Proposed 409A Regs Offer
A Little More Certainty
Proposed regulations issued last week offer more certainty to employers operating nonqualified deferred compensation (NQDC) arrangements that are governed by Internal Revenue Code Section 409A ("Section 409A"). While the proposed regulations do not really create new rules for NQDC, they do clarify certain items and confirm several common interpretive positions already being taken by companies and their advisors.
Background. Since 2004, Section 409A has governed NQDC arrangements offered by companies to their employees and other service providers. NQDC generally refers to any promise of compensation for services that will not be payable until more than 2 ½ months following the close of the year. Examples of potential NQDC include stock options, stock appreciation rights, short and long-term incentives, commissions, and severance and change in control agreements. Section 409A imposes limits on when deferral elections must be made, and the timing and method of payouts. A violation of Section 409A can result in immediate taxation of the NQDC (and other arrangements in the same category) to the employee/service provider, plus a 20% federal tax penalty, plus possible state tax penalties (e.g., California imposes a 10% penalty), plus interest.
Important Points. We have summarized the more interesting parts of the proposed regulations for employers below (note that companies with non-employee service providers will be similarly impacted):
More Flexibility for Equity
- Pre-hire date grants of exempt nonqualified stock options and stock appreciation rights (SARs) can be made to individuals who are reasonably expected to begin, and actually do begin, providing services within 12 months after the grant date. Note that this does not include ISOs.
- An exempt nonqualified stock option or SAR may include buyback provisions allowing the employer to repurchase the right at below fair market value upon an involuntary separation from service for cause, or the breach of a noncompete or non-solicitation covenant.
Additional Ability to Accelerate or Delay Payments
- Accelerated payments are allowed if necessary to comply with bona fide foreign ethics or conflicts of interest laws (previously this right was limited to foreign earned income), or to the extent reasonably necessary to comply with Federal debt collection laws.
- Employers who want to terminate and payout a NQDC arrangement with an employee under Section 409A’s general plan termination rule must terminate all plans of the same category that are sponsored by the employer, not just those covering the employee.
- "Short-term deferral" payments can be delayed past their normal March 15 (or 2½ month) deadline to avoid violating Federal securities laws or other applicable law.
More Flexibility for Beneficiaries
- Beneficiaries may delay payout until no later than December 31 of the first year following the year of the employee’s death (and the beneficiary can designate the taxable year of payment).
- A beneficiary who has become entitled to payment due to an employee’s death may be entitled to earlier payment upon his or her death, disability, or unforeseeable emergency (regardless of payment status)
Employers involved in a sale may choose to cash-out incentive stock options and exempt nonqualified stock options or SARs with payouts on the same delayed schedule that the sale proceeds are paid to stockholders (not to exceed 5 years). (Note that the practice of cashing out stock options in return for a promise of deferred compensation that continues to vest and become payable on the original vesting schedule was not addressed and still appears problematic).
- Even employees who separate during their first year of service can take advantage of the involuntary severance pay safe harbor or window program exemption (using annualized compensation for the year of termination).
- A service provider can be an entity.
The proposed regulations will become final 90 days after publication in the Federal Register, but may be relied upon immediately. Employers should review their NQDC arrangements to determine which, if any, of these provisions should be added or amended, or if other changes are needed to ensure compliance with Code Section 409A.
Nelson Mullins Executive Compensation and Employee Benefits attorneys are ready to assist with your compensation and benefits related matters in a cost-effective and responsive manner. Please contact one of our Executive Compensation and Employee Benefits partners or the Nelson Mullins attorney with whom you work.
This Brief should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and you are urged to consult a lawyer concerning your own situation and any specific legal questions you may have.
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The articles published in this newsletter are intended only to provide general information on the subjects covered. The contents should not be construed as legal advice or a legal opinion. Readers should consult with legal counsel to obtain specific legal advice based on particular situations.