July 13, 2016
Authored by: Chris Rylands and Katharine Finley
On the TV show Futurama, the aged proprietor of the delivery company Planet Express, Professor Hubert J. Farnsworth, had a habit of entering a room where the other characters were gathered and sharing his trademark line, “Good news, everyone!” Of course, his news was rarely good. More often, it was the beginning of some misadventure through which the other characters would inevitably suffer, often to great comedic effect. So we can forgive you for thinking that we may be standing in his shoes when we tell you that new 409A regulations are good news, but really, hear us (read us?) out.
The IRS released proposed changes to both the existing final regulations and the proposed income inclusion regulations. And the news is mostly good. Additionally, taxpayers can rely on the proposed regulations.
The changes are legion, so we are breaking up our coverage into a series of blog posts. This second post relates to changes in stock awards and stock sales. See our first post, “Firing Squad.” Check back for future posts on these regulations.
Discounted Stock Buybacks Are Now Okay, Sort of. The existing regulations had a trap for the unwary. If the stock subject to an option or stock appreciation right (SAR) was subject to a buyback at other than fair market value, then the option or SAR may not be exempt from 409A. This makes sense when the price is more than fair market value since that could be disguised deferred compensation. However, often times, companies will have shareholder agreements with discounted buybacks on termination for cause or if an employee violates a non-compete or similar covenant. Unless an exception applied, this would mean that the option or SAR would have to comply with 409A’s timing rules, which are often contrary to what both the company and the recipient desire.
Under the new proposed rules, mandatory buybacks at less than fair market value are okay as long as they only apply if either (A) the recipient is terminated for cause or (B) the occurrence of a condition within the recipient’s control (such as the violation of a non-compete). Though these buybacks are also permitted under existing rules as long as they are so-called “lapse restrictions” (which means they have a limited duration), the additional flexibility provided by the proposed regulations is welcome in this area.
Awards Prior to Date of Hire can Still Be Exempt. Under the existing rules, an option or SAR had to be for stock of the company for which the individual was working (or certain affiliated entities) for it to be exempt from 409A. But what if you wanted to grant an option to someone prior to date of hire? That option would technically need to comply with 409A and its onerous timing requirements.
The proposed rules add additional flexibility in this regard. You can grant an option or SAR and have it be exempt as long as the service provider is expected to start work within 12 months (and actually does so). If the service provider doesn’t start work within that 12 month period, then the award has to be forfeited (but honestly, you probably wanted it that way anyway).
Change in Control Rule Applies to Exempt Stock Rights. Sometimes in a transaction, employees with stock awards are given rights to get paid on the same terms as shareholders. For awards subject to 409A, the rules generally permit this as long as the payments do not go beyond five years from the date of the change in control. However, since options and SARs with fair market value strike prices are exempt from 409A, there was some question as to whether this rule could be used with those awards. These proposed regulations confirm that it can.
A Stock Sale Means a Stock Sale. Generally, if a company’s stock is sold, the employees are not treated as having terminated employment/separated from service for 409A purposes. On the other hand, in an asset sale, the buyer and seller can agree whether the sale constitutes a separation from service/termination of employment for 409A purposes.
But under Section 338 of the Code, parties can elect to treat a stock sale as a deemed asset sale for tax purposes. Does this include 409A, which would then allow them to choose whether a separation from service has occurred? The proposed regulations say it does not. Therefore, employees will not have a separation from service, even if a 338 election is made.