IS YOUR EQUITY COMPENSATION PLAN COMPLIANT WITH THE NEW DEFERRED COMPENSATION PLAN RULES

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IS YOUR EQUITY COMPENSATION PLAN COMPLIANT WITH
THE NEW DEFERRED COMPENSATION PLAN RULES?

• Ian C. Lofwall
• April 13, 2005

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• Internal Revenue Code Section 409A
• and
• IRS Notice 2005-1
• (http//www.irs.gov/irb/2005-02_IRB/ar13.html)

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Nonqualified Deferred Compensation Plans must
comply with Section 409A

• Distributions from the plan may be made only at
  certain times.
• No acceleration of benefits under the plan.
• Elections to defer compensation under the plan
  must be timely.

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Permissible Distribution Events

• Plans must provide that benefits may not be
  distributed earlier than
• (1) Separation from service.
• Exception 6 months after separation
  from service for Specified Employees.
• (2) The date a participant becomes
  Disabled.
• (3) A specified time (or pursuant to a fixed
  schedule).
• (4) A change in the ownership or effective
  control of the corporation, or in the
  ownership of a substantial portion of the
  assets of the corporation.
• (5) The occurrence of an Unforeseeable
  Emergency.

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No Acceleration of Benefits

• A plan may not permit the acceleration of the
  time or schedule of any payment under the plan,
  i.e., haircuts are not permitted.

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Elections (Initial Deferral Elections)

• General Rule Compensation for services
  performed during a taxable year must be
  deferred no later than the close of the
  preceding taxable year.
• First Year of Eligibility Within 30 days
  after the date the participant first becomes
  eligible to participate in the plan.
• Performance-Based Compensation No later than
  6 months before the end of the performance
  period. Performance period must be at least 12
  months in duration.

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Elections (Changes in Time and Form of
Distribution)
If a plan permits a subsequent election to delay
payment or changethe form of payment, it must
meet the following requirements (1) Election
may not be effective until at least 12 months
after the date on which election is
made. (2) 1-Year/5-Year Rule The election to
delay payment must defer the payment for
at least 5 years from the initial payment date
and may not be made less than 12 months
prior to the date of the initial
payment.
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Consequences for Failure to Comply with 409A

• Gross Income Inclusion All compensation
  deferred under the plan for the taxable year
  and all preceding taxable years must be
  includible in income for the taxable year to the
  extent not subject to a substantial risk of
  forfeiture and not previously included income.
• Interest Interest at the underpayment rate
  plus 1.
• Penalty - 20 Penalty equal to the amount
  required to be included in income.

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Effective Date

• Applies to deferrals made on or after January
  1, 2005.
• Applies to amounts deferred prior to January 1,
  2005, which were not vested as of December 31,
  2004.

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Grandfather Rules

• Amounts earned and vested prior to December 31,
  2004.
• No material modification after October 3, 2004.

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We thought this was about Equity Compensation
Plans, not Deferred Compensation Plans. Why are
we still here?
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What is a Nonqualified Deferred Compensation Plan?

• The term nonqualified deferred compensation plan
  means any plan that provides for the deferral of
  compensation.
• Definition of Deferral of Compensation. A
  plan provides for a deferral of compensation
  only if, under the terms of the plan and the
  relevant facts and circumstances, the service
  provider has a legally binding right during a
  taxable year to compensation that has not been
  actually or constructively received and included
  in gross income, and that, pursuant to the
  terms of the plan, is payable to (or on behalf
  of) the service provider in a later year.
• Exceptions. Qualified employer plans and any
  bona fide vacation leave, sick leave,
  compensatory time, disability pay, or death
  benefit plan.

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Legally Binding Right

Negative Discretion. A service provider does not
have a legally binding right to compensation if
that compensation may be unilaterally reduced or
eliminated by the service recipient or other
person after the services creating the right to
the compensation have been performed (referred to
as negative discretion). Facts and
Circumstances. if the facts and circumstances
indicate that the service recipient is unlikely
to exercise the negative discretion, a service
provider will be considered to have a legally
binding right to the compensation.
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Short-Term Deferrals

Until additional guidance is issued, there is no
deferral of compensation if, absent an election
to otherwise defer the payment to a later date,
at all times the terms of the plan require
payment by, and an amount is actually or
constructively received by the service provider
after the later of (i) the date that is
2½ months from the end of the service providers
first taxable year in which the amount
is no longer subject to a substantial
risk of forfeiture or (ii) the date that
is 2½ months from the end of the service
recipients first taxable year in
which the amount is no longer subject to a
substantial risk of forfeiture.
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How do Equity Compensation Plans fit into these
Rules?

IRS Notice 2005-1 indicates that stock options,
stock appreciation rights (SARs) and other
equity-based compensation provide for a deferral
of compensation.
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Stock Options(Statutory)

• Incentive Stock Options do not constitute a
  deferral of compensation.
• Section 423 Employee Stock Purchase Plan
  Options - do not constitute a deferral of
  compensation.

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Stock Options(Nonstatutory)
Do not constitute a deferral of compensation if
the following three requirements are met
(1) Exercise price may never be less than fair
market value (FMV) on the date of
grant, (2) The receipt, transfer or
exercise of the option is subject to
taxation under Section 83, and (3) The
option does not include any feature for deferral
of compensation other than the
deferral of recognition of income
until the later of exercise or disposition of the
option.
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Example 1 The Missing Option

On January 1, 2004, Corporation X hired a new
CEO, and in the CEOs offer letter agreed to
grant a nonstatutory stock option to purchase
100,000 shares of X stock. The FMV of X stock on
January 1, 2004 was 20 per share. The CEO never
received an award letter from Corporation X. Six
months later, Corporation X discovered that it
had never granted the promised options to the
CEO. To correct this oversight, the Compensation
Committee granted the CEO a nonstatutory stock
option to purchase 100,000 shares of X stock with
an exercise price of 20 per share on July 1,
2004. The FMV of X stock on July 1, 2004 was 25
per share. 50 of the options were vested on the
date of grant and the other 50 were scheduled to
vest on January 1, 2006. Is the CEOs option
subject to Section 409A?
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Example 2 The Extra Year

Corporation Xs Board of Directors and the CEO
did not have the same vision for Corporation X
and on January 1, 2005, CEO agreed to resign. In
this example, the CEO was properly granted
nonstatutory stock options to purchase 100,000
shares of X stock with an exercise price of 20
per share on his date of hire, January 1, 2004.
The options were 100 vested on the date of
grant. The option agreement provides that the
options may be exercised for a period of 90 days
after termination of employment. As part of
CEOs severance package, Corporation X agreed to
extend the CEOs option exercise period for an
additional 1 year from the expiration of the 90
day period following termination of employment.
The FMV of X stock is 22 per share on January 1,
2005. Is the CEOs option subject to Section
409A?
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How is Fair Market Value Determined for these
rules?

For companies that do not have publicly-traded
stock, IRS Notice 2005-1 indicates that any
reasonable valuation method, including the
estate tax valuation methods described in Section
20.2031-2 of the Estate Tax Regulations, may be
used to establish fair market value. This is
the same rule for determining whether an option
has been granted at fair market value for
statutory stock options.
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Substitution or Assumption of Options in a
Corporate Transaction
If you substitute a new option pursuant to a
corporate transaction or assume an outstanding
option, the option will not be treated as the
grant of a new option or a change in the form of
payment for purposes of 409A provided the
following requirements are met (1) In the
case of a new option in exchange for an old
option, the rights of the optionee
under the old option must be canceled. (2)
The spread of the new or assumed option must not
exceed the spread of the old option.
(3) The ratio of the exercise price to the
FMV of the shares of the new or assumed option
must not be greater than the ratio of the
exercise price to the FMV of the shares of
the old option immediately before the
substitution or assumption. (4) The new
option must contain all terms of the old
option. (5) The new option must not give
the optionee additional benefits.
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Example 3 New Option in a Corporate Transaction

On January 1, 2005, X Corporation grants its HR
Director, a nonstatutory stock option (NSO) to
purchase 1,000 shares of X stock with an exercise
price of 20 per share (the FMV of X stock at the
time of grant). The option is not subject to
Section 409A, since the grant was made at 100 of
FMV. On July 1, 2005, when the FMV of X stock
is 40 per share, X Corporation is acquired by Y
Corporation. The HR Directors options to
purchase X stock are canceled and she is granted
an NSO to purchase 4,000 shares of Y stock at an
exercise price of 5.00 per share. The option to
purchase Y stock has the same terms as provided
under the option to purchase X stock, except for
the substitution of Y stock. At the time of
grant of the NSO to purchase Y stock, the FMV of
Y stock is 10 per share. Is HR Directors
option to purchase Y stock subject to Section
409A?
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Stock Appreciation Rights
In general, stock appreciation rights (SARs)
provide for a deferral of compensation, and are
subject to Section 409A, unless one of two
exceptions apply. Under the first exception, an
SAR will not provide for a deferral of
compensation if (1) The SAR exercise price
(the base price for which appreciation is
measured) is never less than the FMV of the
underlying stock on the date of
grant. (2) The underlying stock is
publicly traded on an established
securities market. (3) The SAR is settled
in the publicly traded stock (no cash). (4)
The SAR does not include any feature for the
deferral of compensation other than
the recognition of income until exercise
of the SAR.
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Stock Appreciation Rights (cont.)
Under the second more limited exception, and
until further guidance is issued, the settlement
of an SAR in cash or stock will not be treated as
a deferral of compensation, provided the SAR is
granted pursuant to a program in effect on or
before October 3, 2004, and the SAR meets the
following requirements Under the first
exception, an SAR will not provide for a deferral
of compensation if (1) The SAR exercise
price is never less than the FMV of the
underlying stock on the date of grant.
(2) The SAR does not include any feature for
the deferral of compensation other
than the deferral of recognition of income until
the exercise of the SAR.
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Example 4 Non-Publicly Traded Stock or
Cash-Settled SARs

On July 1, 2005, Corporation X grants its CFO
5,000 SARs under its omnibus plan, which was
adopted by Corporation X on January 1, 2004, with
an exercise price of 10 per share, the FMV of
Xs non-publicly traded stock on July 1, 2005.
50 of the SAR vests after 1 year and the other
50 vests after 2 years. Once vested, the SAR
may be exercised at any time. The SAR may be
settled in cash or in shares of X stock in the
Compensation Committees discretion. Is the
grant of SARs to CFO subject to Section 409A?

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Example 5 Non-Publicly Traded Stock or
Cash-Settled SARs

Now assume that Corporation X adopted its omnibus
plan on January 1, 2005. Is the grant of 5,000
SARs to CFO subject to Section 409A?
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What steps should Corporation X take before
granting the SAR under its Omnibus Plan to the
CFO?

• Provide that the SAR may not be exercised earlier
  than one of the following permissible
  distribution dates
• Termination of Employment.
• Death.
• Disability.
• Change in Control.
• Fixed Dated, i.e., upon vesting of the SAR.
• Unforeseeable Emergency.
• Make sure that if the SAR is exercisable on CFOs
  disability, change in control, or on account
  of an unforeseeable emergency that these terms
  are defined in accordance with Section 409A.
• Provide that the exercise of the SAR may not be
  accelerated.
• If there is a deferral feature, make sure
  elections are made on a timely basis.

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Restricted Stock

Restricted stock is an award of stock, which is
subject to restrictions, such as time-based
vesting. Restricted stock generally does not
constitute deferred compensation subject to
Section 409A, unless the restricted stock award
contains an additional deferral feature.
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Phantom Stock/Restricted Stock Units (RSUs)

Phantom stock and restricted stock units are
stock equivalents, representing the right to
receive, on a date specified in the award
agreement (referred to as the settlement date),
an equivalent number of shares, cash, or a
combination of cash or shares. Phantom stock and
restricted stock units are generally subject to
Section 409A unless the short-term deferral rule
applies. For example, on July 1, 2005,
Corporation X grants CEO 1,000 Restricted Stock
Units which fully vest on July 1, 2008. The
terms of the RSU Award provide that on vesting
the CEO will receive an equivalent number of
shares of X stock. Since the award is settled on
vesting, there is no deferral of compensation
under the short term deferral rule.
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Performance-Based Compensation

Unless the short-term deferral rule applies,
performance-based compensation is subject to
Section 409A if, the service provider has a
legally binding right to the performance-based
compensation during a taxable year and pursuant
to the terms of the plan, the performance-based
compensation is payable to the service provider
in a later year.
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Performance-Based Compensation (Election Timing)

With respect to performance-based compensation
based on services performed over a period of at
least 12 months, a service provider may elect to
defer such bonus compensation no later than six
months before the end of the performance period.
The Treasury Department anticipates issuing
guidance on what constitutes performance-based
compensation. Until additional guidance is
issued, bonus compensation refers to compensation
where (i) the payment of or amount of
compensation is contingent on the
satisfaction of organizational or individual
performance criteria, and (ii)
the performance criteria are not substantially
certain to be met at the time a
deferral election is permitted.
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Performance-Based Compensation (Subjective
Criteria)

Bonus compensation may include payments based
upon subjective performance criteria, but
(i) any subjective criteria must relate to the
participant service provider, a group
of service providers that includes the
participant service provider, or a
business unit for which the participant
service provider provides services and
(ii) the determination that the subjective
criteria have been met must not be made
by the participant service provider or a family
member.
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Example 6 Performance-Based Compensation
Corporation X, whose stock is traded on the NYSE,
maintains a long-term incentive plan (LTIP)
that provides an annual payout equal to between
50 and 100 of a service providers base
compensation based on Corporation Xs performance
over a 12-month period, beginning January 1 of
each year, coinciding with its taxable year. In
accordance with the terms of the LTIP, CFO
elected to defer 100 of any annual payout for
the 2005 year under the LTIP on November 30,
2005, until her termination of employment. On
March 16, 2006, Corporation Xs Compensation
Committee met and determined that the 75
performance target had been met for 2005 and
directed Corporation X to pay out awards on April
1, 2006, to anyone who did not elect to defer
payment of the award by November 30, 2005. On
January 1, 2007, CFO resigned and received the
amounts she had deferred under the LTIP on
January 15, 2007. Are there any problems with
CFOs deferrals under this arrangement under
Section 409A? What about the payment of amounts
deferred by CFO? What other problems arise under
Section 409A with respect to the LTIP?
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Example 7 - My Omnibus Incentive Plan has
Noncompliant Terms
Corporation X maintains an omnibus incentive plan
under which Corporation Xs Compensation
Committee, in its discretion, may grant incentive
stock options, nonstatutory stock options, stock
appreciation rights, restricted stock units, and
other stock-based awards to eligible employees.
The omnibus plan permits nonstatutory stock
options to be granted at less than Fair Market
Value. Additionally, the omnibus plans
definition of change in control does not comply
with definition under Section 409A. In
practice, the Compensation Committee has granted
only incentive stock options and non-discounted
nonstatutory stock options. Does the omnibus
plans noncompliant terms taint the incentive
stock options and non-discounted nonstatutory
stock options granted by the Compensation
Committee?
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Transition Relief
The plan is operated in good faith compliance
with Section 409A and IRS Notice 2005-1 during
2005. The plan is amended on or before December
31, 2005, to conform to Section 409A. Example.
Under the transition relief, an SAR that provides
for a deferral of compensation may be amended to
provide for fixed payment terms, or to permit the
service provider awarded the SAR to elect fixed
payment terms, without the amendment or election
being treated as a change in the form and timing
of a payment or an acceleration of a payment if
on or before December 31, 2005 (i) the SAR is so
amended, and (ii) the service provider makes any
such election.
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Analysis of Examples 1 and 2
Example 1 Although an argument could be made
that the option to purchase 10,000 shares of X
stock was granted to CEO on January 1, 2004, the
terms of the offer letter probably would not
constitute a grant of options. Thus, on July 1,
2004, CEO was granted a discounted nonstatutory
stock option. Since 50 of the options were
earned and vested as of December 31, 2004, that
portion of the option is grandfathered under
Section 409A. The other 50 of the options
scheduled to vest on January 1, 2006 are subject
to Section 409A. The provision in the option
agreement permitting exercise at any time after
the option is vested violates Section 409A.
Under transitional guidance, the option agreement
could be amended to comply with Section 409A with
respect to the non-grandfathered component of the
option. Example 2 Since CEOs options were
earned and fully vested as of December 31, 2004,
the options are grandfathered and not subject to
Section 409A unless they are materially modified
after October 3 , 2004. Corporations X
severance agreement with CEO extending the
exercise period for an additional year would
constitute a material modification of the option
agreement. When you materially modify an option,
the revised terms of the option is considered to
be a new grant. Since the FMV at the time of the
modification is 22 per share, the option would
be a discounted option subject to Section 409A.
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Analysis of Example 3
Example 3 HR Directors options to purchase Y
stock are not subject to Section 409A, since the
substituted options satisfy the ratio and
aggregate spread tests. The ratio of the
exercise price to FMV is identical for both the
option to purchase X stock (20/40) and the
option to purchase Y stock (5/10).
Additionally, the aggregate spread of each option
is 20,000 and the terms of the options are
otherwise identical. Therefore, the option to
purchase Y stock is not considered to be a new
grant of an option. Had the option been treated
as a new grant of an option, it would have been a
discounted option (5 exercise price with a FMV
of 10) subject to Section 409A.
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Analysis of Examples 4 and 5
Example 4 The July 1, 2005, SAR grant to the
CFO is not subject to Section 409A. Although the
amounts are not grandfathered and not subject to
the publicly-traded stock exception, the SAR is
granted pursuant to a program in effect before
October 3, 2004. Since the SAR exercise price is
equal to the FMV of the underlying stock on the
date of grant, the temporary exception is
available. The issuance of cash or stock on
settlement is not subject to Section
409A. Example 5 The January 1, 2005 SAR grant
to the CFO is subject to Section 409A, since none
of the exceptions apply. The SAR was not earned
and vested prior to January 1, 2005, is not
settled in publicly-traded stock, and was not
granted pursuant to a program in effect on or
before October 3, 2004. Therefore, the SAR is
subject to Section 409A.
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Analysis of Example 6
Example 6 (i) CFOs deferral election was
not made 6 months prior to the end of the
performance period, which violates Section
409A. (ii) CFO is a specified employee,
and payment two weeks after separation from
service violates the requirement that payments be
delayed for 6 months after separation from
service for specified employees. (iii)
The April 1 payouts to other service providers
are subject to Section 409A, since the
payments are made more than 2 ½ months after
both the service providers and service
recipients taxable year in which the legally
binding right to the payments arose
(December 31- the last day of the performance
period). Had the amounts been paid by March
15, the short-term deferral rule would apply
and the amounts would not be subject to Section
409A.
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Analysis of Example 7
Example 7 The omnibus incentive plans
noncompliant terms do not taint the grant of
incentive stock options and non-discounted
nonstatutory stock options. Treasury officials
have indicated that you analyze each component of
an omnibus plan individually, and look at each
service providers grant separately to determine
whether the terms as modified by the option
agreement satisfy Section 409A.
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Ian C. Lofwall [phone] ian.lofwall_at_dlapipe
r.com