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.
Good news for CA taxpayers involved in violations of Section 409A: the state has reduced its penalty tax for these violations from 20% to 5%.
CA’s penalty is in addition to the federal penalties of a 20% tax plus interest at 1% higher than the penalty rate. With the combined federal and CA state penalties, an individual that is subject to the maximum federal and CA state marginal income tax rates of 39.6% and 10.3% respectively, could have incurred a cumulative tax liability as a result of a 409A violation that was close to, or possibly even more than, 100% (don’t forget that FICA would also apply to the income). So now CA taxpayers that end up subject to the 409A penalties are only paying an additional combined federal and state penalty tax of 25% (on top of the standard tax rates that apply to the income) instead of a combined 40% penalty (of course, at the maximum individual tax rates, that’s still potential a tax liability of around 80%).
The new CA penalty tax is effective retroactively to Jan 1 of this year. Here are a couple of alerts on the change: Skadden, Pillsbury, Cooley.
Blog Survey: 409A Compliance Failures Thinking about how draconian the taxes could be for a 409A compliance failure got me wondering whether anyone (other than that poor guy in Sutardja v. United States, see “409A in the Courts“) is actually paying these penalties . So I put together a quick survey.
Back in May, the Senate Finance Committee published a report of possible ways that the tax treatment of employee benefits might be changed as part of the tax reform project that the Committee is working on. Today I take a look at some of the strategies they are considering.
These strategies were suggested by witnesses at hearings that the Committee held, as well as by various bipartisan commissions, tax policy experts, and members of Congress. Not all members of the Committee agree on which direction constitutes “reform” for the tax code (e.g., whether tax reform should reduce the deficit or lower tax rates), so some of the ideas are contradictory. It’s sort of a grab bag of tax reform.
Section 162(m)
The report suggests expanding the group of employees whose compensation is subject to the deduction limit under Section 162(m); applying the limit to all stock compensation, including stock options; and reducing the maximum deduction companies are entitled to. If this all sounds familiar, it’s because it’s already happening for health insurance providers (see my blog “CHIPs: More Than a Cheesy TV Show“). If Congress goes in this direction, I have to believe that the IRS might take it one step further and implement the allocation rules that they have proposed for health insurance providers as well. This could have a pretty significant impact on stock plan administration.
An alternative suggestion to all of these ideas is to repeal Section 162(m) altogether. With all the media outrage over executive compensation, I’d be pretty surprised if this is the direction Congress takes. But, never say never–I’ve been surprised many times in my life.
Section 409A and Deferred Compensation
Despite the draconian rules under Section 409A, deferred compensation continues to be a point of controversy. The report suggests requiring all non-qualified deferred compensation to be taxed when earned. Which would make it “nondeferred compensation” or just regular compensation. Essentially the ability to defer taxation on any compensation outside of a tax-qualified plan would be eliminated. If deferrals aren’t eliminated entirely, then perhaps the amount of compensation that can be subject to deferral might be limited.
Or, rather than eliminating the ability to defer compensation, an alternative suggestion is to require companies to pay a special investment tax on earnings attributable to non-qualified deferred compensation. If the compensation hasn’t been paid out, then the company is presumably earning a return on the unpaid amounts and could be paying a special tax on that return. I can only begin to imagine the complicated rules that would apply to stock compensation under this approach. I foresee lots of NASPP Conference sessions.
The report also suggests repealing Section 409A altogether, repealing it for only private companies, or repealing the 20% penalty.
Stock Options
As noted above, the report suggests making stock options subject to Section 162(m) without exception. Use of full value awards had already outpaced usage of stock options–this would be just another nail in the coffin.
The report also suggests eliminating incentive stock options; I can’t see many public companies shedding a tear over this, but private companies might be bummed. Hopefully this idea wouldn’t be extended to include ESPPs, however.
And, you guessed it–Senator Levin’s proposal (“Senator Levin, Still Trying“) on limiting corporate tax deductions for stock options to the amount of expense recognized for them rears its ugly head in the report as well.
As those of you that have been keeping up with my blog entries know, for the past few weeks, I’ve been covering the executive compensation-related provisions of the Dodd-Frank Act, highlighting tidbits I learned at a presentation by Mike Andresino of Posternak Blankstein & Lund and David Wise and Sara Wells of Hay Group at the July Silicon Valley NASPP chapter meeting. This week I discuss some of the changes David thinks we can expect to see for stock compensation as a result of the Act. (If you’re keeping score, that’s three blog entries from one chapter meeting–now that’s what I call a productive meeting!)
Stock Compensation Under Dodd-Frank Here are a few changes we might see to stock compensation under the Dodd-Frank Act.
More Double-Triggers
In the NASPP’s 2010 Stock Plan Design Survey (co-sponsored by Deloitte), I was surprised by the number of companies with plans that provide for immediate acceleration of vesting on a change-in-control. With shareholders now given the opportunity to vote on executive pay packages and a separate vote for change-in-control provisions that haven’t previously been voted on, expect to see more companies move to a double-trigger (i.e., vesting accelerates only if the executive is terminated within a specified period after the CIC).
Greater Use of Performance Awards
With companies now required to disclose how executive pay relates to performance, it seems fairly clear that this will propel the use of performance-based awards. At the same time, the requirement to disclose the ratio of CEO pay to median employee pay may cause boards to look for ways to reduce the value of CEO pay. Since this disclosure is based on amounts in the SCT–rather than actual payouts–one way to accomplish this is to grant options and awards that are subject to performance conditions.
For LTI programs in general, David expects to see more interest in relative goals (because absolute goals have become so challenging to set), more use of multiple goals (e.g., an absolute goal with a relative goal), more companies using three measures instead of just two measures, lowering of plan maximums, and longer vesting schedules.
Premium-Priced Options
Options granted with a price above the grant date FMV have never really caught on, but do result in a lower grant-date valuation. Since this is the value reported in the SCT, premium priced options could help improve the CEO to median employee pay ratio, perhaps increasing their popularity.
Broad-Based Plans?
Another way to make the CEO to median employee pay ratio look better is to increase employee pay. Could this cause companies to consider expanding eligibility for stock compensation programs? Maybe–if you are looking at raising pay, seems like it would be easier to do this with a non-cash expense than with cash compensation.
Deferrals
More companies may also start requiring deferred payout for awards. David points out that deferrals serve two goals: (i) they can be of assistance in enforcing clawback provisions–now required under Dodd-Frank and (ii) they help facilitate enforcement of stock ownership/holding requirements–a primary means of risk mitigation in stock plans.
The 18th Annual NASPP Conference is Just Five Weeks Out! Scheduled for Sept 20-23, the 18th Annual NASPP Conference is timed perfectly to help our members prepare for mandatory Say-on-Pay and the other requirements of the Dodd-Frank Act. We’ve added a special Say-on-Pay track, featuring key advice and real-world strategies from in-the-know practitioners. Register for the Conference today.
NASPP New Member Referral Program Refer new members to the NASPP and your NASPP Conference registration could be free. You can save $150 off your registration for each new member you refer, up to the full cost of registration. You’ll also be entered into a raffle for an Apple iPad and the new members you refer save 50% on their membership–it’s a win-win! Don’t delay–this program ends on August 31.
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.
It’s a big week for NASPP Chapter meetings: don’t miss the meetings in Atlanta, Denver, NY/NJ, Orange County, Phoenix, and San Diego. Robyn Shutak, the NASPP’s Education Director, will be attending the San Diego meeting; be sure to say hello!
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.