U.S. Chamber of Commerce

U.S. Chamber of Commerce www.uschamber.com 1615 H Street, NW Washington, DC 20062 January 3, 2006 Courier s Desk Internal Revenue Service 1111 Constitution Avenue, N.W. Washington, DC 20224 ATTN: C:PA:LPD:PR (REG-158080-04) Room 5203 Re: IRS Proposed Regulation (REG 158080-04) on Application of Section 409A to Nonqualified Deferred Compensation Plans Dear Sir/Madam: On behalf of the U.S. Chamber of Commerce, we are submitting this letter in response to the request for comments on Proposed Treasury Regulations issued under Internal Revenue Code ( Code ) Section 409A, which were published on October 4, 2005. The U.S. Chamber of Commerce is the world s largest business federation, representing more than three million businesses and organizations of every size, sector, and region, with substantial membership in all 50 states. These comments have been developed with particular input from the Chamber s Employee Benefits Committee, which is comprised of representatives of a wide variety of companies, all experts in the field. We understand that Code Section 409A was implemented to combat perceived abuses in the area of deferred compensation. We completely support all efforts to eradicate such abuse. However, we remain concerned that these efforts may have unforeseen and untenable consequences upon the business community. As you are aware, deferred compensation plans are important incentive and retention tools for many types of businesses. Therefore, it is vitally important that rules aimed at ending abuses do not interfere with the benefits that these programs provide to employers and their workers. We appreciate the efforts of the Department of the Treasury ( Treasury ) and the Internal Revenue Service ( Service ) in issuing these proposed regulations providing guidance and transition rules under Section 409A of the Code. Notwithstanding, there are several areas where the guidance provided under the proposed regulations is unclear or where our members have concerns about the practicality of the guidance provided in the proposed regulations. The comments included in this letter are separated into the following general categories: the

definition of service recipient stock, stock option extensions, separation pay, and miscellaneous issues. I. SERVICE RECIPIENT STOCK A. Expand Definition of Service Recipient Stock. 2 The proposed regulations define service recipient stock as stock that, as of the date of grant, is common stock of a corporation that is a service recipient (including any member of a group of corporations or other entities treated as a single service recipient) that is readily tradable on an established securities market, or if none, that class of common stock of such corporation having the greatest aggregate value of common stock issued and outstanding of such corporation, or common stock with substantially similar rights to stock of such class (disregarding any difference in voting rights). This definition is overly restrictive with respect to publicly traded companies that have more than one class of stock. This definition essentially precludes such companies from granting stock rights (e.g., options or stock appreciation rights ( SARs )) on a class of stock other than its readily traded common stock, regardless of whether the other stock is materially different from that common stock. With respect to companies that do not have stock that is readily tradable on an established securities market within the controlled group, the proposed regulations define service recipient stock as that class of common stock having the greatest aggregate value of the common stock issued and outstanding or common stock with substantially similar rights to stock of such class (disregarding any difference in voting rights). However, a publicly traded company is precluded from treating non-publicly traded stock as service recipient a stock, despite the non-publicly traded stock having substantially similar rights to the publicly traded stock. For example, under the definition of service recipient stock used in the proposed regulations, a publicly traded company is precluded from granting stock rights on a class of preferred stock that is substantially similar to its publicly traded stock, but with additional voting rights. We request the definition of service recipient stock be broadened to include additional classes of stock for publicly traded companies. We do not believe that the legislative history supports a definition of service recipient stock that is as narrow as the one set forth in the proposed regulations. The preamble to the proposed regulations explains that Treasury and the Service crafted a narrow definition to the definition of service recipient stock because of their concerns that grants of options or SARs on preferred stock with substantial debt characteristics could create an arrangement that more closely resembles a traditional nonqualified deferred compensation plan, thus creating a 409A loophole. We believe, however, that a definition of service recipient stock may be crafted that precludes such abuse by setting forth specific examples of the characteristics of debt that would disqualify a class of stock from being considered service recipient stock, and allowing classes of stock that do not have such characteristics to be treated as service recipient stock. B. Clarify Definition of Service Recipient Stock for Nonpublicly Traded Companies. With respect to private companies with no publicly-traded entities within the controlled group, the proposed regulations are not clear as to whether service recipient stock is defined with respect to the controlled group or the entity for which the service provider performs

3 services. There are many good business reasons why a private company that is the direct service recipient may wish to issue stock grants on its own stock. There are also good business reasons why a private company may wish to issue stock rights with respect to stock of another member of the company s controlled group. We request that the definition of service provider stock be clarified to provide that with respect to non-publicly held companies (where there is no publicly traded stock within the controlled group), service recipient stock may be determined with respect to either the entity for whom the service is provided or the stock of another member of the controlled group. For example, in a parent-subsidiary controlled group (where there is no publicly traded stock within the controlled group), an employee who is working for a subsidiary may be granted stock rights issued either on the subsidiary s stock or on the stock of another corporation in the controlled group. C. Make Limitations on Service Recipient Stock Prospective. Regardless of whether Treasury and the Service decide to expand the definition of service recipient stock, the definition of service provider stock set forth in the proposed regulations is significantly narrower from the guidance included in Notice 2005-1. For this reason, the final regulations should apply the definition prospectively. Service recipients who granted options or SARs on stock that would have been service provider stock under Notice 2005-1 but that would not be so under the proposed regulations should not be required to restructure such awards, and the service recipients who received such awards should not be penalized by application of Section 409A. For options and SARs granted after issuance of Notice 2005-1, but prior to the proposed regulations, Section 409A should not apply if the options or SARs would otherwise be excluded from coverage under Section 409A, except that the stock does not meet the definition of service recipient stock to the extent that it is narrower than the guidance in Notice 2005-1. To apply the rule in any other way would subject individuals to a significant penalty for options granted prior to the publication of the proposed regulations in good faith compliance with Notice 2005-1. II. OPTION TERM EXTENSIONS. A. Definition of Extension Extend the Safe Harbor. Under the proposed regulations, any modification of a stock right is treated as a grant of a new stock right as of the date of the modification. Such new grant may or may not constitute a deferral of compensation under Section 409A, depending on whether the stock right is in the money when the modification occurs. However, an extension or renewal of a stock right is treated differently from a modification; it results in the stock right having had an additional deferral feature from the date of grant, which makes it subject to Section 409A from its inception, subject to an exception for certain short-term extensions. We suggest that this short-term extension exception be lengthened to two full years following the date the option would otherwise have become non-exercisable. This two-year safe harbor should be in addition to the 30-day extension granted to individuals precluded from exercising because of possible violations of securities laws. Providing the two-year safe harbor

4 would be consistent with current common practice, and does not provide a significant risk that a service provider will use the extension to manipulate the value of the compensation. B. Prospective Treatment of Stock Right Term Extension as Retroactive Modification. As described above, it is not uncommon for an employment agreement or other arrangement describing separation pay to provide for an extension of the period to exercise a stock right. Many of these are included in contractual arrangements that were in effect prior to the publication of the proposed regulations (in fact, prior to the enactment of Code Section 409A). Regardless of whether the safe harbor extension period suggested above is included in the final regulations, we request that the final regulations provide that the extension of a stock right will not be treated as an extension that makes Section 409A applicable if the extension was provided in a binding, written contractual arrangement that was in place prior to the date of publication of the proposed regulations. III. SEPARATION PAY A. Separation Pay due to Involuntary Termination- Safe Harbor. The proposed regulations exempt from Section 409A separation pay arrangements that make payments upon an involuntary separation from service as long as the amount of separation pay is not greater than two times the lesser of (i) the service provider s annual taxable compensation (as defined in Treas. Reg. 1.415-2(d)(2)) for the calendar year before the year of separation from service or (ii) the maximum amount that may be taken into account under a qualified plan pursuant to Section 401(a)(17) for such year before the year in which the service provider separates from service. We request clarification as to how the Section 401(a)(17) limit is applied for this safe harbor. Specifically, we request clarification that the Section 401(a)(17) limit for the current year (e.g., the year the separation occurs) and not the prior year (used for determining compensation under this rule) be applied. To have the 401(a)(17) limit for the year prior to the year of separation apply may preclude otherwise unobjectionable separation pay from falling within this safe harbor. Furthermore, as to a person who was hired in the separation year (and who, therefore, otherwise would have a zero limit under this safe harbor rule), final regulations should permit the individual s compensation (not counting severance) for the separation year to be used. Finally, as to any individual who commenced employment after the beginning of the year with respect to which compensation is being determined, final regulations should permit annualized compensation to be used. B. Exempt Installment Payments from the Six-Month Rule. Section 409A(a)(2)(B) provides that a deferred compensation arrangement may permit a distribution to be made upon a service provider s separation from service, except that a distribution may not be made for at least six months after separation from service if the service provider is a key employee of a corporation whose stock is publicly traded on an established

5 securities market (the six-month rule ). In the preamble to the proposed regulations, the Service has stated that it lacks the authority to exempt installment payments from the six-month rule. The Service, however, has been granted broad authority to prescribe regulations to carry out the purposes of Section 409A. We recommend that the regulations permit immediate commencement of installment payments for key employees in the form of a loan that would be forgiven at the end of the sixmonth period unless the company becomes insolvent during the six-month period. The legislative history of Section 409A clearly indicates that the six-month rule was passed to prevent inappropriate control or access to deferred compensation. Permitting the immediate commencement of payments for key employees upon their separation from service in the form of such loans is consistent with the intent of Congress in establishing Section 409A(a)(2)(B), and more important, consistent with the statute. IV. MISCELLANEOUS A. Plan Termination. The proposed regulations provide rules addressing the acceleration of payment in the event of a termination of a deferred compensation arrangement. Among the rules that apply to the termination of an arrangement is a requirement that the service recipient for five years not adopt a new arrangement that would have been aggregated with any terminated arrangement. We request that that the final regulations clarify that the five-year restriction on the establishment of a new arrangement does not apply if payment is not accelerated in connection with the termination of the arrangement. B. Acceleration of Payment for Payment of Employment Taxes. The proposed regulations permit the accelerated payment from an arrangement in order to pay the Federal Insurance Contributions Act ( FICA ) tax imposed on compensation deferred under the arrangement, as well to pay income tax withholding on such deferred compensation. Section 409A applies broadly to service providers, including certain service providers who are not employees of the service recipient. We request that the final regulations clarify that an arrangement may also permit accelerated payment in order to pay the Self Employment Contributions Act ( SECA ) tax imposed on compensation deferred under the arrangement, as well as to pay estimated income taxes on such deferred compensation. C. Transition Guidance. The preamble to the proposed regulations provide for the extension of certain transition relief included in Notice 2005-1. In the preamble, the it is noted that the limited time for terminating participation in a plan subject to 409A or canceling a deferral election under such a plan is not extended. Accordingly, such termination or cancellation of deferred compensation arrangements must occur in calendar year 2005 and the amounts subject to the cancellation must be includible in income of the participant in the calendar year 2005 or, if later, in the taxable year in which the amounts are earned and vested. We request clarification that a service provider who makes such a termination or cancellation election in 2005 with respect to deferred compensation that becomes

6 earned and vested in 2005, but does not receive payment in 2005 in accordance with the service recipient s normal pay practices, will still be treated as having satisfied the transition rule set forth in Notice 2005-1 where the service recipient pays the amount to the service provider in accordance with its normal pay practices in early 2006 (in no event later than March 15, 2006). In conclusion, we hope that you find our comments and suggestions regarding the proposed regulations under Code section 409A useful. As this process continues, we look forward to continuing discussions with you as our members implement and utilize the rules and guidance under Code section 409A. We sincerely appreciate your consideration of these comments. Sincerely, Randel K. Johnson Vice President Labor, Immigration and Employee Benefits U.S. Chamber of Commerce Aliya Wong Director, Pension Policy Labor, Immigration and Employee Benefits U.S. Chamber of Commerce OF COUNSEL: Althea R. Day, Esq. Morgan, Lewis & Bockius LLP 1111 Pennsylvania Avenue NW Washington, DC 20004 Phone: 202.739.3000