More complications for deferred compensation

12 Mar More complications for deferred compensation

Madison, Wis. – Since my column on non-statutory options (aka non-qualified options), I have received a number of comments and questions regarding the viability of the classic, non-statutory option. Why? These people know about the new rules governing deferred compensation.
As part of the Jobs Creation Act of 2004, a new section was added to the Internal Revenue Code: Section 409A. This new section has sent ripples through the legal community, especially those of us dealing with deferred compensation in any form. So, this column will take some time to review 409A. As you might imagine, the details here are complex and final rules were promulgated just last April, so please confer with your own adviser if you have questions about your compensation plan.
Not so fine 409
Section 409A was designed largely in response to the Enron debacle and related scandals. Congress recognized that many executives were playing games with their deferred compensation arrangements, often changing the rules of their deferred compensation as they went along. As a result, they benefited handsomely, all while the ordinary employees lost their life savings.
At its core, Section 409A creates a whole new set of rules for “deferred compensation.” Deferred compensation is compensation to which someone has a “legally binding right,” but is paid in a later taxable year. This can include everything from performance bonuses, to severance pay, to post-employment fringe benefits, to non-statutory stock options, although there is an exception for certain payments made within 2½ months after the employee’s tax year.
The newly issued rules under 409A govern every aspect of how deferred compensation arrangements are documented and operated. Generally, (a) you must look to 409A to determine when and how a recipient can elect to defer compensation and (b) you must establish up front how the deferred compensation is to be paid, with no modifications later (other than a few specific exceptions, such as death or “change in control” of the employer, which is specifically defined in the rules).
You can see how these rules would tend to curb abuses. The problem is that Congress cast a very wide net. As a result, all companies must be very, very careful about how they compensate their employees; we can no longer rely on what we would classically think of as deferred compensation. And, if you fail to comply with 409A, the penalties are harsh: immediate taxation of the compensation, a 20 percent penalty tax, and a high interest rate on amounts not timely paid.
Non-statutory options
A detailed analysis of how Section 409A applies to the various types of deferred compensation is beyond the scope of this column, but let’s take a look at how Section 409A applies to the non-statutory option I discussed a few columns ago.
First, does a non-statutory stock option classify as deferred compensation under 409A? It depends – if it is granted in one year, but paid in a later year, and then it is deferred compensation. Note that certain statutory options and other statutorily created plans, like 401(k) plans, get a free pass: they are specifically exempt from 409A. So, we are concerned here only with the non-statutory option.
409A also exempts certain non-statutory options if you jump through a few hoops, including the following (note: this list is not exhaustive): (a) the exercise price of the option must be equal to the “fair market value” of the stock when the option is granted, (b) the number of shares must be fixed, (c) you can only use common stock, not preferred stock, and (d) the exercise of the option itself cannot be deferrable.
This would seem to be a relatively good way to avoid complying with the myriad of 409A rules, but for companies that are not publicly traded, the first requirement can be tricky. How does one establish the “fair market value” of stock option stock if there is no market for the stock? The IRS rules state that you must “reasonably” apply a “reasonable” valuation method. Specific methods are presumed to be reasonable: (a) an independent appraisal, (b) certain formula-based valuations, and (c) for corporations less than 10 years old, a “reasonable good faith written valuation” that takes into account factors that an independent appraiser would, with a few very specific limitations.
Penny wise, value foolish
The temptation for early-stage companies is to save money on the appraisal and do it on their own “good faith.” However, you must be very careful not to be penny wise, but pound foolish. If there is a problem with the valuation, the severe penalties I described above will be imposed.
I cannot emphasize enough the importance of working through the details of your plans with your own advisers – the 409A rules are very complex, and this column is meant only as an introduction to the issues.
In my next column, we will turn our attention to some of the alternatives to stock options, such as stock appreciation rights and phantom stock plans.
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