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Proposed Section 409A Regulations Affecting Executive Compensation

July 28, 2016
By Jarrett Hoffman

Download: Proposed Section 409A Regulations Affecting Executive Compensation (PDF, 258.40 K)

Section 409A of the Internal Revenue Code (the “Code”) governs various arrangements between employers and other service recipients, on the one hand, and employees and independent contractors, on the other, that provide for rights to receive compensation or benefits in future taxable years. Many executive compensation arrangements, including incentive and equity-based awards and severance programs, can be subject to Section 409A unless appropriately structured to be exempt. The Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) issued on June 21, 2016 proposed regulations that clarify, amend and modify both the final regulations and the proposed income inclusion regulations promulgated under Section 409A of the Code (together with such regulations, “Section 409A”). While the proposed regulations contain various changes to the current regulations, below are highlights of certain provisions relating to executive compensation arrangements and transaction-based situations.

Stock Rights

Inducement Grants. On-boarding executives often negotiate for equity-based compensation from the new employer, and sometimes the parties desire for the equity grant to occur prior to the commencement of employment. In order for certain stock rights such as options and stock appreciation rights to be exempt from Section 409A, the final regulations require that, among other things, the stock rights relate to an “eligible issuer of service recipient stock,” which is the company or certain affiliates for which the service provider provides direct services as of the grant date. Complaints by practitioners were raised that this definition prohibited pre-employment stock rights because no services would be provided on the applicable grant date. The proposed regulations address these complaints by providing that if it is reasonably anticipated that a person will begin to, and actually does, provide services to a company within 12 months after the grant date, then the company will be considered an eligible issuer, thereby permitting the grant of pre-employment stock rights under Section 409A. Consideration should be given, though, to other implications of such grants under applicable securities laws, accounting requirements and the terms of the governing equity plan.

Call Rights and Repurchase Obligations. Another requirement for stock rights to be exempt from Section 409A under the final regulations is that the rights cannot relate to stock that is subject to a mandatory repurchase obligation, or a permanent put or call right, if the purchase price is anything other than fair market value. As a means to discourage behavior detrimental to the employer’s business, employers often reduce the purchase price of outstanding stock in connection with call rights and repurchase obligations if the service provider is terminated for cause or violates restrictive covenants (such as a non-compete or a confidentiality clause). To relieve concerns that such a practice would cause a stock right to be subject to Section 409A, the proposed regulations provide that a below fair market value purchase price for a call right or repurchase obligation will be permitted in connection with a termination for cause or the occurrence of a condition that is within the control of a service provider, such as a breach of covenant.

Separation from Service

Change in Status. For many purposes under Section 409A, a service provider’s services as an employee and as an independent contractor are treated separately, and different rules apply to employees and independent contractors for determining when a separation from service occurs.  However, the final regulations contained a sentence stating that if a service provider transitions entirely from an employee to an independent contractor, or vice versa, the service provider will not be considered to have a separation from service until the service provider ceased providing all services to the service recipient. Concerns were raised that this sentence conflicted with the specific rule applicable to employees that if an employee’s services are reasonably anticipated to permanently decrease to no more than 20% of the average services performed over the immediately preceding 36-month period, then the employee would have separated from service. The proposed regulations address the potential conflict by removing the offending sentence.

For example, under the proposed regulations, an executive officer who transitions to a non-employee consultant position and who is reasonably expected to provide no more than 20% of the preceding 36-month average services will experience a separation from service at the time of the transition. However, if the separation from service does not occur at the time of the transition (e.g., because significant consulting services are reasonably expected to be provided), then the separation from service will occur later when the contractual relationship expires, which is the rule applicable to independent contractors. 

Deemed Asset Sales. Recognizing that employees in a typical asset sale transaction often do not encounter a change in the type or level of services they provide before and after the transaction, the final regulations permit the parties to an asset sale to specify whether a service provider experiences a separation from service. However, the proposed regulations provide that the parties may not specify that a separation from service has occurred in connection with a deemed asset sale under Code Section 338 (where the parties elect to treat a stock sale as an asset sale) because the service providers do not experience a termination of employment, actually or constructively. So, deferred compensation payable upon a separation from service will not be triggered in a Code Section 338 transaction without an affirmative resignation or termination of employment.

Payment Timing

Transaction-Based Compensation. In many private acquisitions, a portion of the purchase price may be paid to the selling shareholders at various times following closing (e.g., due to earn-outs or indemnification holdbacks). The final regulations permit compensation based on the sale of stock (or calculated by reference to the stock price) and related to certain change in control events to be paid at times that are treated as complying with Section 409A if the transaction-based compensation is paid on the same schedule and under the same terms and conditions as those applicable to the selling shareholders generally, as long as the compensation is paid within five years following closing. An issue often arose regarding whether applying this same rule to cause a delay in payments with respect to stock options (including incentive stock options) and stock appreciation rights that are otherwise exempt from Section 409A would cause such stock rights to become subject to and immediately violate Section 409A. The proposed regulations clarify that the application of the transaction-based compensation rules to otherwise exempt stock rights will not cause a violation of Section 409A.

Securities Law-Related Delays. The final regulations permit certain delays in payments when determining whether the short-term deferral exception applies to compensation exempt from Section 409A and whether a payment is timely made for compensation subject to Section 409A; specifically, (i) delays due to administrative impracticability, (ii) if the payment would jeopardize the service recipient from operating as a going concern or (iii) if a deduction would not be permitted under Code Section 162(m) (generally relating to certain compensation in excess of $1 million). An additional delay is permitted under the rules governing compensation subject to Section 409A if making the payment would violate Federal securities laws or other applicable law. For consistency, the proposed regulations extend this additional permitted delay to short-term deferrals. Note, though, that making a payment causing income inclusion or penalties under the Code is not treated as a violation of law for this purpose.

Plan Terminations

Section 409A’s prohibition on the acceleration of payments has an exception for payments in connection with the termination and liquidation of a plan in certain circumstances. A service recipient may elect to terminate a plan so long as all other plans that are aggregated with such plan under Section 409A (e.g., all elective account balance plans, all separation pay plans, etc.) are also terminated “if the same service provider had deferrals of compensation”. Thus, a question arose about whether only the plans in which a particular service provider actually participates must be terminated in order to accelerate the payments. Treasury states, and the proposed regulations clarify, that the reference to the “same service provider” refers to a hypothetical service provider in all such plans, and therefore all such plans in the same aggregation category need to be terminated, regardless of whether a particular service provider participates.

Changes to Unvested Deferrals

The proposed income inclusion regulations permit the correction of noncompliant deferred compensation plans while the amounts are unvested without including the amounts in income or being subject to Section 409A taxes. An anti-abuse rule exists, though, to disregard such changes and treat the amount as vested for this purpose if the service provider has a pattern or practice of permitting impermissible changes. Treasury states that it did not intend for service recipients to change a plan’s time or form of payment provisions that otherwise comply with Section 409A to fail to comply, or permit them to create new errors with the intention of using those errors as grounds to establish or change the time or form of payment in a manner that fails to comply.

Accordingly, the proposed regulations make the following amendments to the anti-abuse rule: (i) in order to make a change, there must be a reasonable, good faith basis for concluding that the original provision failed to satisfy Section 409A and the change is necessary for compliance; (ii) the service recipient cannot have a pattern or practice of permitting impermissible changes in the time or form of payment (and the proposed regulations provide examples of such patterns or practices); and (iii) if there exists generally applicable guidance regarding a particular correction method (e.g., under Notice 2008-113 or 2010-6), that method must be used for the correction, and a similar method for correction must be used for similar failures. Interestingly, the proposed regulations permit corrections under generally applicable guidance even if the failure is not eligible for correction under such guidance (e.g., due to applicable timing requirements). Furthermore, the correction would not be subject to income inclusion, additional taxes or applicable premium interest under Section 409A, and the service provider is not required to notify the IRS of the correction.

Effectiveness of Proposed Regulations

The proposed changes to Section 409A are subject to review and comment, and will generally take effect once published as final regulations.  However, until the final regulations are published, taxpayers may rely on these proposed regulations.

For more information, contact:

Jarrett Hoffman
Partner, New York
212 754 4345

Related Lawyer: Jarrett R. Hoffman

Download: Proposed Section 409A Regulations Affecting Executive Compensation (PDF, 258.40 K)