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.
The 2013 Domestic Stock Plan Design Survey is now open for participation. This is the industry’s most comprehensive survey on stock plan design, easily worth the cost of NASPP membership. Seriously–consulting firms charge upwards of $1,000 to participate in surveys that offer less data with fewer respondents. We let you participate for free–but issuers have to participate to receive the full survey results. Don’t put it off; you’re going to want this data and you only have until April 5 to complete the survey.
For today’s blog, I highlight just a few of the many data points in the survey that I am eagerly anticipating an update on. These are hot topics today and I’m looking forward to finding out where current practices stand with respect to them:
Performance Award Usage: In the 2010 survey, usage of full value awards largely caught up to usage of stock options. Usage of performance awards had increased significantly, but still lagged a bit. I am very curious to see if performance award usage has plateaued or if usage of these awards will rival that of traditional service-based awards. The 2010 survey also revealed that companies were granting performance awards down further into the organization. I’m not sure that performance awards work well below management; I’m very interested to see if this trend continues or if companies have pulled back on their performance award programs.
Clawbacks: Only 32% of respondents indicated that awards are subject to a clawback provision. This seemed surprisingly low, given the shareholder optics on this issue, as well as pressure from regulators (a la SOX and Dodd-Frank). When we conducted the survey in 2010, Say-on-Pay had not yet gone into effect. Now that we’ve completed two rounds of Say-on-Pay votes and are in the middle of a third, I’m curious to see where clawbacks come out.
Double-Triggers: Almost 60% of respondents indicated that vesting is automatically accelerated on a change-in-control and only 38% of respondents reported that awards were subject to a double-trigger. I was very surprised to see such low usage of double-triggers and I’m very interested to see if this data reverses itself in the new survey.
Flexible Share Reserves: Only 17% of respondents in 2010 reported that their stock plan had a flexible share reserve. I’ve heard a lot of consultants promoting flexible share reserves and I agree that they make a lot of sense, so I was surprised that usage was low and even more surprised that it really hadn’t changed since we last conducted the survey in 2007. I’m intrigued to see if usage remains flat again in 2013 or if this plan feature has started to take hold.
Deferrals: Only 22% of respondents in 2010 reported that they allowed (or required) deferral of payout of RSUs. I think deferral programs offer some key advantages, including tax planning opportunities for award holders and easier enforcement of clawbacks and stock ownership guidelines for companies. I’m curious to see if usage of deferral programs has increased in 2013.
– Barbara
P.S. (can I do a PS in a blog?) – If you missed my cat, Kaylee’s appearance in the blog last week, you should check it out for your daily quota of cute.
Important Reminder This is the last week to participate in the NASPP-PwC Global Equity Incentives Survey. Issuers must participate to access the full survey results; you’re going to be sorry if you miss out. You must complete the survey by May 25; I would not count on this date being extended.
My $.02 on Facebook Facebook’s IPO is all over my Google alerts these days, so it feels like I ought to say something about it. Earlier this year, Jenn covered the painting contractor that was paid in Facebook stock and stands to make a bundle in the IPO (see “Tax Cuts and IPOs: Part II,” February 16, 2012). And he’s not the only one. Based on what I’ve been reading, many Facebook employees are going to do quite well–but not for another six months, when the lock-up ends.
Here are a few interesting tidbits about Facebook that I’ve read:
Facebook has a broad-based RSU plan. While RSUs have been commonly used at public companies for years now, they are relatively new for Silicon Valley start-ups, which have traditionally offered only stock options. Facebook is definitely a groundbreaker here–other start-ups have followed suit (e.g., Twitter).
Even more unusual, the RSUs won’t pay out until six months after the IPO (typically RSUs pay out upon vesting). From an administrative standpoint, the delayed payout makes a lot of sense. You wouldn’t want the RSUs to pay out while the company was still private because then employees would have a taxable event before the shares were liquid–I could write a whole blog entry on why this is something to avoid. Plus, in the pre-JOBS era, the employees would have counted as shareholders, which could have forced Facebook into registration with the SEC earlier than they wanted.
Here in the US, Facebook is looking at a pretty hefty tax deposit–Facebook estimates the deposit liability at over $4 billion–that will most likely have to be made within one business day after the awards pay out. Facebook is planning to use share withholding to cover employee tax liabilities, making cash flow an important consideration. Facebook’s S-1 states that they intend to sell shares to raise the capital to make this deposit, but may use some of the IPO proceeds or may draw on a credit arrangement that they have in place. If Facebook sells stock to raise the capital, the stock that is sold would have to be registered and could, of course, impact their stock price.
Facebook estimates the tax withholding rate to be 45%. I’m not completely sure how they are arriving at this rate. It’s possible they are going to withhold using W-4 rates or, perhaps, the payouts will be so large that most employees will be receiving more than $1,000,000 in supplemental payments for the year and they are going to have to withhold Federal income tax at 35%. Where a payment, such as payout of an RSU, straddles the $1 million threshold, the company can choose to apply the 35% rate to the entire payment (35% + the applicable CA tax rate = about 45%).
All of these employees making lots of money creates problems beyond the tax considerations. As other highly successful high-tech IPOs have experienced, employees may decide they don’t need to work anymore and end up leaving. Those that do stick around, may not be so motivated anymore–maybe I’m wrong but it seems like a millionaire employee is an attitude problem waiting to happen. And there will be the pay disparity to deal with as well; employees that were hired more recently may not do so well in the IPO (and those that are hired after the IPO will really be at a disadvantage).
More at the NASPP Conference
Facebook is presenting on a panel at the 20th Annual NASPP Conference (“Liking Global Equity: Learning from Facebook’s Successful Communication and Compliance Strategies”); while none of the problems I’ve described here are new, Facebook is a company known for innovation and I’m excited to hear their approaches, as well as new ideas they have to offer in other areas of stock plan administration. Register for the Conference by May 31 for the early-bird rate.
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 we keep an ongoing “to do” list for you here in our blog.
Register for the 20th Annual NASPP Conference in New Orleans. Don’t wait, the early-bird rate is only available until May 31.
One of the fundamental principles behind deferring payout on awards is the desire to lessen the potential time gap between the point at which an executive is rewarded for his or her policies and the point at which the company realizes the consequences or benefits of those same decisions. The deferral is one way to help keep executives focused on the long-term impact of business strategy.
Advantages
As Barbara pointed out in her August 17th blog entry, deferring the payout of shares can be particularly useful when used in conjunction with a clawback provision or to supplement the company’s ownership guidelines. A deferral may also be valuable for performance awards if there is the possibility of a future negative adjustment exists.
With clawbacks and potential negative adjustments on performance award payouts, it can be very difficult to recover shares or income after the fact, even with carefully constructed provisions. If the company must take back vested shares, it is obviously easier to do if the shares have not been disposed of, yet.
Depending on the parameters of a company’s holding requirements or ownership guidelines, it may be advantageous to an executive subject to these policies to also be subject to deferral on certain grants. The deferral may effectively delay the income event out to a point that either coincides with or is closer to the point at which the executive can dispose of the shares.
Considerations
Of course, any deferral program should be compliant with 409A. However, because there is no deferral election, designing within the parameters of 409A is easier. Another consideration is whether or not the deferral would require, or even be best suited for, a non-qualified deferred compensation program into which the vested shares may be deposited. Visit our Section 409A portal or Bruce Brumerg’s new site, www.myNQDC.com, for more on this issue.
In conjunction with 409A compliance, the general timing of the deferral is a key issue. On one hand, the deferral should be far enough into the future to align the executive’s risk on that potential income with the company’s risk. However, executives are making policy that could impact the company far into the future; there is little incentive for income that is delayed indefinitely. A compromise must be reached to find an appropriate period of time that is effective as a risk-mitigation technique that does not negate the incentivizing power of the reward.
Taxation
Some RSU programs permit participants to elect to defer the payout of shares to a future date, presumably a time when the participant’s tax bracket is lower than in the year of the original vest. 409A has made elective deferral programs more cumbersome, but they do still exist. A non-elective deferral does not give the participant control over whether or not receipt of the vested shares is deferred. As our panelists in the Conference session “Risk Mitigation for Stock Compensation” pointed out, we are at a point when income tax rates are likely to increase in the near future, which makes deferring income less appealing right now. A company implementing a required deferral of RSU or performance shares should carefully consider how to communicate the program’s goals and application to executives or other employees who will be subject to the deferral.
On a more practical administrative level, deferral of the share payout only defers the income tax withholding requirement. FICA withholding, along with the associated FUTA contribution, are due at the vest date.
Quick Survey on 6039 Returns and Information Statements
Take our quick survey on filing Forms 3921 and 3922 to report ISO and ESPP transactions to the IRS and on distributing the associated information statements to plan participants. Find out how other companies are planning to comply with these new requirements.