IRS Executive Compensation Audit Program

IRS Executive Compensation Audit Program

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GEORGIA NORTH CAROLINA SOUTH CAROLINA VIRGINIA WASHINGTON, D.C. EQUITY PLAN DESIGN CHANGES REQUIRED TO COMPLY WITH CODE SECTION 409A PROPOSED REGULATIONS January 25, 2006 Both public and private companies will need to review and in most cases amend their equity-1based plans in 2006 to comply with recently proposed regulations under Code Section 409A, which establishes a new federal income taxation scheme for any plan or arrangement deemed to involve "deferred compensation." Section 409A may apply to many types of equity-based awards, including stock options, stock appreciation rights ("SARs"), restricted stock awards, restricted stock units, performance awards and phantom stock awards, and will have a significant impact on the design and operation of many types of equity arrangements. Although companies have until December 31, 2006 to amend their plans and arrangements to comply with Section 409A, good faith operational compliance was required beginning January 1, 2005. This client memorandum highlights key provisions of the Section 409A proposed regulations that companies should now be considering. Background New Section 409A, which was enacted as part of the American Jobs Creation Act of 2004, drastically changes the design and operation of all "nonqualified deferred compensation plans," as that term is broadly defined by the new law. Section 409A applies to plans for not only employees, but ...

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GEORGIA NORTH CAROLINA SOUTH CAROLINA VIRGINIA D.C.WASHINGTON, EQUITY PLAN DESIGN CHANGES REQUIRED TO COMPLY WITH CODE SECTION 409A PROPOSED REGULATIONS January 25, 2006 Both public and private companies will need to review and in most cases amend their equity 1 based plans in 2006 to comply with recently proposed regulations under Code Section 409A,which establishes a new federal income taxation scheme for any plan or arrangement deemed to involve "deferred compensation."Section 409A may apply to many types of equitybased awards, including stock options, stock appreciation rights ("SARs"), restricted stock awards, restricted stock units, performance awards and phantom stock awards, and will have a significant impact on the design and operation of many types of equity arrangements.Although companies have until December 31, 2006 to amend their plans and arrangements to comply with Section 409A, good faith operational compliance was required beginning January 1, 2005.This client memorandum highlights key provisions of the Section 409A proposed regulations that companies should now be considering. Background  NewSection 409A, which was enacted as part of the American Jobs Creation Act of 2004, drastically changes the design and operation of all "nonqualified deferred compensation plans," as that term is broadly defined by the new law.Section 409A applies to plans for not only employees, but also for directors, consultants and independent contractors, and applies to both public and private companies (as well as any other business form), regardless of their size or the number of employees. The legislation applies to deferrals made after December 31, 2004.Deferrals before this time are not covered, as long as the awards were vested and earned on or before December 31, 2004 and as long as the plan or arrangement is not materially modified after October 3, 2004.  Ifcompensation is considered deferred under an arrangement subject to Section 409A, it may not be distributed earlier than the following events: (i) separation from service (and key employees in publicly traded companies are subject to an additional sixmonth waiting period following such separation); (ii) disability; (iii) death; (iv) a specified time (but not a specified event, such as purchase of a principal residence or a child attending college) or pursuant to a fixed schedule; (v) to the extent permitted by IRS rules, change in ownership or effective control of the employer or in the ownership of a substantial portion of the employer’s assets; or (vi) occurrence of an unforeseeable emergency.  Failureto satisfy the new Section 409A requirements either in form or operation will result in all compensation deferred under the plan for the current year and all preceding years (including earnings) being includible in gross income.In addition, other related plans may also be considered in
1 Seehttp://www.treas.gov/press/releases/reports/reg15808004.pdf.
violation of Section 409A in certain circumstances.Interest also applies to all amounts previously deferred. A20% excise tax applies to all amounts included in income.Only those plan participants with respect to whom the failure relates are subject to the tax treatment and penalties described above. Awards Exempt from Section 409A  UnderSection 409A, certain types of equity awards are exempt from the reach of Section 409A. Theseinclude: Statutory options, such as incentive stock options ("ISOs") and purchase rights granted under a Code Section 423 employee stock purchase plan ("ESPP"), including discounted ESPP purchase rights. Nonqualified stock options ("NQSOs") and SARs (collectively referred to as "stock rights" in the proposed regulations) granted with an option price or SAR "base" price at least equal to the fair market value of the underlying common stock at the time of grant, generally as long as the stock right provides for no further means of deferral other than timing of exercise or disposition of the award.Conversely, discounted options and discounted SARs are subject to the onerous provisions of Section 409A  including distribution only upon the occurrence of one of the six triggers described above  unless protected under certain grandfather provisions applicable to awards vested and earned as of December 31, 2004. Restricted stock awards, as long as the award does not permit any deferrals (other than deferrals of income based on the vesting schedule).However, a promise to transfer property (for instance, pursuant to a restricted stock unit) may be subject to Section 409A unless distribution of the stock or cash subject to the award occurs within a specific shortterm deferral period permitted under Section 409A (described below). Valuation Issues for Options and SARs  Asnoted above, Section 409A and related guidance exempt "fair market value" options and SARs from Section 409A coverage, but at a price:The importance of qualifying for the Section 409A "fair market value" exception for options and SARs will make it more critical than ever for companies to carefully establish  and document  that the option price or SAR base price is at least 2 equal to the fair market value of the underlying stock.As a result, board or compensation committee minutes should be carefully drafted to reflect the factors considered in establishing fair market value.
2 The employer stock underlying the options must be common stock, and only the class of common stock that has the highest aggregate value of any class of common stock, or a class of common stock substantially similar to that class (disregarding differences in voting rights).In addition, among other restrictions, the underlying stock cannot have liquidation or dividend preferences.
WCSR 459656v2
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 Underthe terms of the proposed regulations and additional IRS guidance issued earlier this 3 month (IRS Notice 20064),the following principles apply: Publicly traded stock:Stock that is readily tradeable on an established securities market can be valued based on the last sale before or first sale after grant, the closing price on the trading day before or trading day of grant, an average price over a specified time period within 30 days before or after grant "or any other reasonable basis using actual transactions" in the stock as reported by the particular market and consistently applied. For corporations whose stock is not readily tradeable on anPrivate companies: established securities market, generally, fair market value may be determined "through the reasonable application of a reasonable valuation method," based on the particular facts and circumstances.The proposed regulations identify certain specific factors that will be taken into account in determining whether a valuation method is reasonable and also provide three safe harbor valuation methods, which, if met, establish a presumption that the award price equals the fair market value of the underlying stock.The specific factors include:
Value of tangible and intangible assets; o
Present value of future cash flows; o
Market value of stock/equity interests in similar corporations engaged in o businesses substantially similar to the employer's business where the value can be determined through objective means;
Control premiums; o
Illiquidity discounts; and o
Whether the valuation method is used for other purposes that have a material o economic effect on the corporation, its shareholders or creditors.
A valuation method is not considered reasonable if it does not take into consideration "all available information material to the value of the corporation," and a valuation previously calculated is not reasonable if it does not reflect information available after the date of the valuation that may materially affect the value of the corporation or if the valuation is more than 12 months old.In addition, the use of a valuation method for other purposes (e.g., unrelated to participant compensation) also supports reasonableness.
Safe Harbors:Besides the general valuation guidance described above, the o proposed regulations provide three safe harbors, which, if one is met, establish a "presumption of reasonableness," i.e., that the fair market value standard was met. These safe harbors include:
3 Seehttp://www.irs.gov/pub/irsdrop/n0604.pdf. 3 WCSR 459656v2
Use of an independent appraisal not more than 12 months old that meets tax qualified employee stock ownership plan ("ESOP") valuation requirements;
Formula price:Use of a valuation formula that meets certain Code Section 83 requirements applicable to nonlapse restrictions, if the method is consistently used for compensatory and noncompensatory purposes (e.g., loan covenants, regulatory filings) in all situations where the company is the buyer or seller of the stock; and
Reasonable and good faith valuations of the illiquid stock of a startup company (one that is less than 10 years old and not publicly traded) if these conditions are met: (i) the valuation is documented in a written report that takes into account the factors described above; (ii) the stock generally cannot be subject to puts/calls; (iii) neither a change in control nor an IPO is reasonably anticipated within 12 months of valuation event (grant, exercise, etc.); and (iv) the person performing the valuation must have significant knowledge and experience or training in valuations.
For stock rights issued before January 1, 2005, the IRS has said that, until further o guidance is issued, companies can rely on the good faith valuation standard applicable under ISO tax regulations (Reg. Section 1.4222(e)(2)), even if the stock right is not an ISO.Under the ISO regulations, if there was a good faith attempt to set the exercise price of the stock right at a price not less than the fair market value of the underlying stock at the time of grant, then that exercise price will be treated as being not less than the fair market value for Section 409A purposes. For stock rights issued on or after January 1, 2005 (and before the effective date o of the final Section 409A regulations), companies may either rely on IRS Notice 4 20051 (whichgenerally provides that any reasonable valuation method, including valuation methods described in certain federal Estate Tax Regulations, may be used) or may rely on the more specific factors and safe harbors in the proposed regulations which are described above. Subsequent Changes to Options or SARs  Theproposed regulations raise a potentially significant problem for companies:Even if the original stock option (whether an ISO or a NQSO) or SAR grant was exempt from Section 409A coverage, if the option/SAR is modified, extended or renewed, the altered award may become subject to Section 409A.In that case, compliance with Section 409A may not be possible since many of the requirements would not have been met at the time of grant (e.g., if the original award or plan did not specify that distribution may occur only upon the Section 409Apermitted events), with the result potentially being immediate taxation and a tax penalty.Under the proposed regulations, the following general principles apply:
4 Seehttp://www.treas.gov/press/releases/reports/notice20051.pdf. 4 WCSR 459656v2
Modifications: A"modification" is any change in the terms of a stock right that may give the holder (i) a direct or indirect reduction in the option/base price, (ii) an additional deferral feature, or (iii) an extension/renewal of the stock right, even if the holder does not in fact benefit from the changed terms.Any modification of a stock right(other than an extension or renewal) is treated as the grant of a new stock right, which may or may not be exempt from Section 409A depending upon its terms (e.g., if the option price is below the fair market value of the stock at the time of the modification).
For instance, a change in stock price (other than changes due to certain corporate o transactions, a stock split, a stock dividend or a similar event) generally is a modification which results in a new grant.However, as noted above, the new grant may still be exempt from Section 409A if it qualifies to be excluded under Section 409A (that is, the new stock right is a "fair market value" award and does not permit deferrals).Serial repricings are subject to special scrutiny.
Under the proposed regulations, a modification would not include a change in o award terms to permit transfer of the stock right, permit cashout of the award (in an amount equal to the spread), permit payment by share delivery (preowned stock) or facilitate payment of employment or withholding taxes.Similarly, acceleration of vesting is not a modification unless the award is subject to 409A (in which case accelerations may be prohibited).
Extensions and renewals:In the past, many companies have amended option agreements, for instance, at the time of a participant's termination of service, to extend the option exercise period.However, this practice may now have adverse tax consequences.Under the proposed regulations, an extension of the time period to exercise a stock right from the original award term generally is treated as an additional deferral feature, so that the stock right is treated as being subject to Section 409A from the grant date.If the original award did not comply with Section 409A (for instance, by permitting distributions only upon the six specified triggers), the award may be subject to immediate taxation under Section 409A at the time of the extension.The proposed regulations provide a limited th exception for extensions to a date no later than the later of (i) the 15day of the third month after the date when the right would otherwise expire, or (ii) December 31 of the calendar year during which the right would otherwise expire.(The proposed regulations also provide a limited exception for extensions intended to comply with securities laws requirements.)
WCSR 459656v2
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Substitutions and Assumptions in Corporate Transactions
The proposed regulations clarify that substitution and assumption of stock options and SARs made pursuant to a corporate transaction and in accordance with certain tax regulations applicable to ISOs (Reg. Section 1.4241) are generally exempt from Section 409A (i.e., are not treated as a new grant).
Dividend Equivalents
The proposed regulations also impose new requirements on dividends and dividend equivalents. Underthe proposed regulations, the right to receive, upon exercise of a stock option or SAR, an amount equal to all or part of dividends declared between the grant date and the exercise date is treated as an offset of the option price (or an increase in the SAR benefit)  and thus could cause an option or SAR that would otherwise be exempt from Section 409A as a "fair market value" stock right to be treated as a discount award subject to 409A, unless the dividend rights are "explicitly set forth as a separate arrangement."In addition, dividend equivalents on other types of awards (e.g., restricted stock units) may be treated as deferred compensation and thus should be structured to comply with Section 409A.
ShortTerm Deferral Exception  Inaddition to the exception from Section 409A coverage for restricted stock and "fair market value" options and SARs, corporations may be able to avoid the reach of Section 409A for certain types of equity awards (such as restricted stock units) if the award can be structured to comply with a separate "shortterm deferral" exception.Under Section 409A,awards are exempt under this "short term deferral" exception if the compensation is received by the participant by the later of (i) 21/2 months after the end of the participant's first taxable year when the amount is no longer subject to a substantial risk of forfeiture, or (ii) 21/2 months after the end of the company's first taxable year in which the amount is no longer subject to a substantial risk of forfeiture. Required Plan Terms  Inorder to comply with Section 409A, certain provisions must be included in the terms of the plan and/or award.For instance, for awards subject to Section 409A, the plan must provide that deferred compensation cannot be distributed earlier than the certain specific events described above, and the plan must also contain specific restrictions regarding initial and subsequent deferral elections. In addition, IRS representatives have informally cautioned that merely adding a catchall Section 409A compliance provision may not suffice.As a result, companies generally cannot attempt to merely comply with Section 409A "in fact."Rather, companies will need to take action to amend their plans (equity or nonequity) and/or agreements to comply with Section 409A by no later than December 31, 2006   keeping in mind that some amendments may trigger stock exchange or other shareholder approval requirements.Companies will need to be careful to ensure that they comply with Section 409A but retain as much plan flexibility as possible.
WCSR 459656v2
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Recommended Actions  Section409A will have a significant impact on how equity compensation plans are designed and operated, and companies should begin now to take steps to ensure that their plans comply with the new tax law while at the same time providing sufficient flexibility and incentive.At the same time, other initiatives that also impact equity plans must be considered, such as (i) the recently proposed SEC rules regarding expanded executive and director compensation disclosure, and (ii) the noweffective accounting rules requiring fair value expensing for all equity awards under Statement of Financial Accounting Standards No. 123 (revised 2004), "Share Based Payments." The following Womble Carlyle Corporate and Securities attorneys are available to assist you in addressing any questions that you may have regarding the proposed regulations.Please contact the attorney with whom you usually work or any one of the following attorneys if you have any questions. Garza Baldwin, III(Charlotte) (704)3314907 LeighR. Johnson(RTP) (919)4842345 Meredith P. Burbank(Charlotte) (704)3314949 JaneJeffries Jones(Charlotte) (704)3314953 Jeffrey A. D. Cohen(No. Virginia)(703) 3942238G. William Joyner III(Winston (336)7213579 Salem) Elizabeth O. Derrick(Atlanta) (404)8887433 AlonzoL. Llorens(Atlanta) (404)8887353  (Greenville)(864) 2555415Keith J. Mendelson(No. Virginia)(703) 3942246 Robert M. Donlon(Charlotte) (704)3314964 RossH. Parr(Charlotte) (704)3314925 John D. Hopkins(Atlanta) (404)8792429 KennethN. Shelton(RTP) (919)4842319 Jeffrey C. Howland(WinstonSalem) (336)7213516
The following Womble Carlyle Employee Benefits attorneys are available to assist you in addressing any questions that you may have regarding the proposed regulations.Please contact the attorney with whom you usually work or any one of the following attorneys if you have any questions.
Patrick M. Allen(WinstonSalem) (336)7213574 MichaelD. Gunter(Winston (336)7213607 Salem) Janice C. Baldwin(WinstonSalem) (336)7213654 BryanL. Tyson(Charlotte) (704)3314973 James E. Daniel(Charlotte) (704)3314931 WilliamR. Whitehurst(Winston (336)7213653 Salem) Diane J. Fuchs(Washington) (202)8574457 Womble Carlyle client alerts are intended to provide general information about significant legal developments and should not be construed as legal advice regarding any specific facts and circumstances, nor should they be construed as advertisements for legal services. IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).
WCSR 459656v2
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