IRC Section 409A determines when an employee is taxed for stock-based compensation awards (see SC 10.2.6
, SC 10.6.3
, SC 10.6.4
, and SC 10.6.5
). Section 409A provides a broad definition of nonqualified deferred compensation and provides rules related to the timing of elections and distributions under deferred compensation arrangements. In addition to affecting deferrals of cash compensation, IRC Section 409A has significant implications for stock-based compensation plans.
While Section 409A includes a very broad definition of nonqualified deferred compensation, the regulations confirm that ISOs, qualified ESPPs, and restricted stock awards (but not restricted stock units) are specifically exempt from the provisions of IRC Section 409A. In addition, the regulations provide that nonqualified options are not deferred compensation and are not subject to Section 409A if:
- The option is over "service recipient stock;"
- The exercise price of the option can never be less than the fair market value of the underlying stock on the grant date;
- The receipt, transfer, or exercise of the option is subject to taxation under IRC Section 83; and
- The option does not include any deferral feature other than deferral of income from the grant date until the option exercise date.
Options with a floating exercise price that could be less than the fair market value of the stock on the grant date will be treated as deferred compensation under Section 409A. Further, the payment of a dividend equivalent contingent upon the exercise of the option will be treated as a reduction in the exercise price causing the option to be deferred compensation under Section 409A. Companies should review their plans to ensure that the exercise price and dividend equivalent rights meet the requirements under Section 409A.
The regulations include a similar exception for both cash- and stock-settled SAR plans.
In order for both nonqualified stock options and SARs to be exempt from Section 409A, the award must be over "service recipient stock." Generally, a stock right may cover common stock of the employing company or another company directly up the corporate chain. The rules regarding service recipient stock are complex and should be carefully examined in each individual circumstance. The regulations provide that service recipient stock is any class of stock that is common stock for the purposes of IRC Section 305. Any class of common stock may be used, even if another class of service recipient stock is publicly traded or has a higher aggregate value outstanding, provided that the common stock does not have a preference to distributions and cannot be subject to mandatory repurchase (other than a right of first refusal) or a put or call right that is not a lapse restriction, unless the price paid is the current fair market value on the repurchase event. An American Depository Receipt or American Depository Share, to the extent that the stock is traded on a foreign exchange, continues to qualify as service recipient stock.
Other stock-based compensation grants may be exempt from IRC Section 409A if the compensation is paid during the "short-term deferral period." The Treasury Regulations provide an exclusion to Section 409A for compensation that is paid in the year of vesting or no later than 2 1/2 months after the end of the later of the employer's tax year or the employee's tax year in which vesting occurs. Thus, for example, an RSU that transfers the stock in the year of vesting is generally excluded from Section 409A.
Stock-based compensation awards that do not fall within the exceptions are generally subject to the requirements of IRC Section 409A. Section 409A imposes restrictions on the timing and form of deferral elections, the timing of distributions/payments and the use of certain trusts to fund the arrangements. If these requirements are not met, the individual is subject to accelerated taxation, enhanced underpayment interest, and an additional 20% tax.