We have been thinking and talking about Section 409A for more than 8 years now, but most of that discussion has been hypothetical. We have pursued compliance with Section 409A, but have been left to wonder: What would actually happen if an arrangement violated Section 409A? Is the IRS monitoring compliance or enforcing these requirements?

Well now we have some answers.

A federal court recently issued a ruling (here) dealing with the consequences under Section 409A of a discounted stock option arrangement. In addition to providing some specific legal analysis on Section 409A issues, the court’s decision provides some insights into how a case like this might arise.

Background. The case involves a founder and senior executive of a technology company (Marvell Semiconductor) who was granted stock options in 2003. In the wake of the various stock option backdating scandals, the company reviewed its option program and repriced the 2003 option grant. As a result, the executive paid over $5,000,000 in additional exercise price, presumably reflecting that the options had been substantially discounted when awarded.

The IRS Takes Notice. Disclosures regarding this repricing must have caught the IRS’s attention. In 2010, it issued the executive a notice of deficiency to the executive assessing additional taxes and penalties under Section 409A in excess of $3,000,000. The executive paid the assessed amounts and then sued to obtain a refund, arguing that the option arrangement was not governed by Section 409A.

The Court’s Analysis. The court made several important rulings regarding the impact of Section 409A for      Continue Reading...

A year-end deadline for correcting certain impermissible payment language in employment, severance, or similar agreements is fast approaching.

As background, Code Section 409A - which governs most arrangements providing for future payments of taxable compensation - generally requires that deferred amounts be paid at fixed or identifiable times (e.g., termination of employment or a specified date) and that the covered individual (e.g., employee) not have the right to designate the calendar year in which payment will be made. These rules apply to most severance-pay and similar arrangements that provide for payments in the event of a specified loss of employment (e.g., a termination without cause).

It is common for severance-pay and similar arrangements to condition an employee's right to payment on the employee providing a release of claims. But this can create an issue under Section 409A, depending on how the payment language is written. The IRS takes the position that the payment language must not provide any opportunity for the employee to control or manipulate the calendar year in which payment will be made.

As an example, assume an agreement provides for a right to payment at any time within 90 days after termination of employment, once the employee has delivered a release of claims. If the employee terminates employment on November 1, the employee can effectively choose which calendar year in which to receive payment (the year of termination or the next year) by deciding when to deliver the release. In comparison, if the agreement says payment will be made on the 90th day      Continue Reading...

A new ruling from the IRS (Rev. Rul. 2012-19) addresses when dividends and dividend-equivalents paid to an employee in connection with restricted stock or restricted-stock units (RSUs) will qualify as performance-based compensation for purposes of the deduction limitation under Code Section 162(m).

Note. This ruling is of particular relevance to publicly traded companies. They are limited by Code Section 162(m) in their ability to deduct compensation paid to a "covered employee," unless the compensation is qualifying performance-based compensation.

The ruling concludes that rights to dividends and dividend-equivalents must be analyzed separately from the underlying restricted stock or RSUs to determine whether they qualify as performance-based compensation.

For example, if an employee is granted restricted stock that qualifies as performance-based compensation but is also given the right to receive dividends with respect to the restricted stock without regard to whether the performance conditions are satisfied with respect to the restricted stock, the dividends will not qualify as performance-based compensation and will be subject to the deduction limitation under Section 162(m). But if the arrangement provides that the dividends will be accumulated and paid to the employee only if and when the performance-based conditions on the restricted stock are satisfied, the dividends also will qualify as performance-based compensation.

The IRS has provided two important pieces of new guidance regarding Code Section 83, which governs the taxation of property (e.g., stock and stock options) transferred in exchange for the performance of services.

First, new regulations have been proposed that would revise or clarify the standards on when property is subject to a "substantial risk of forfeiture" for purposes of Section 83. (This is a key consideration, because property transferred in connection with the performance of services generally is not taxable so long as it is subject to a substantial risk of forfeiture.)

• Conditions Other Than Service or Performance. The proposed regulations would clarify that a substantial risk of forfeiture may be established only through a service condition (e.g., a vesting schedule) or a condition related to the purpose of the transfer (e.g., a performance-based condition). For example, an obligation to sell property back to the employer in lieu of transferring it to a third party would not qualify as a substantial risk of forfeiture.
• Likelihood That Condition Will Occur. The proposed regulations would clarify that, in determining whether a performance-based condition is a substantial risk of forfeiture, the likelihood that the condition will occur must be considered, in addition to considering the likelihood that the condition will be enforced. For example, if stock transferred to an employee will be forfeited if the employer's gross receipts fall by 90% over the three-year period after the transfer, the likelihood that gross receipts actually will fall by that amount must be considered in      Continue Reading...

Facebook's pre-IPO regulatory filings (click here) with the Securities and Exchange Commission (SEC) highlight a common issue with equity compensation programs -- the tax bill can be very large and trigger a burdensome withholding obligation.  Facebook reports that its employees and contractors hold about 378.5 million restricted stock units (RSUs).  Each RSU represents a right to receive one share of Facebook stock when the RSU vests.  The RSUs will vest approximately six months after the IPO.  Facebook is estimating a median IPO price of $36 per share.  If that valuation holds up, the RSU holders will vest in equity compensation worth approximately $13.6 billion.  Assuming a combined state and federal tax rate of 40%, that will produce a tax bill of about $5.5 billion.

A big tax bill can be a nice problem to have; however, employers are required to withhold taxes with respect to equity compensation as it vests, and the IRS wants to be paid in cash, not shares.  So where does the money come from?  In Facebook's case, it looks like they are planning to use a good chunk of the money they will receive from selling shares to the public in the IPO for business purposes; however, Facebook will likely hold back a percentage of the shares each employee would receive upon vesting of the RSUs and then use some of the cash from the IPO to make the required tax payments.  This is sometimes referred to as "netting down" the shares the employees receive.  It is convenient for employees, but requires the      Continue Reading...