Deferred Compensation
It is not uncommon for a closely-held business to provide an economic incentive to its key employees. The incentive may take the form of compensation the payment of which is deferred until the compensation is “earned,” which may be upon the occurrence of some specified business-related event, such as the sale of the business. In other situations, a key employee may be granted an equity (or equity-flavored) interest in the business, or the right to purchase such an interest, in order that the employee may “participate” in the ultimate sale of the business.

In each of these scenarios, the employer and the employee must pay close attention to the rules and principles that govern the income tax treatment of deferred compensation arrangements. Only by doing so can the employee avoid being taxed on the value of the deferred compensation before it is paid to the employee.

Thus, the arrangement must satisfy certain statutory and regulatory requirements under IRC Sec. 409A, some of which were recently clarified by the IRS.

Section 409A, In Brief
Under Sec. 409A, all amounts deferred under a compensation plan for the benefit of an employee are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture,” unless certain requirements are satisfied relating to the timing of the distribution of the deferred compensation.

A substantial risk of forfeiture exists when 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 separation from service on the sale of the business.

If a plan fails to comply or to be operated in accordance with the rules under Sec. 409A “at any time during a taxable year,” and there is compensation deferred under the plan that is not subject to a substantial risk of forfeiture (i.e., the employee is vested in the compensation), the amount of such compensation is includible in the employee’s gross income for the taxable year.

If the plan is not compliant, but the deferred amount is subject to a substantial risk of forfeiture at all times during the taxable year (i.e., it is not vested), the compensation is not immediately includible in income under Sec. 409A.

The Regulations – Revisited
In 2007, the IRS issued long-awaited final regulations under Sec. 409A. These final regulations defined certain terms used in Sec. 409A , set forth the requirements for the time and form of payments under nonqualified deferred compensation plans, and addressed certain other issues under Sec. 409A.

More recently, the IRS proposed certain clarifications and modifications to the regulations in order to help taxpayers comply with the requirements of Sec. 409A.

Among other things, these proposed regulations address certain issues that are often encountered in connection with change-in-control events and stock options.

“Haircut” On Repurchase of Stock
The regulations provide that certain stock options and stock appreciation rights (“SARs”; together with options, so-called “stock rights”) granted with respect to service recipient stock do not provide for the deferral of compensation because their exercise price is equal to the fair market value (“FMV”) of the underlying stock at the time of grant.

The term “service recipient stock” is defined as common stock of a corporation that, as of the date of grant, is an eligible issuer of service recipient stock. For this purpose, service recipient stock does not include any stock that is subject to a mandatory repurchase obligation (other than a right of first refusal), or a permanent put or call right, at less than the FMV of the stock.

However, employers may want to deter key employees, to whom employer stock has been granted, from engaging in behavior that could be detrimental to the employer. Toward that end, employers may reduce the amount that the employee receives under a stock rights arrangement if the employee is dismissed for cause, or violates a noncompetition or nondisclosure agreement.

Because this type of reduction is generally prohibited under the above definition of “service recipient stock,” many employers worry that claw-backs might violate Sec. 409A.

The proposed regulations address this issue by providing that a stock right will not violate Sec. 409A where it is subject to repurchase at less than FMV upon an employee’s involuntary separation from service for cause, or upon the employee’s violation of a covenant-not-to-compete. It is unclear whether the occurrence of another condition that is within the control of the employee would also be covered.

Separation from Service
The regulations permit the seller and an unrelated buyer in an asset purchase transaction to specify whether a person who is an employee of the seller immediately before the transaction is treated as separating from service if the employee provides services to the buyer after, and as a result of, the transaction.

The rule is based on the recognition that, while employees may formally terminate employment with the seller and immediately recommence employment with the buyer in an asset transaction, the employees often experience no change in the type or level of services they provide.

Questions have arisen whether this rule may be used with respect to a transaction that is treated as a deemed asset sale under Sec. 338.

In a deemed asset sale under Sec. 338, however, employees do not experience a termination of employment. Accordingly, it would be inconsistent with Sec. 409A to permit the parties to a deemed asset sale to treat employees as having separated from service upon the occurrence of the transaction.

Thus, the proposed regulations provide that a stock purchase transaction that is treated as a deemed asset sale under Sec. 338 is not a sale or other disposition of assets for purposes of this “separation” rule under Sec. 409A . the same guidance should apply to deemed asset sales under IRC Sec. 336(e).

Changes in Status from Employee to Independent Contractor
The regulations provide that an employee separates from service with an employer if the employee has a termination of employment with the employer. A termination of employment generally occurs if the facts and circumstances indicate that the employer and employee reasonably anticipate that no further services would be performed after a certain date (for example, the sale of a division of the employer’s business), or that the level of bona fide services the employee would perform after that date (whether as an employee or as an independent contractor) would permanently decrease to no more than 20 percent of the average level of services performed over the immediately preceding 36-month period.

The regulations further provide that “[i]f a service provider . . . ceases providing services as an employee and begins providing services as an independent contractor, the service provider will not be considered to have a separation from service until the service provider has ceased providing services in both capacities.”

The quoted sentence could be read to provide that an employee who becomes an independent contractor for the same service recipient, and whose anticipated level of services upon becoming an independent contractor are 20 percent or less than the average level of services performed during the preceding 36-month period, would not have a separation from service because a complete termination of the contractual relationship with the service recipient has not occurred and, therefore, there is no separation from service as an independent contractor.

Such a reading, however, is inconsistent with the rule that an employee separates from service if the employer and employee reasonably anticipate that the level of services to be performed after a certain date (in whatever capacity) would permanently decrease to no more than 20 percent of the average level of services performed over the preceding 36-month period.

To avoid potential confusion, the proposed regulations delete the quoted sentence from the regulations.

Certain Transaction-Based Compensation
The regulations provide special rules for payments of transaction-based compensation.

There are payments related to certain types of “changes in control” that (1) occur because an employer purchases its stock held by an employee, or because the employer or a third party purchases a stock right held by an employee, or (2) are calculated by reference to the value of employer stock.

Under the regulations, such transaction-based compensation may be treated as paid at a designated date or pursuant to a payment schedule that complies with the requirements of Sec. 409A if it is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders, generally, with respect to stock of the employer pursuant to the change in control, and it is paid not later than five years after the change in control event.

It is unclear, however, whether this payment schedule could be applied to stock options or SARs that are otherwise exempt from Sec. 409A.

The proposed regulations clarify that the special payment rules for transaction-based compensation apply to a stock rights that did not otherwise provide for deferred compensation before the purchase of the stock right. Accordingly, the purchase of such a stock right in a manner consistent with these rules will not result in the stock right being treated as having provided for the deferral of compensation prior to the transaction.

Prohibition on Acceleration of Payments
Under the regulations, a plan may provide for the acceleration of a payment made pursuant to the termination and liquidation of a plan under certain circumstances. For example, a plan may provide for the acceleration of a payment if the plan is terminated and liquidated within 12 months of a taxable corporate liquidation (such as may follow a sale of assets).

The regulations also provide that a payment may be accelerated pursuant to a change in control event, or in other circumstances, provided certain requirements are satisfied. To terminate a plan under these provisions, the regulations provide that the employer must terminate and liquidate all plans sponsored by the employer that would be aggregated with the terminated plan under the “plan aggregation rules” if the same employee had deferrals of compensation under all such plans.

The plan aggregation rules identify different types of nonqualified deferred compensation plans. All plans of the same type in which the same employee participates are treated as a single plan.

The proposed regulations clarify that the acceleration of a payment pursuant to the above rule is permitted only if the employer terminates and liquidates all plans of the same category that the employer sponsors, and not merely all plans of the same category in which a particular employee actually participates.

The proposed regulations also clarify that under this rule, for a period of three years following the termination and liquidation of a plan, the employer cannot adopt a new plan of the same category as the terminated and liquidated plan, regardless of which employees participate in the plan.

What’s Next?
These amendments to the regulations are proposed to be effective on or after the date on which they are published as final regulations. Taxpayers may, however, rely on the proposed regulations – to take advantage of the clarification and flexibility they provide – before they are published as final regulations, and the IRS will not assert positions that are contrary to the positions set forth in the proposed regulations.

That being said, it is worth noting that certain provisions of the proposed amendments are not intended as substantive changes to the current requirements under Sec. 409A. thus, certain positions may not properly be taken under the existing regulations; for example, that a stock purchase treated as a deemed asset sale under Sec. 338 is a sale or other disposition of assets for purposes of determining when an employee separates from service as a result of an asset purchase transaction; or that the exception to the prohibition on acceleration of a payment upon a termination and liquidation of a plan applies if the employer terminates and liquidates only the plans of the same category in which a particular employee participates, rather than all plans of the same category that the employer sponsors.