Incentive Compensation

It is not uncommon for a closely-held business to provide an economic incentive to its key employee. Often, the incentive takes the form of an annual cash bonus. Alternatively, the business may provide the key employee with a longer-term incentive, in the form of a deferred compensation arrangement that may be payable on retirement or upon the sale of the business. In other situations, the key employee may be granted an equity interest in the business, or the right to purchase such an interest.

In each of these scenarios, both the employer and the employee must pay close attention to the rules and principles that govern the income tax treatment of the compensation arrangement. Only by doing so can the employee avoid being taxed prematurely on (i.e., before its actual receipt of) the value of the compensation provided. Where the incentive granted is an option to purchase equity in the business, the parties must be especially aware of IRC Sec. 409A.

Section 409A, In Brief

Under Section 409A, all amounts deferred under a nonqualified plan (for both the current and all preceding taxable years) are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture”—in other words, to the extent that the employee’s rights to the compensation are conditioned upon the performance of substantial services or the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings or the sale of the business – unless certain requirements are satisfied relating to the timing of the distribution of the deferred compensationStock-Protection-Using-Stock-Options

The Options At Issue

A recent IRS advisory reviewed the income tax consequences of one equity-based compensation arrangement.  The advisory arose out of an examination of the “Employee’s” tax return for Year 3. Two years prior to the tax year under examination (Years 1 and 2), “Employer” had granted Employee a nonstatutory stock option (“Option”) to purchase a certain number of shares (“Option Shares”) of Employer’s common stock. These two tax years were closed at the time the IRS examined Year 3.

Employer and Employee executed an option agreement (“Agreement”) providing for the grant of the Option under the terms of a “Plan.” Plan provided that the Option would be granted on Date.

The consideration for the grant of Option was Employee’s provision of future services to Employer. Employee was not required to pay any additional amount in exchange for grant of Option.

The option agreement provided that “Exercise Price” was the strike price per Option Share.

Under the terms of the option agreement, a certain number of Option Shares would vest each year following the grant date. The vested Option Shares could then be exercised at any time during a specified number of years from the vesting date.

Two days prior to Date, Employer’s common stock began trading on an over-the-counter market.  Trades made on Day 1, Day 2, and on Date were on a “when, as and if issued” (commonly called a “when issued”) basis.

The lowest when-issued trading price for Day 1, Day 2, and Date was at least $X more than Exercise Price. On Date, the lowest when-issued trading price was over $Y more than Exercise Price.

Employee became vested in a number of Option Shares in Year 2 and in Year 3, and exercised Option as to these shares.

Section 409A Failure

The Section 409A regulations provide that an NSO to purchase a fixed number of shares of employer stock is not treated as a nonqualified deferred compensation plan subject to section 409A (and therefore is exempt from section 409A) if the exercise price is not less than the fair market value (“FMV”) of the underlying stock on the grant date of the option and certain other requirements are met.

Conversely, if the exercise price is less than such FMV, the option is treated as a nonqualified deferred compensation plan subject to section 409A that must meet the time and form of payment requirements under the section 409A regulations.

A nonqualified deferred compensation plan subject to section 409A(a) must provide, upon adoption of the plan, for a deferred amount to be paid at a time and in a form meeting the section 409A time and form of payment requirements. To satisfy the time and form of payment requirements, the plan must designate that a specified nondiscretionary and objectively determinable deferred amount may be paid only upon a specified (or the earlier or later of certain specified) permissible payment event (or events), such as a specified time or date, death, disability, separation from service, or a change in control event, or a permissible period following the applicable payment event.

For an NSO that is treated as a nonqualified deferred compensation plan, the terms of the option must designate the nondiscretionary and objectively determinable number of shares that may be purchased through full or partial exercise of the option upon a permissible payment event, or a permissible period following the payment event.

For purposes of determining the FMV of employer stock underlying an NSO intended to be exempt from section 409A, the regulations provide that, for stock that is readily tradable on an established securities market, the FMV of the stock on the grant date of the option is determined based on a reasonable method using actual transactions in the stock as reported by the established securities market.

The regulations further provide that, for employer stock that is not readily tradable on an established securities market, the FMV of the stock on the grant date of an NSO is determined based on the reasonable application of a reasonable valuation method, taking into consideration events occurring after the date of the calculation that may materially affect the value of the employer stock.

Employer’s common stock was traded on a when-issued basis on an OTC market on Date (the grant date of Option). According to the IRS, the OTC market on which Employer’s stock was traded was an established securities market for purposes of Sec. 409A. Therefore, the stock underlying the NSO was treated for purposes of section 409A as having been readily tradable on an established securities market on the grant date of Option.

However, the IRS found that the FMV of a share of Employer’s stock on Date, the grant date of Option, was higher than Exercise Price, the strike price per Option Share under the terms of the option agreement.

As a result, the Option did not meet the regulatory requirements for exemption from section 409A. Thus, the Option was treated as a nonqualified deferred compensation plan subject to section 409A from the grant date until the end of the taxable year during which the Option was either fully exercised or expired.

Because the Agreement generally provided that Option Shares could be purchased through Option exercise at any time following vesting, the Option terms did not designate a permissible payment event as the only time that Option Shares could be purchased. Therefore, Option failed to meet the requirements of Section 409A from the grant date.

Check in tomorrow for a discussion of the income tax consequences arising from this failure.