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Pension & Benefi ts Daily ™ Reproduced with permission from Pension & Benefits Daily, 171 PBD, 09/04/2014. Copyright ஽ 2014 by The Bu- reau of National Affairs, Inc. (800-372-1033) http://www.bna.com Commentary to Model Equity Compensation Plan Exempt From Section 409A 409A, but are not otherwise necessary to satisfy the requirements for the exemptions for equity compensation plans. Service recipients7 may wish to use the provisions that satisfy the requirements for nonqualified deferred compensation plans in their equity compensation plans so that the equity compensation plans are consis- tent with the nonqualified deferred compensation plans that cover the same group of service providers. In this manner, the service recipient can seek to achieve the elusive goal of having a compensation program that makes sense. BY STEVEN H. SHOLK The Promised Land of Exemption From he ABC, Inc. Equity Compensation Plan (the Section 409A ‘‘Model Plan’’) is designed to satisfy the exemp- T tions from Section 409A of the Internal Revenue In the absence of exemption from Section 409A, ser- 1 vice providers can exercise options and SARs only on Code of 1986, as amended (the ‘‘code’’) for equity com- 8 pensation plans under the final Section 409A regula- one or more of the following six permissible payment 2 events and times for nonqualified deferred compensa- tions (the ‘‘Final Regulations’’). The Final Regulations 9 10 contain exemptions for nonqualified stock options,3 in- tion plans: (1) separation from service; (2) disability; centive stock options,4 stock appreciation rights 5 6 (‘‘SARs’’), and restricted stock. 7 The Final Regulations define service recipient as the per- The Model Plan contains the provisions that satisfy son for whom services are performed and with respect to the requirements of the exemptions for equity compen- whom the legally binding right to compensation arises, and all sation plans. It also contains provisions that satisfy the persons with whom such person would be considered a single requirements of the Final Regulations for nonqualified employer under I.R.C. §§ 414(b) or 414(c). Treas. Reg. deferred compensation plans that are subject to Section § 1.409A-1(g). The Final Regulations modify this definition for determining the service recipient employer on a separation from service. Treas. Reg. § 1.409A-1(h)(3). See discussion of 1 Section 409A was added to the code by the American Jobs this modification infra notes 121-122 and accompanying text. Creation Act of 2004, Pub. L. No. 108-375, § 885, 118 Stat. The service provider is the person that performs services for 1418, 1634-41. (This article and Model Plan update a version the service recipient. Treas. Reg. § 1.409A-1(f). The Final published last year (38 PBD, 2/26/13;40 BPR 560, 3/5/13). Regulations contain detailed rules for determining whether an 2 Department of the Treasury, Internal Revenue Service, independent contractor is a service provider subject to I.R.C. Application of Section 409A to Nonqualified Deferred Com- § 409A. Treas. Reg. § 1.409A-1(f)(2). 8 pensation Plans, Final Regulations, 72 Fed. Reg. 19,234 (April Treas. Reg. § 1.409A-3(b) (a plan of nonqualified deferred 17, 2007), and Department of the Treasury, Internal Revenue compensation may provide for payment upon the earliest or Service, Application of Section 409A to Nonqualified Deferred latest of more than one event or time, provided that each event Compensation Plans, Correction, 72 Fed. Reg. 41,620 (July 31, or time is described in Treas. Reg. § 1.409A-3(a)(1)-(6)). 9 2007). I.R.C. § 409A(a)(2)(A)(i) (separation from service as deter- 3 Treas. Reg. § 1.409A-1(b)(5)(i)(A). mined by the Secretary is a permissible payment event); I.R.C. 4 Treas. Reg. § 1.409A-1(b)(5)(ii). § 409A(a)(2)(B)(i) (required six month delay in payment to a 5 Treas. Reg. § 1.409A-1(b)(5)(i)(B). specified employee on separation from service); Treas. Reg. 6 Treas. Reg. § 1.409A-1(b)(6). § 1.409A-1(h) (definition of separation from service); Treas. Reg. § 1.409A-3(a)(1) (separation from service is a permissible payment event for nonqualified deferred compensation); Steven H. Sholk ([email protected]) is Treas. Reg. § 1.409A-3(i)(2) (required six month delay in pay- a director in the Corporate Department of ment to a specified employee on separation from service). 10 I.R.C. § 409A(a)(2)(A)(ii) and (C) (disability as defined in Gibbons P.C. and chair of the Employee Ben- the statute is a permissible payment event); Treas. Reg. efits and Executive Compensation Group. § 1.409A-3(a)(2) and (i)(4) (disability as defined in the Final Regulations is a permissible payment event). COPYRIGHT ஽ 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 2 (3) death;11 (4) at a specified time or pursuant to a fixed cipient can transfer the stock or property to the service schedule;12 (5) a change-in-control;13 and (6) the occur- provider only on a Section 409A permissible payment rence of an unforeseeable emergency.14 event or time. The provision for payments to be made at a specified In light of the inflexibility that results from comply- time or pursuant to a fixed schedule limits the service ing with Section 409A, equity compensation that is ex- provider’s flexibility as to when the service provider can empt from Section 409A preserves the service provid- exercise options and SARs. Amounts are payable at a er’s discretion to exercise an option or SAR at any time specified time or pursuant to a fixed schedule if objec- after vesting. Furthermore, the prohibition on the accel- tively determinable amounts are payable at a date or eration of the time or schedule of any payment does not dates that are nondiscretionary and objectively deter- apply.18 The service recipient can freely accelerate the minable at the time the amount is deferred.15 If an amount is payable in a service provider’s taxable year vesting of the service provider’s right to exercise an op- (or pursuant to a fixed schedule of the service provid- tion or SAR, or the vesting of restricted stock. er’s taxable years) that is designated at the time that the Equity compensation plans often grant the service re- amount is deferred and that is objectively determinable, cipient the discretion to accelerate vesting on a change- the amount is treated as payable at a specified time (or in-control, an involuntary separation from service pursuant to a fixed schedule). A specified time or fixed within two years after a change-in-control, or a separa- schedule also includes the designation at the time that tion from service for good reason within two years after the amount is deferred of a defined period or periods a change-in-control. In addition, when the plan is ex- within the service provider’s taxable year or taxable empt from Section 409A, the plan’s definition of 16 years that are objectively determinable. change-in-control does not have to satisfy the definition Under these provisions, a stock right subject to Sec- in the Final Regulations. Finally, executive employment tion 409A can provide the service provider with the agreements often provide for the acceleration of vesting right to exercise the stock right in only one specified of all or a portion of equity compensation on a separa- taxable year, or on another permissible payment event, tion from service without cause or resignation for good such as separation from service or change-in-control. reason. Because most service providers want the discretion to exercise a stock right at any time after vesting, comply- Thus, exemption from Section 409A is truly the ing with Section 409A’s payment rules deprives the ser- promised land wistfully reminiscent of a prior time vice provider of much of the flexibility to choose when when parties could negotiate the terms of their arrange- 19 to exercise the stock right. ments free from the shackles of Section 409A. Another way to comply with Section 409A’s payment rules is for the stock right to permit exercise at any time after vesting, but to provide for payment only at a speci- Exemption for Nonqualified Stock Options fied time, such as the last year of the term of the stock right, or on a permissible event, such as separation The Final Regulations provide that a nonqualified from service or change-in-control. This approach also stock option is not a deferral of compensation subject to deprives the service provider of much of the flexibility Section 409A when the following requirements are sat- to choose when to exercise a stock right. isfied: Similarly, a promise to transfer stock or other property in a future taxable year in which the stock or prop- (1) the issuer of the stock is an eligible issuer of ser- erty will be substantially vested is subject to Section vice recipient stock;20 409A’s payment rules.17 This means that the service re- (2) the option is an option to purchase service recipient stock;21 11 I.R.C. § 409A(a)(2)(A)(iii) (death is a permissible payment event); Treas. Reg. § 1.409A-3(a)(3) (same). (3) the exercise price may never be less than the fair 12 I.R.C. § 409A(a)(2)(iv) (a specified time (or pursuant to a fixed schedule) specified under the plan at the date of deferral market value of the underlying stock, disregarding of the compensation is a permissible payment date); Treas.

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