IRS Issues Final Regulations on 409A
By Martin Staubus, Beyster Institute Staff

On April 10, 2007, the IRS issued final regulations interpreting section 409A of the Internal Revenue Code, enacted by Congress as part of the “American Jobs Creation Act” of 2004. Effective January 1, 2008, these final regulations will supersede the proposed regulations that the IRS had previously published in October of 2005.

Effect of Final Regulations on Equity Compensation Arrangements
By its terms, Code section 409A is principally concerned with deferred compensation arrangements, meaning any program or agreement by which an employer will deliver compensation to the person employed (whether as an employee or independent contractor) after the year in which the employee performed the work for which the compensation is due. The purpose of such programs is typically to defer taxation of that income on the part of the recipient employee. While such arrangements are commonplace – particularly in the context of compensation arrangements for executive management personnel – they are generally not considered to be a form of equity compensation and therefore are not typically included in discussions of equity compensation.

The initial IRS interpretation of Code section 409A, however, made it clear that the IRS considered some forms of equity compensation as potentially coming within the scope of section 409A. Since those early IRS pronouncements, the employee ownership/ equity compensation community has been awaiting the IRS’s final regulatory word on the actual impact of section 409A on equity compensation. The answer has now been provided.

The key issue for programs of equity compensation is basic and straightforward: Will any or all of the typical equity compensation tools (stock options, stock grants, SARs, etc.) be considered “deferred compensation” and thus come under the terms and restrictions of section 409A and the associated IRS regulations?  The following is a brief summary of what we now know.

Stock Options and Stock Appreciation Rights (SARs)
Stock options and SARs that are issued with an exercise price at least equal to the fair market value of the underlying equity unit on the date of the grant are generally outside the scope of section 409A (in other words, they are not considered to be deferred compensation). A key issue for private companies, however, concerns the determination of “fair market value” on the date of the grant. In general, the IRS promises that any reasonable application of a reasonable valuation method can be used for this determination. Knowing for sure that your opinion of what is reasonable will be the same as the IRS opinion, however, may be problematic. To resolve that concern, the IRS has provided some “safe-harbor” techniques for assigning fair market value that it blesses in advance:

• Appraisal by Paid Professional. No doubt the safest and surest way to satisfy the IRS with regard to the fair market value of a non-public company is to obtain a professional opinion of that value from an independent third party expert. Unfortunately, this is also the most expensive and time-consuming.

• Appraisal of “illiquid start-up” by a knowledgeable person. For early stage start-ups that cannot yet provide a reliable stream of past and/or projected financial results, the IRS has provided that stock options or SARs may be issued based on a valuation of the company performed by any person, whether inside or outside the company, with “significant knowledge, experience, education, or training” in such matters, whereby a reasonable individual would be willing to rely on that opinion of value. This required level of expertise is further described as generally requiring “at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other compatible experience in the company’s line of business or industry.” A further requirement of this process for illiquid start-ups is that no change of control may reasonably be expected to occur within 90 days after the valuation, nor an IPO within 180 days (in other words, you can’t issue a bunch of options based on an inside expert’s opinion of “today’s” exercise price knowing that a deal is in the works to sell the company for a price that is almost certainly going to be much higher).

Options on Stock of a Subsidiary Company
The final regulations offer a significant improvement over the proposed regulations that preceded them by providing latitude to grant employees stock options or SARs on the stock of the company they actually work for even if that company is a subsidiary corporation of which the parent company owns 50 percent or more. The proposed regulations had required that if there was a public parent company, then options or SARs would be considered to fall outside the scope of section 409A only if employees of a subsidiary company were granted options or SARs on shares of the parent company, not the shares of the subsidiary those employees actually worked for. Employers in such situations still retain the choice of awarding options or SARs on the parent company’s stock if they prefer.

The Bottom Line
All equity compensation arrangements (as well as deferred compensation plans or severance pay programs) that extend beyond the end of this year should be reviewed for compliance with section 409A under the terms of the final regulations. Any needed amendments to such programs should be made prior to December 31, 2007.

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