applicable effective dates. Equity Arrangements Stock option and stock appreciation rights programs are generally exempt from Section 409A if: The exercise price of the option or the base price for the stock appreciation right equals or exceeds the fair market value of the underlying stock on the date of grant; The equity program has no other feature that permits the deferral of compensation; and The equity program is limited to common stock. Fundamentally, therefore, as long as a service recipient grants stock options/stock appreciation rights at or above fair market value, NEW YORK LONDON CHICAGO PARIS LOS ANGELES WASHINGTON, D.C. SAN FRANCISCO PHILADELPHIA PITTSBURGH OAKLAND MUNICH ABU DHABI PRINCETON N. VIRGINIA WILMINGTON BIRMINGHAM DUBAI CENTURY CITY RICHMOND GREECE r e e d s m i t h. c o m

2 Section 409A will not apply. The proposed regulations provided fairly detailed guidance for purposes of valuing stock in connection with determining what is fair market value. The final regulations generally adopt the provisions of the proposed regulations, with some clarifying modifications. Concerning public companies, fair market value may be: Based on the last sale before or the first sale after the grant; The closing price on the trading day before or the trading day of the grant; or Any other reasonable basis using actual transactions in the company s stock as reported in such market. This may include, for example, the use of an average selling price that is within 30 days before or after the applicable valuation date. Thus, with respect to public companies, the guidance is fairly consistent with how most public companies determine fair market value and should not result in any major issues regarding equity grants. On the other hand, setting fair market value for private companies is more challenging. According to the regulations, fair market value must be determined by a reasonable application of a reasonable valuation method. The factors to be considered in determining fair market value under the final regulations are generally consistent with the proposed regulations and include: The value of tangible and intangible assets; The present value of future cash flows of the company; The market value of stock or equity interests in similar corporations; and Other relevant factors such as control premiums or lack of marketability. The final regulations also modify the proposed regulations by including among these factors the consideration of any recent equity sales made by the corporation in arm s-length transactions. In addition, the final regulations clarify that a service recipient may use one valuation method to establish an exercise price and an alternative valuation to establish a buyback amount (e.g., in the context of an option where the option shares are subject to a buyback) or a payment amount (i.e., for stock appreciation rights). The regulations provide certain safe harbors that will be presumed reasonable: A valuation determined by an independent appraisal and which is of a date no more than 12 months before the grant of the stock option or stock appreciation right, will be presumed reasonable unless subsequent events have occurred that have had a material effect on the stock value. A valuation method based upon a buyback formula will be presumed reasonable if the formula is consistently applied to both compensatory and noncompensatory transactions with the issuer or a person owning more than 10 percent of the stock of the issuer. In a change from the proposed regulations, such a formula is not required to be used in transactions with other persons or arm slength transactions constituting the sale of all or substantially all of the stock of an issuer. For purposes of private companies that have conducted business for less than 10 years, a valuation will be considered reasonable if: It is made in good faith; It is evidenced by a written report; It takes into account the factors set forth above in determining fair market value; - 2 -

3 It is made with respect to stock not subject to any put or call right other than a right of first refusal. and certain repurchase rights that arise in connection with a termination of employment; and It is performed by a person with knowledge and experience in performing valuations. The final regulations provide that the standard for determining whether an individual possesses the requisite knowledge and experience to conduct an evaluation is whether a reasonable person, with knowledge of such individual s experience and training, would reasonably rely on the individual s advice. The final regulations also specify that for this purpose, significant experience means at least five years of relevant experience in certain specified fields (e.g., business valuation, appraisal, financial accounting) or other comparable experience within the line of business in which the service recipient operates. Section 409A and the regulations also require that the options and stock rights be granted in service recipient stock in order to be exempt from the requirements of 409A. The final regulations modify and expand the classes of stock and the issuing entities that qualify as service recipients under these rules. Under the final regulations, any class of common stock without preferential dividend rights can qualify as service recipient stock. Service recipient stock can be the common stock of the direct employer of the service provider or any stock within the parent-subsidiary chain. While options and stock appreciation rights that are granted at fair market value are generally excluded from Section 409A, the regulations provide certain rules under which a modification to or extension of such an award would cause it to be subject to 409A. Key points to consider: A modification or an extension of the exercise period of an award essentially results in the grant of a new award. If the option or stock appreciation right is in the money at the time of the modification or extension, then the new award will be considered granted at a discount and therefore is no longer exempt from 409A. The final regulations generally retain the provisions from the proposed regulations, but have enhanced an exception to the general rules that applies when an exercise period is extended in connection with a separation from service. If an option exercise period is extended following a separation from service, the extension will not be considered to result in a new grant so long as the exercise period is not extended beyond the earlier of the original maximum term of the option, or 10 years from the date of original grant of the option. In addition, the extension of an exercise period at a time when the stock is underwater does not constitute an additional deferral feature (i.e., will not, in and of itself, cause the option to become subject to Section 409A). Separation Pay Arrangements Section 409A generally applies to separation pay arrangements. The regulations provide certain exceptions to the general rule, including a provision that separation pay will not be subject to 409A, and therefore will not be subject to the six-month payment delay for certain key employees of publicly traded corporations, if it is paid upon an involuntary termination and is not greater than the lesser of: Twice the participant s compensation; or A maximum amount established by the Internal Revenue Service (two times the Code Section 401(a)(17) limitation currently $225,000) and is paid no later than Dec. 31 of the second calendar year following the year of separation. The final regulations clarify that even if this limit is exceeded, the amount up to the limit will be exempt from Section 409A. In addition, the final regulations clarify that certain good reason terminations may be treated as involuntary separations. Generally speaking, the good-reason termination requires actions by the service recipient which result in a material negative change in the employment relationship. The final regulations also provide a safe - 3 -

4 harbor under which a good-reason termination will be deemed to constitute an involuntary separation for purposes of Section 409A. Among the conditions for satisfying the safe harbor are: The service provider separates from service within a limited period of time following the initial existence of the good-reason event (note: the preamble to the regulations states that a limited period of time is one year, while the regulations themselves reference two years; presumably clarification will be forthcoming); The amount, time and form of payment upon a good- reason termination must be identical to that provided in the event of an involuntary termination. To satisfy the safe harbor provisions, the regulations also require that the service provider provide notice (within 90 days) of the initial existence of the good-reason condition, and the service recipient have a period of at least 30 days to remedy the condition. The regulations also specify various conditions that will constitute good reason for purposes of the safe harbor (e.g. material diminution in the service provider s authority, duties or responsibilities). The regulations further provide that whether a separation from service is voluntary or involuntary is determined based on all the facts and circumstances, and provide that any characterization of the separation from service as voluntary or involuntary by the service provider and the service recipient in the documentation related to the separation is rebuttably presumed to be a proper characterization. Timing/Transition Issues The final regulations are generally applicable for tax years beginning on or after Jan. 1, 2008, although taxpayers may rely on them for tax years beginning prior to that date. Existing plans which do not otherwise comply with the requirements of Section 409A must be amended by Dec. 31, 2007 to conform to Section 409A, and must be operated in good faith compliance with Section 409A prior to such time. For periods prior to Jan. 1, 2008, taxpayers may generally continue to rely on the transition rules as in effect prior to the issuance of the final regulations. However, the preamble to the final regulations provides some additional transition guidance with initial deferral elections, stock rights and service providers in pay status: Deferral elections made before Jan. 1, 2008 that are consistent with the proposed regulations or other applicable transition guidance will be deemed to comply with Section 409A, even if the deferral extends beyond Dec. 31, Taxpayers may rely on the provisions of the proposed or final regulations with respect to the determination of fair market value for stock rights issued prior to Jan. 1, In regard to rights issued before Jan. 1, 2008, taxpayers may continue to rely on a good faith interpretation of the proposed guidance for determining whether the underlying stock qualifies as service recipient stock. However, stock rights issued on or after April 10, 2007 will not be treated as service recipient stock after Dec. 31, 2007, unless such stock satisfies the requirements of the final regulations. If payments have started prior to Jan. 1, 2008, based upon a reasonable good faith interpretation of the statute and guidance issued prior to the final regulations, the plan may continue to make such payments consistent with the plan terms at the time payments commenced, or it may stop the payments and amend the plan to comply with the final regulations on or before Dec. 31, If payments have not commenced by Jan. 1, 2008, but all events necessary to receive the payment have occurred by that date, the plan may make the payments in accordance with the application of the plan terms on Dec. 31, 2007, or it may amend the plan to conform to the final regulations in accordance with the transition rules. Finally, with respect to plan terms, the regulations require that plans be in writing and contain specific provisions complying with certain identified requirements, such as to the extent applicable, permissible payment provisions, deferral election provisions, and suspension provisions, and also include any terms that establish - 4 -

5 compliance with any exemptions or exceptions being relied upon under the plan. Further, regarding plan terms, the regulations specify that savings clauses (for example, general statements of intent to comply) will not be sufficient to overcome clearly non-compliant terms or supply required provisions that are missing. Accordingly, such clauses will not allow one to circumvent a clear statutory failure. * * * * * * Reed Smith is a top-15 global relationship law firm with more than 1,500 lawyers in 21 offices throughout the United States, the United Kingdom, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multi-jurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and cross-border transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, manufacturing and education. For more information, visit reedsmith.com