On October 21, 2004, President Bush signed into law the American Jobs Creation Act of 2004. The Act created a new section of the Internal Revenue Code (“Code”), Section 409A, which contains new rules regarding nonqualified deferred compensation plans. See our October 2004 Hot Topics update for more information regarding the new deferred compensation rules set forth in Section 409A. While plan sponsors expected Section 409A to affect the design and administration of executive deferred compensation plans, what plan sponsors might not be aware of is the impact of Section 409A on equity compensation programs. Notice 2005–1, published by the Internal Revenue Service and the Department of Treasury on December 21, 2004, provides that the design and administration of stock options, stock appreciation rights, restricted stock, restricted stock units, and phantom stock programs will be affected by Section 409A.
Application of Section 409A to Equity Compensation
The basic rule promulgated under Section 409A in Notice 2005–1 is that, unless an exception applies, Section 409A applies to the grant of stock options, stock appreciation rights and other equity-based compensation. If a nonstatutory stock option or stock appreciation right is subject to the new deferred compensation rules, the award holder generally will be subject to
taxation when the option or stock appreciation right vests, even if the award holder has not exercised the award. Alternatively, award holders could elect, at the time the award is granted, a specific date on which they would be deemed to exercise the award and be subject to taxation on that date. Similarly, if a grant of restricted stock units or phantom stock was subject to Section 409A, the award holder would be subject to taxation when the awards vest unless a specific date for receipt was elected at the time of grant.
Nonstatutory Stock Options
Nonstatutory stock options (defined as stock options that are not incentive stock options as defined in Code section 422 or options granted pursuant to an employee stock purchase plan as defined in Code section 423) that are granted or that vest after December 31, 2004, will be subject to Section 409A unless the following three conditions are met:
- First, the exercise price of the nonstatutory stock option must be equal to or greater than the fair market value of the stock underlying the option determined on the date of grant. As a result, discounted stock option programs are required to comply with Section 409A beginning January 1, 2005, and any discounted stock option that is unvested as of January 1, 2005, also must comply with Section 409A. For this purpose, fair market value may be determined using any reasonable valuation method. We expect that the definition of fair market value in most equity compensation plans will be considered reasonable for purposes of Section 409A.
- Second, the nonstatutory stock option must be subject to taxation under Code section 83. Note that most compensatory stock option programs will meet this requirement.
- Third, the nonstatutory stock option must not provide for the possibility of deferral of income. Employers that have adopted stock option gain deferral programs should review their programs to determine whether options containing the deferral feature were vested or unvested as December 31, 2004. All options that were vested on December 31, 2004, should be grandfathered and, therefore, not subject to Section 409A, so the stock option gain deferral program may continue to operate as in the past with respect to the vested options. All options that were unvested as of January 1, 2005, and that contain the deferral feature must comply with Section 409A, unless the options are administered in 2005 as if the deferral feature did not apply, and the unvested options are amended to eliminate the deferral feature before December 31, 2005.
Notice 2005–1 also provides that nonstatutory stock options that are eligible for a potential repricing may be subject to Section 409A even if all three conditions outlined above have been met. We are hoping for additional guidance from the IRS on the application of this prohibition on repricing. Until such guidance is issued, we recommend that nonstatutory stock options that are granted under an equity incentive plan that expressly permits repricing contain a provision that states such option shall not be repriced.
Certain design features that are often associated with nonstatutory stock options will not trigger the application of Section 409A according to Notice 2005–1:
- Options that are substituted pursuant to a corporate reorganization or change in control will not be subject to Section 409A even if the substituted option has an exercise price less than the fair market value of the underlying acquirorÕs stock as determined on the date of grant, so long as the substituted option meets the requirements of the applicable Treasury Regulations. Note that most substituted options will qualify under this exception from the application of Section 409A.
- Options that contain an early exercise feature (commonly used by privately-held, ventured backed companies) will not be subject to Section 409A simply because of the inclusion of such feature in the option.
Finally, with respect to nonstatutory stock options, if the option is granted in tandem with another award that would be subject to Section 409A, then the whole arrangement is subject to Section 409A. For example, if a nonstatutory stock option is granted in tandem with a stock appreciation right and the stock appreciation right is subject to Section 409A (see the discussion below), then the nonstatutory stock option also would be subject to Section 409A. Notwithstanding the foregoing, any unvested nonstatutory stock option that is currently outstanding that has been granted in tandem with a stock appreciation right that is subject to Section 409A, but that is administered in 2005 as if the stock appreciation right feature did not apply and amended to remove the stock appreciation right feature before December 31, 2005, will be exempt from the application of 409A if the three conditions outlined above are otherwise met.
Incentive Stock Options and Section 423 Employee Stock Purchase Plans
Incentive stock options that are tax-qualified under Code section 422 and options granted under employee stock purchase plans that are tax-qualified under Code section 423 are not subject to Section 409A. Note, however, that non-qualified employee stock purchase plans may be required to comply with Section 409A.
Stock Appreciation Rights
As is the case with nonstatutory stock options, stock appreciation rights that are granted or that vest after December 31, 2004 (and in some cases after October 3, 2004) are subject to Section 409A unless an exception applies. Notice 2005–1 provides an exception for certain stock appreciation rights from the application of Section 409A if four conditions are met:
- First, as with nonstatutory stock options, the exercise price of the stock appreciation right must be equal to or greater than the fair market value of the underlying stock determined on the date of grant.
- Second, the stock appreciation right must not contain a deferral feature.
- Third, the stock underlying the stock appreciation right must be traded on an established market. In other words, only stock appreciation rights granted by public companies will be eligible for this exception from the application of Section 409A.
- Fourth, the stock appreciation right must be settled in stock with no opportunity to be settled in cash. Therefore, cash-settled stock appreciations rights will be subject to Section 409A. In addition, however, if the employer has a stock buy back program in place, whereby the employer will repurchase stock acquired by an employee upon the exercise of a stock appreciation right, then the stock appreciation right may be subject to Section 409A even if the stock appreciation right otherwise met these four conditions.
Stock appreciation rights that do not meet these four conditions are subject to the new deferred compensation rules under Section A. However, Notice 2005–1 provides that, until further guidance is issued, stock- or cash-settled stock appreciation rights that were granted pursuant to a program that was in effect on or before October 3, 2004 will not be subject to Section 409A if the right is not eligible for repricing, and does not contain a deferral feature.
Notice 2005–1 also provides that even if a stock appreciation right otherwise would be subject to Section 409A, the right will be in compliance with Section 409A if it has a fixed exercise date. Unvested stock appreciation rights that are currently outstanding and that are not eligible for an exemption from Section 409A, but that are administered in 2005 to comply with the four conditions outlined above or are administered as if subject to a fixed exercise date, and that are similarly amended before December 31, 2005, will be exempt from the application of Section 409A.
The prohibition on repricing applies to stock appreciation rights. In addition, the early exercise feature or the substitution of stock appreciation rights in connection with a corporate transaction or change in control will not trigger the application of Section 409A if the stock appreciation right was otherwise exempt from the application of Section 409A.
Restricted Stock, Restricted Stock Units and Phantom Stock
Restricted stock is not subject to Section 409A if the award holder recognizes income at the time the stock becomes vested, in part because the restricted stock is subject to taxation under Code section 83. However, restricted stock units, phantom stock and other awards of restricted property may be subject to Section 409A if the award recipient obtains in one year the right to receive property in a future year. For example, restricted stock units and phantom stock awards that are paid out in stock when the awards vest generally would not be subject to Section 409A; however, if the award holder has the ability to defer the payment date beyond the vesting date, then Section 409A will apply to the award.
Please contact us with your questions regarding the application of Section 409A to your equity compensation programs.
