A number of tax law provisions and interpretations that may affect your stock grants occur in:
The text below explains the possible impact. Links in the table of contents take you to the relevant sections.
1. ISOs & ESPPs
2. Supplemental withholding rate
3. Stock pay for senior execs in expat companies
4. Stock grants as deferred compensation:
5. Recommendations
6. Editor's note
1. ISOs and ESPPs. AJCA makes a permanent part of the tax law (i.e., codifies) the current practice that no withholding, Social Security, Medicare, or FUTA taxes apply to gains at exercise, purchase, or sale of ISOs and Section 423 ESPPs (these continue to apply to NQSO exercises and restricted stock vesting). The IRS wanted to impose this withholding. In addition, under AJCA, if you go into public service and conflict of interest laws force you to make an early sale of ISO or ESPP stock, you will automatically meet the holding period requirements for the best tax treatment, even though this sale would have otherwise been considered a disqualifying disposition.
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2. Supplemental income withholding rate. When your aggregate supplemental income (e.g., from exercising NQSOs or the vesting of restricted stock) in a calendar year exceeds $1,000,000, the withholding rate defaults to the maximum of 35%. (Before 2005, the 25% supplemental withholding rate applied to all income levels, no matter what your gains were.) The supplemental rate is not your actual effective tax rate and does not accurately reflect the amount you will eventually owe: it's just the amount your company must withhold. For details and unresolved issues related to the calculation of supplemental income, see the relevant FAQ.
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3. Stock compensation for senior executives in expatriated corporations. You must pay an excise tax equal to the maximum capital gains rate (15% through 2012) on the value of certain stock compensation during the 12-month period that starts six months before your company reincorporates from the USA to a foreign jurisdiction. The excise tax applies to Section 16 insiders of public and private companies, although the Internal Revenue Service (IRS) needs to clarify the scope.
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4. Stock grants as deferred compensation. The broad definition in Section 885 of the AJCA (adds 409A to the Internal Revenue Code) of "nonqualified deferred compensation plan" is read to encompass certain types of equity-based compensation, such as stock appreciation rights (SARs), restricted stock units (RSUs) that delay share delivery, and options that permit deferral of gains at exercise. Eventually IRS guidance and regulations detailed what type of stock grants and features can trigger problems and thus need changes.
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Standard stock grants. Standard options and SARs with an exercise price equal to or above the market price at grant, along with tax-qualified (i.e., Section 423) ESPPs, see no change in the tax rules under this IRS guidance and regulations. Under the rules, American Depositary Receipts (ADRs) are treated in the same way as company stock.
These other forms of equity compensation, usually for executives and directors, are not so fortunate if the vesting date is later than December 31, 2004. Generally, deferrals that were made before 2005 which are not subject to substantial risk of forfeiture are grandfathered from 409A unless the plan is materially modified.
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Penalties and taxes. Regardless of the reasons why your company's plan does not meet the requirements under the AJCA, any violations will cause you to pay 20% additional tax on your previously deferred gross income, plus additional interest and penalty for underpayment of taxes. The IRS and the Treasury have issued proposed rules (REG-148326-05) with guidance for calculating the 20% additional income tax that would stem from any violation of Section 409A. Some states, such as California, impose a similar tax.
IRS Announcement 2007-18 provided details about extra tax stemming from exercises of discounted stock options in 2006, and procedures that let your company pay them. For more information about the taxation of stock options that are discounted because of backdated grants, see the relevant FAQ elsewhere on this website.
Alert: The IRS has started audits of 409A deferred compensation arrangements (see a memo from the law firm Jones Day). The agency began to issue information document requests (IDRs) on these plans in the fall of 2009. You pay any penalties for noncompliance even though the plan is controlled by your company. Jones Day warns that "a Section 409A audit of the company has the potential to result in severe adverse tax consequences for employees. It remains to be seen how the IRS will attempt to coordinate Section 409A audits of companies with the potential assertion of tax deficiencies against the participating employees."
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Withholding and Form W-2. In IRS Notice 2008-113, the IRS extended the transition rules of tax-reporting and wage-withholding for deferrals of compensation and amounts includible in gross income under IRC Section 409A. The IRS intends to issue more guidance (beyond that in REG-148326-05) on calculating the amount includible in income. Previously, in late November 2006, the IRS issued additional guidance for reporting and wage withholding under 409A for 2005 and 2006 (Notice 2006-100, which Notice 2007-89 extended for 2007, and which Notice 2008-113 extended for 2008).
Companies will eventually be required to separately report (in Box 12 of IRS Form W-2 using Code Y, or in Box 15a of IRS Form 1099-MISC) amounts properly deferred during the year under a nonqualified deferred compensation plan that is subject to but not penalized under Section 409A. When amounts are includible in gross income because they do not comply with 409A, your company is also required to break these out in Box 12 using Code Z along with including them in Box 1 (Form 1099-MISC Box 7 and Box 15b). While this additional gross income is taxed at the withholding rates for supplemental income, the 20% tax and interest are not subject to withholding. Until the IRS changes the guidance in Notice 2008-115, if you are subject to penalties under 409A you may need to make estimated tax payments to prevent additional under-withholding penalties.
Even if this is not clearly broken out on your W-2, speak with your tax advisor about whether and how you must report income subject to 409A on your tax return. Your company can also pay any additional taxes owed, adding the amount to your taxable income and your W-2.
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Compliance by companies. Your company had until December 31, 2008, to modify its plans to comply. (This date was extended twice. See IRS Notice 2007-86, which pushed back the deadline and the effective date for the final regulations after a prior extension in 2006 (IRS Notice 2006-79) gave companies until the end of 2007. See also the related press release by the US Treasury.) There were certain advantages in making changes before the end of 2005 if the company wanted to give you any "make whole" payments. Adhering to the proposed regulations during the transition period was deemed good-faith compliance with the AJCA.
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Correcting administrative and document mistakes in new grants. The IRS has acknowledged that administrative accidents and mistakes can lead to grants of stock rights with an exercise price that is lower than the fair market price of the company's stock at grant. IRS Notice 2007-100 (pages 18–19) explains that companies can fix unexercised new grants only during the same tax year in which the error happened: the exercise price can be reset to the fair market value (FMV) of the underlying stock on the original grant date (or to a higher price). This solution is not available for stock rights that have already been exercised, or for stock rights whose exercise price was intentionally set below FMV on the grant date.
IRS Notice 2008-113 expands the voluntary correction program for inadvertent Section 409A operational failures when these are fixed in the same tax year as the failure or, for non-insiders, no later than the following tax year. This program pertains only to certain operational failures where the plan itself is in compliance. Until the end of 2009, companies could correct past operational failures going back to January 1, 2005 (the effective date of Section 409A).
In Notice 2010-6 and Notice 2010-80, the IRS announced a program that allows companies to correct documents for nonqualified deferred compensation (NQDC) plans that do not comply with Section 409A in exchange for reduced or no penalties. This covers situations in which an NQDC plan is operating in compliance but for some reason the documents for it have not been properly or fully amended. According to Section IIIG (page 12) of this IRS notice, stock rights, such as discounted stock options, are not eligible for relief.
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Stock appreciation rights (SARs). Originally the AJCA was read as taxing SARs at vesting, not at exercise. In Notice 2005-1 (pages 10–12), the IRS exempted standard stock-settled SARs at public companies from the definition of deferred compensation.
The proposed regulations (pages 15–17) on deferred compensation under Section 409A expand on this to give all forms of SARs the same treatment as stock options, referring to all exempt grants as "stock rights." Stock- or cash-settled SARs, whether granted by public or private companies, would be considered exempt. As with stock options, the SARs would need to be granted at fair market value (FMV) without any discount or deferral features. They would be exercisable only for the common stock of the company or the cash value of the spread. The final regulations (pages 18–19) confirm this again when they state that 409A excludes "nondiscounted stock options and nondiscounted stock appreciation rights that do not include any additional deferral feature."
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Discounted stock options. The full value of below-market NQSOs is taxed at vesting, not at exercise. In the proposed regulations (page 15), and in Notice 2005-1 (page 11), which are followed in the final regulations, the IRS defines a "discounted" stock option as an option with an exercise price of less than FMV on the grant date. The proposed regulations have detailed rules on reasonable valuations (pages 21–26, and adopted by the final regulations) that may be used to determine FMV at grant. Several easy-to-adopt approaches will be permitted for public companies. These approaches include the closing price on the grant date or on the prior day, or the average price (1) on that day or (2) within 30 days before and after the grant.
For private companies (i.e. stock that is "not readily tradable on an established securities market"), the IRS wants FMV to be determined by a "reasonable application" of a "reasonable valuation" method. These include using an independent appraiser (though not more than 12 months before the grant date). The proposed regulations list factors that should be considered in the private-company valuation, with more flexibility in the valuation of illiquid stock of startup corporations (page 25, and the final regulations at pages 32–35). IRS Notice 2006-4 gives private companies additional safety for grants awarded before 2005 if they made a "good-faith attempt" to set the exercise price at not less than FMV. For more on discounted stock options, see a related FAQ and our FAQ on backdating.
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Restricted stock units (RSUs) and performance shares with a deferred delivery of shares feature. With these types of RSUs and performance shares (see a related FAQ), before the AJCA you owed tax only when the shares were received, not at vesting. These continue to be permitted, with less flexibility in when you decide to defer. Under the proposed regulations (pages 68–69), the deferral election must be made within 30 days of the grant and cannot vest for at least 12 months after the election. A redeferral election after December 31, 2008, for any scheduled payment needs to be made at least 12 months before that date, and the payout must be deferred for at least five years. Also, even during that transitional period, you could not change an election in the same tax year in which you expected payment (e.g., payments owed in 2008 needed an election before the end of 2007), as explained in IRS Notice 2007-86 (pages 6–8).
For RSUs considered "performance-based," the election is allowed six months before the scheduled payout if the work takes place over at least 12 months. Under the proposed regulations (pages 60–63), performance-based compensation can be pay stemming solely from the appreciation in the value of company stock after the grant date. Standard RSUs that have value even if the underlying stock does not rise are not performance-based unless they fit the definition for other reasons. In general, "performance-based" means compensation that is paid only after you reach pre-established "organizational or individual performance criteria" that are not "substantially certain" to be met when the criteria are made.
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Stock options with a deferral of gain feature and restricted stock converted to RSUs with deferral feature. Most experts see the AJCA as making these impractical because the deferral elections must be solicited no later than the last day of the taxable year before the date the option or restricted stock award was originally granted. This would make it impossible to exchange the options or restricted stock during their vesting period for a right to receive future payments. Before the final regulations, some experts seemed more open on this topic because the Senate version of the bill, which clearly disallowed deferral of stock option gains, did not appear in the final version of the AJCA (see related FAQ).
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Choice of stock grant. You may have an election to be paid a bonus or another payment in cash, restricted stock, or stock options. The final regulations (pages 41–42) clarify that when none of the choices offers a deferral of compensation, the election is not subject to the 409A timing restrictions. Should any alternative offer a deferral of compensation (some experts interpret this as applying to restricted stock units when the employee has a choice of grants), the election must follow the timing rules of 409A discussed above.
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Modifications of stock options and SARs grants. The proposed regulations (pages 26–31) lay out rules for modifications and extensions of previously granted stock options and SARs. A "modification" is a change in the terms that gives you a direct or indirect reduction in the exercise price, an additional deferral feature, or an extension or renewal of the stock grant. These types of modifications are considered new grants, and the exercise price must not be less than the FMV or it becomes subject it to 409A. For example, extending the post-termination exercise period (e.g., from three months to one year) raised modification problems under the proposed regulations. The final regulations (pages 36–37) eased concerns about certain exercise extensions. They allow extensions to the shorter of either (1) the original maximum term or (2) 10 years from the original grant date. Exercise extensions for underwater stock options are not considered an additional deferral feature.
The regulations also clarify that adding a stock swap feature to pay the exercise price, adding stock withholding rights to pay taxes, and accelerating the vesting date would not be considered modifications. In addition, the assumption, substitution, or conversion of options and SARs in a merger or acquisition would not trigger the modification restrictions if it satisfied the requirements of Treasury Reg. Section 1.424-1 (which provides rules for substitution of ISOs). The proposed regulations (pages 29–30) explain how this section sets out "aggregate spread" and "ratio" requirements.
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5. Recommendations
Experts recommend that your company:
- inventory its plans and compensation arrangements to tally the AJCA impact
- communicate with executives, directors, and employees about the impact and any changes in their employment, stock grant, and deferred compensation agreements and plans
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6. Editor's note: The IRS finalized the regulations on April 10, 2007, adopting the proposed regulations with amendments. The US Treasury Department continues to release more guidance, clarifications, and additional proposed regulations on Section 409A. The effective date for operational compliance was January 1, 2009. Under Notice 2007-78, the deadline by which plan documents had to comply with the rules was December 31, 2008. In IRS Notice 2010-6, for plans not complying with Section 409A the IRS announced a program that allowed companies to correct documents in exchange for reduced or no penalties, essentially extending this deadline to the end of 2010.
Until the end of 2008, companies relied on the final regulations, Notice 2005-1, and certain sections in the preamble of the proposed regulations (see pages 3–4 of Notice 2007-86) to show good-faith compliance with Section 409A. Unintentional operational failures that would trigger 409A penalties for nonqualified deferred compensation plans can be corrected in some situations: see IRS Notice 2007-100 and IRS Notice 2008-113.
Alert: The IRS has started audits of 409A deferred compensation arrangements (see a memo from the law firm Jones Day). The agency began to issue information document requests (IDRs) on these plans in the fall of 2009. The IRS is looking at compliance issues with both administrative and plan documents.
myStockOptions.com will closely follow these developments to update this FAQ and other relevant content on the site. The National Association of Stock Plan Professionals (http://www.naspp.com) devotes a special section of its website to the deferred compensation provisions of the AJCA, with a useful collection of memos, reports, and articles written by leading law, accounting, and consulting firms.
Another resource with in-depth coverage of the Section 409A rules for nonqualified deferred compensation is myNQDC.com, a sister website of myStockOptions.com.
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