The IRS has announced an audit initiative focused on Section 409A compliance. Frankly, I’m a little surprised that they haven’t undertaken this sort of audit initiative sooner–I’ve heard from practitioners that, up until now, Section 409A has rarely been a focus of IRS audits. Given the complexity of this area of the tax code and the fact that every time I have a question about it, my sources never seem to be entirely sure of the answer (and I sometimes get conflicting answers), it seems like 409A could be an untapped wealth of compliance errors for the IRS.
Who Are the Lucky Winners?
Some companies are just lucky. The IRS has picked 50 companies to be the subject of the audits, all of which have already been selected for employment tax audits–I guess the IRS is a believer of “when it rains, it pours.” The good news is that if you haven’t already been selected for an employment tax audit, you won’t be part of the initial 409A audit initiative.
What Is the IRS Looking For?
The audits will focus on deferral elections (both initial deferrals and re-deferrals) and payments (including payments to key employees upon separation of service). It’s pretty rare that we see deferral elections for stock compensation; only 29% of respondents to the NASPP’s 2013 Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting) allow deferrals for time-based RSUs and only 24% allow deferrals for performance awards. Based on this, it seems that the audits will concentrate primarily on more traditional NQDC plans, rather than stock compensation.
This seems like a missed opportunity for the IRS–I’ve always found the application of Section 409A to stock compensation to be particularly confounding and full of traps for the unwary. Moreover, I think this is an area of the tax code that often is overlooked when we are thinking about potential concerns related to stock awards. But perhaps the IRS will expand to stock compensation in the next phase of the audit initiative.
The Next Phase?
I say “next phase” because this could be a precursor to a larger, more intensive audit of Section 409A compliance. In a memo on the initiative, Groom Law Group says “The IRS will assess what further steps, if any, to take after the results of these audits are in.” Now is a good time to get out ahead of this and perform your own self-audit of 409A compliance. In his blog on CompensationStandards.com, Mike Melbinger of Winston & Strawn points out that there is a corrections program available for some operational errors under 409A, but that the corrections program is no longer an alternative once you are the subject of an audit.
A court (Sutardja v. United States) recently confirmed that discounted stock options are subject to Section 409A. You probably didn’t even know that there was any question about this. But I guess when someone is slapped with the penalty tax under 409A, they are willing to try just about any argument. It certainly would have been big news if the plaintiff had prevailed.
As it stands, you probably think it’s hardly news worth blogging about. That’s because you don’t write a blog. If you had to come up with something pithy and timely to say every week, you’d know that anything is on the table. Which brings us to today’s blog entry…
Don’t Do That!
First, there are a couple of important lessons here:
Lesson 1) If you are thinking of taking the IRS on with regards to whether stock options are subject to 409A, the fact that a court has now backed the IRS on this matter makes it a lot less likely that you’ll succeed. It might be better to just cut your losses and deal with those discounted stock options that you granted accidentally.
Lesson 2) This issue arose out of a backdating investigation. The option in question was approved by the company’s compensation committee at one meeting and then later, at a subsequent meeting, the compensation committee ratified their earlier decision. When the company later conducted an investigation of its grant procedures, it decided that the grant date was when the decision was ratified at the second meeting. The FMV of the stock was higher on this date than at the earlier meeting, but the option price had been set based on the earlier FMV. As a result, the investigation deemed the option to have been discounted.
I’m not sure why the comp committee would approve the grant at one meeting and then ratify the decision at a second meeting (perhaps there was something wrong with the initial approval). Don’t do that! Approve options just once.
What About the Corrections Program?
Another interesting point in this case is that when the company’s internal investigation concluded that the options were discounted, they required the executive to pay the amount of the discount back to the company. If you’re keeping score, that means this guy has been dinged twice. He’s paid the higher (non-discounted) exercise price for the stock yet has also paid the 409A 20% penalty tax plus interest.
But wait–isn’t there some sort of corrections program for discounted stock options? If the exec has made up the difference in the exercise price, why wouldn’t the option be exempt under the corrections program? Why yes, Virginia, there is a 409A corrections program for discounted stock options–I even blogged about it back in 2009 (“Recent 409A Developments,” Jan. 13, 2009). I think there are several reasons why this option doesn’t qualify for the corrections program, however:
The events in this drama unfolded from 2003 to 2006, long before the corrections program–announced in late 2008–existed.
To be eligible for correction, the option can’t have been exercised yet. The executive in this case didn’t pay the additional cost to make up for the discounted option price until after he had already exercised the option.
Options granted to Section 16 insiders have to be corrected by the end of the calendar year in which they are granted. The options in this case were granted in 2003 but not corrected until 2006.
The grant documentation has to indicate that the option was intended to have price equal to FMV. I have no idea if this is an issue in this case, but it’s a good thing to make sure is specified in your own grant documentation. If you are ever in a situation where you need to rely on the 409A corrections program, you’ll be glad you did.
At this point, the case is not yet resolved. While the judge did agree that discounted stock options are subject to 409A, this decision was a partial summary judgment (meaning the judge thought that the IRS’s case was so obviously right that it wasn’t necessary to go to trial over this issue–something else to keep in mind if you were thinking of taking the IRS on). But the remaining question, which is whether or not the option was actually discounted, remains to be decided.
Is This Up to a Jury?
Coincidentally, I just got a jury duty summons, which got me thinking: are these sorts of tax law questions decided by a jury of my peers? Nothing against my peers, but most of ’em (except, of course, for my colleagues in stock compensation) don’t know beans about stock compensation or tax law. So if that’s the case, that’s a little scary. Also, how come when I’m called for jury duty, it’s never for cases that involve stock compensation? I think I’d have a lot to add as a juror for a case like this. Heck, I could probably even count it as “work.” You know, research for the blog…
This week I discuss a hodge podge of tax related updates: IRS Notice 2010-80, Code Y reporting, and the Social Security wage base for 2011.
IRS Expands 409A Documentation Corrections Program to Include Stock Rights Early this year, when the IRS issued Notice 2010-6, I got a much appreciated reprieve from having to understand it because it handily didn’t apply to stock rights. (Well, handily for me at least; others may not have been so thrilled with this outcome.) Alas, my reprieve lasted less than a year; last week the IRS issued Notice 2010-80, expanding Notice 2010-6 to cover stock rights.
I’m surprised at this development because I wasn’t aware that very many, if any, companies needed this relief. I thought that, by now, companies had pretty much dealt with 409A in terms of their stock plans. If companies are in need of this relief, however, it may be necessary to take action by December 31, 2010–which is coming up quick; you’d think the IRS could have provided a little more time on this.
Luckily, I’m not sure that many companies are in need of this relief. It applies only to options that were not intended to be exempt from Section 409A. In my experience, this is pretty rare. So long as options are granted with a price equal to FMV at grant, it’s relatively easy to ensure that they are exempt. Where a company inadvertently grants a discounted option, assuming the option was intended to be exempt from 409A, it isn’t eligible for correction under Notice 2010-80 (however, it may be eligible for correction under IRS Notice 2008-113, which provides relief for operational errors).
I don’t know any companies that are granting options that aren’t intended to be exempt under 409A. Even where companies had pre-409A grants that weren’t exempt, I think the typical fix was to modify the options to be exempt, rather than to try to comply with 409A. So the bad news is that this relief probably isn’t that helpful for most of you but I guess the silver lining is that you probably don’t need to scramble to understand it by December 31.
Thanks to Art Meyers of Choate Hall & Stewart and Mike Melbinger of Winston & Strawn for helping me with my rudimentary understanding of Notice 2010-80.
Code Y While we’re on the topic of 409A, I thought I’d mention that Code Y reporting still hasn’t gone into effect. You will recall–or maybe you won’t, it’s been so long since 409A was enacted–that 409A requires companies to report amounts subject to deferral in Box 12 of Form W-2 using Code Y. IRS Notice 2008-115 suspended this requirement until Treasury can issue regulations on it. So far no regulations have been issued so chances are you won’t have to worry about Code Y for this year (but, then again, there are still 23 shopping days left until December 31, so I suppose the IRS could still come through with a late December Code Y surprise).
Thanks to Mike Melbinger of Winston & Strawn for confirming that there wasn’t some announcement about Code Y that I had missed.
Social Security Wage Base Pursuant to a Social Security Administration press release issued on October 15, the maximum amount of wages subject to Social Security is not increasing for 2011–it will remain at $106,800 for another year. See the NASPP alert on this announcement for more information.
Vote for Broc and Dave! Broc Romanek and David Lynn’s blog on TheCorporateCounsel.net was selected by the ABA Journal as one of the Top 100 Legal Blawgs. Readers can vote on their favorite blogs and we want Broc and Dave to win (they won last year), so we’re asking our readers to vote. I know you all would vote for the NASPP Blog if you could, but we don’t count as a legal blog, so this is as close as you’ll come to voting for us. Come on, don’t make me beg!
Anyone can vote, you don’t have to be a member of the ABA. If you read and enjoy Broc and Dave’s blog–or even if you don’t–I hope you’ll vote for it. BTW–if you have multiple email addresses, you can register and vote under each one. See Broc’s December 6 blog entry for instructions on voting.
If you’ve never checked out the blog; it’s definitely worth a read. Unlike the lazy folks here at NASPP Blog, Broc and Dave manage to post an entry every day. And it’s free to anyone, whether you subscribe to TheCorporateCounsel.net or not. At a minimum, someone in your legal department should be reading it.
Less Than One Month Left to Get your Free Conference Session Audio All NASPP memberships expire on a calendar-year basis. Renew your membership by Dec 31 and you’ll qualify to receive the audio for one NASPP Conference session for free! Don’t wait any longer–the new year will be here before you know it!
This offer is also available to anyone the joins the NASPP before December 31–tell all your friends!
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Renew your NASPP membership for 2011 (if you aren’t an NASPP member, join today). Renew or join by Dec 31 to qualify to receive the audio of one NASPP Conference session for free.
We are just weeks away from the last chance for companies to rely on the transitional relief provided under IRS Notice 2008-113. I hope that your company has already taken action to complete a thorough review of compensation arrangements to identify and correct any arrangements that do not comply with Section 409A. Although it might be too late administratively to make major changes to correct errors under the transition relief, it is still a good idea for stock plan managers to do a final review and confirm that corrective action has been taken, especially when it comes to discounted options or SARS.
Background
Section 409A provides for significant adverse tax consequences to individuals whose compensation arrangements are considered to be a non-qualified deferral of income. Such non-compliant arrangements include certain RSU deferrals, change-in-control or retirement arrangements, and exercises of options or SARS with an exercise price that is less than the FMV at grant. For more information on the types of plans and agreements that are considered non-qualified deferred compensation, go to our Section 409A Portal. Although the tax penalties (and interest if the correction is not made after two years) are imposed on the individual rather than the company, employers must now withhold and report appropriately.
Corrections Program
IRS Notice 2008-113 details corrections programs for plans or arrangements that unintentionally fail to comply operationally with Section 409A, including options or SARs that are unintentionally granted at a discount price. For more information on IRS Notice 2008-113, see our alert, 409A Corrections Program for Discounted Stock Options.
These corrections programs are available for operational errors on an ongoing basis; the special deadline that we are approaching now is the for the transitional relief provided by the Notice. This transitional relief allows errors for arrangements pertaining to non-insiders that occurred between 2005 and 2007 to qualify for the corrections program in section VII of the Notice. Under this method, if the correction is made by the end of the tax year immediately following the year in which the error occurred, then the individual will not be subject to the tax and interest penalties associated with the 409A violation.
In addition to the transitional relief deadline, December 31, 2009 is also the deadline for companies to make correction to errors for arrangements pertaining to non-insiders that occurred in 2008 and for arrangements pertaining to insiders that occurred in 2009.
For more information on the 2009 deadline, see our 409A Corrections Must Be Completed By Year-End alert.
Vote for Broc and Dave!
Broc Romanek and David Lynn’s blog on TheCorporateCounsel.net was selected by the ABA Journal as one of the Top 100 Legal Blawgs (I don’t know why they can’t spell “blog”; it must be a lawyer thing). This is quite an honor, but we’re hoping for even more. Readers can vote on their favorite blogs and we want Broc and Dave to win in the “Practice Specific” category. Broc has a lifelong goal of winning a beauty contest and I guess he figures this is as close as he’ll get.
Anyone can vote, you don’t have to be a member of the ABA, you just need to complete the free registration on the ABA Journal website. If you read and enjoy Broc and Dave’s blog–or even if you don’t–I hope you’ll vote for it and help Broc achieve one of his life goals!
If you’ve never checked out the blog; it’s definitely worth a read. Unlike the lazy folks here at NASPP Blog, Broc and Dave manage to post an entry every day. And it’s free to anyone, whether you subscribe to TheCorporateCounsel.net or not. At a minimum, someone in your legal department should be reading it.