As we reported to you in our Special Alert earlier in October, proposed regulations have been published under Internal Revenue Code section 409A covering a variety of deferred compensation arrangements, including stock options, stock appreciation rights and restricted stock awards, restricted stock unit awards and other stock awards. IRS Notice 2005–1, which we summarized in our January 2005 edition, provided guidance on the application of 409A to equity compensation arrangements. The proposed regulations have provided additional relief from Section 409A with respect to equity compensation arrangements and additional guidance on the application of Section 409A to equity compensation arrangements.

Application of Section 409A to Equity Compensation Arrangements
Generally, Section 409A does not apply to stock options that qualify as incentive stock options under Code section 422 or as employee stock purchase plan rights under Code section 423. Moreover, Section 409A does not generally apply to restricted stock awards that are subject to taxation under Code section 83. On the other hand, Section 409A does apply to nonstatutory (or nonqualified) stock options and stock appreciation rights unless certain requirements are met. Finally, Section 409A does apply to restricted stock unit awards, phantom stock, performance shares and other equity compensation arrangements which are denominated in stock equivalents.

Nonstatutory Stock Options
Nonstatutory stock options (defined as stock options that are not incentive stock options defined in Section 422 or stock options granted pursuant to an employee stock purchase plan defined in 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:

• The exercise price of the stock option must be equal to or greater than (and can never be less than) the fair market value of the underlying stock on the date of grant;
• The transfer or exercise of the stock option must be subject to taxation under Section 83 (generally the case with respect to compensatory stock options); and
• The stock option must not provide for the deferral of income beyond the exercise date.

The proposed regulations provide that if the exercise price of the stock option is or could become less than the fair market value of the underlying stock on the date of grant, then the stock option may be deferred compensation for purposes of Section 409A. It appears that the proposed regulations, like Notice 2005–1, intend to prohibit the repricing of stock options by subjecting stock options that have been repriced to the application of Section 409A.

The proposed regulations confirm our understanding from Notice 2005–1 that an early exercise feature attached to a stock option, or the ability to pay the exercise price of the option with previously owned stock, does not cause the option to be subject to the application of Section 409A.

If a stock option is deferred compensation subject to Section 409A, then in order to avoid penalties imposed by Section 409A the optionholder must recognize tax on the date the option is vested regardless of whether the optionholder has exercised the option.

Service Recipient Stock
In addition, to receive the favorable treatment for stock options under Section 409A, the stock underlying the option must be service recipient stock. Stock of the service recipient is defined as stock that is the common stock of the optionholder’s employer or a member of the employer’s controlled group that is readily tradable on an established securities market (i.e., publicly traded). If none of the common stock of controlled group member companies is publicly traded, then service recipient stock is the common stock of the employer or member of the employer’s controlled group that has the highest value. In other words, if the stock of the employer is not publicly traded but the employer is part of a controlled group of corporations (for example the employer is a wholly-owned subsidiary of a publicly traded company), then in order to avoid the application of 409A the subsidiary/employer must grant options to purchase stock of the publicly traded parent corporation. This is true even if the parent corporation is traded on an established exchange located outside of the United States. Note that American Depository Receipts (ADRs) may constitute service recipient stock, but only to the extent that the ADRs otherwise would qualify as service recipient stock, and that preferred stock is not service recipient stock.

With respect to stock options granted on or before December 31, 2004, any class of employer stock underlying the option is deemed to be service recipient stock.

Stock Appreciation Rights
The proposed regulations provide that stock appreciation rights (SARs) that are granted or that vest after December 31, 2004, are subject to Section 409A unless the following three conditions are met:

• Compensation payable with respect to the SAR cannot be greater than the difference between the fair market value of the underlying stock on the date of exercise and the fair market value of the stock on the date of grant;
• The exercise price of the SAR must be equal to or greater than (and can never be less than) the fair market value of the underlying stock on the date of grant; and
• The SAR must not provide for the deferral of income beyond the exercise date.

SARs are subject to the same repricing rules as nonstatutory stock options and, similarly, the stock underlying SARs must be service recipient stock in order to avoid the application of Section 409A.

In a departure from Notice 2005–1, the proposed regulations do not make a distinction between SARs based on publicly-traded stock and SARs based on privately-held stock. Under Notice 2005–1, only SARs based on publicly traded stock were exempt from the application of Section 409A. The proposed regulations, therefore, provide welcome relief for those privately-held corporations that wish to compensate their employees and other service providers with SARs.

Corporate Transactions
As provided in Notice 2005–1, the proposed regulations provide that equity compensation awards that are exempt from the application of 409A will remain exempt if they are assumed or substituted in connection with a corporate transaction in compliance with the regulations promulgated under Code section 424, and the assumption or substitution of the stock award is not otherwise a modification of the award. The proposed regulations also provide that the stock underlying the award that is substituted for the original award will be treated as service recipient stock. For example, Corporation Z grants stock options to its employees, spins off a subsidiary, and the Corporation Z stock options are replaced with stock options to purchase both Corporation Z stock and subsidiary common stock. Assuming that such substitution is not otherwise considered a modification of the options, then both Corporation Z stock and subsidiary common stock will be treated as service recipient stock for purposes of Section 409A.

The assumption or substitution of an award that does not meet the requirements of the regulations promulgated under Section 424 will be treated as a modification of the option as described below.

Modification of Equity Compensation Awards
A nonstatutory stock option or stock appreciation right that otherwise might have been exempt from the application of Section 409A may become subject to the requirements of Section 409A if the award is modified, extended or renewed after the date of grant. A modification of a stock award is treated as the grant of a new award, and the award must meet the requirements set forth above as of the modification date in order to be exempt from the application of Section 409A. An extension or renewal of a stock award is treated as a deferral feature and thus the award would no longer qualify for the exemption from 409A.

For this purpose, a modification means any change in the terms of the stock award that may provide the awardholder with a direct or indirect reduction in the exercise price, an additional deferral feature, or an extension or renewal of the stock award, even if the awardholder does not ultimately benefit from the modification. Any increase in the number of shares underlying the award or a change in the terms of the underlying stock that increases the value of the stock is also a modification. It is not a modification of a stock option or SAR to shorten its term or provide for different payment methods with respect to the exercise price. Finally, it is not a modification of the award if the awardholder exercises his or her right to transfer the stock award.

The acceleration of the vesting of a stock award is not considered a modification for these purposes; however, the acceleration of the vesting could result in an impermissible acceleration of the payment of deferred compensation under Section 409A as described more fully in our latest Special Alert.

An extension of the exercise period of a stock option or SAR is an extension of the underlying award and will result in the award being subject to Section 409A with the following exceptions:

• The extension of the post-termination exercise period of an option or SAR to a date that is no later than the fifteenth day of the third month following the date at which, or December 31 of the calendar year in which, the option or SAR otherwise would have expired.
• The extension of the exercise period when the exercise of the option would violate applicable securities laws, provided that the exercise period is not extended more than thirty days beyond the date the award first becomes exercisable under the securities laws.

Valuation — Publicly-Traded Stock
With respect to nonstatutory stock options and stock appreciation rights, it is important to establish whether the exercise price of the award is equal to or greater than the fair market value of the underlying stock on the date of grant. The proposed regulations provide guidance with respect to the valuation of the stock underlying the stock awards. The proposed regulations provide that the fair market value of publicly-traded stock may be defined as equal to the last sale before or the first sale following the date of grant. Alternatively, the fair market value of the publicly-traded stock may be defined as equal to the closing price on the trading day before or the trading day of the grant. Generally, the fair market value of publicly traded stock may be determined using any reasonable basis, provided that the basis is used consistently.

Valuation — Privately-Held Stock
Just as the regulations published under Code section 422 in August 2004 made it more difficult to value privately-held stock for purposes of granting incentive stock options, the proposed Section 409A regulations make valuation more complicated and less flexible. The proposed regulations provide that the fair market value of privatelyheld stock means a value determined by the reasonable application of a reasonable valuation method. A valuation method is determined as reasonable using a facts and circumstances test.

The proposed regulations list a number of factors that should be taken into account in determining the fair market value of privately-held stock, and further provide that a valuation method is not reasonable if such method does not take into consideration all available information material to the value of the corporation. Moreover, the valuation of privately-held stock is only deemed to be accurate for one year, or a shorter period of time if there is an intervening corporate event that would be expected to affect the value of the stock.

The following valuation methods are presumed to be reasonable under the proposed regulations:

• A valuation determined by an independent appraisal that meets the requirements of Code section 401(a)(28)(C) related to tax-qualified employee stock ownership plans;
• A valuation based on a formula that meets the requirements of regulation Section 1.83–5, which shifts the burden of proof from the taxpayer to the IRS; and
• With respect to the stock of privately-held corporations (called start-up corporations in the proposed regulations) that have been in business for ten years or less, a valuation made reasonably and in good faith and evidenced by a written report that takes into account factors deemed reasonable pursuant to the proposed regulations and taking into account any anticipated change in control transaction or the initial public offering of the corporation.

Any valuation method must be used consistently with respect to any obligation of the employer regarding the common stock. A new valuation method may be used only on a prospective basis.

Other Stock Awards
Restricted stock unit awards, phantom stock, performance shares and other similar stock awards that are not subject to taxation under Section 83 are deferred compensation and are subject to the application of Section 409A. As a result, the stock award must be included in income on the vesting date or the deferral of the recognition beyond the vesting date must meet all of the requirements of Section 409A.

The proposed regulations provide welcome guidance on how restricted stock unit awards, performance shares and other similar stock awards may be deferred beyond the vesting date. The proposed regulations provide that an awardholder may elect to defer receipt of the award beyond the vesting date if:

• The award is subject to a forfeiture provision requiring the continued performance of services by the participant for at least twelve months from the date of grant;
• The deferral election is made within thirty days after the date of grant; and
• The deferral election is made at least twelve months in advance of the end of the vesting period.

For example, participant A receives a restricted stock unit award on June 1, 2006, subject to a four-year cliff vesting schedule. A could elect to defer receipt of the stock payable on the vesting of award within thirty days after the award was granted. Contrast this example with the grant of an award that vests 25% annually over four years. A could elect to defer receipt of the stock payable on the second, third and fourth vesting dates but not the first vesting date, because by the time A made his deferral election less than twelve months would remain before the first vesting date and A would not qualify for the special deferral rule. Therefore, we can expect to see awards granted with an initial vesting of period of at least thirteen months to provide participants with the most flexibility during the thirty-day deferral election period.

Restricted stock unit awards, performance shares and other similar stock awards frequently provide that the awardholder will be credited with dividend equivalents during the vesting period and/or deferral period of the award. These amounts may be accumulated and paid at the same time as the underlying award, or the plan may specify that such amounts shall be treated as earnings and paid no later than the fifteenth day of the third month following the end of the calendar year for which the earnings are credited.

Transition Rules
Section 409A is generally effective with regard to any stock award that is granted or vests after January 1, 2005. Certain transition rules relating to stock options and stock appreciation rights that were set forth in Notice 2005–1 generally are still applicable. Specifically, stock appreciation rights granted before January 1, 2005, generally are not subject to Section 409A or the proposed regulations, nor are stock awards that were granted after October 3, 2004, and before January 1, 2005, and were granted pursuant to an existing compensation program already in place with respect to the employer.

Please contact us with your questions regarding the application of Section 409A to your equity compensation arrangements, as well as your other deferred compensation arrangements.