409A Implications for PE Funds

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Information about 409A Implications for PE Funds
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Published on January 9, 2008

Author: Massimo

Source: authorstream.com

Non-Qualified Deferred Compensation Under Section 409A: Implications for Private Companies:  Non-Qualified Deferred Compensation Under Section 409A: Implications for Private Companies A. Kent Graham Performance & Reward Practice Ernst & Young LLP Background:  Section 409A was enacted on October 22, 2004, as part of the American Jobs Creation Act of 2004: New rules for timing of elections to defer compensation under a nonqualified deferred compensation (NQDC) plan New rules for when distributions can be made under a NQDC plan New rules relating to funding of NQDC Violation of the rules results in current taxation, a 20% additional income tax, and potentially interest The rules are effective for NQDC that is either earned or vested after 2004 Background Background (cont’d):  Initial guidance was provided in Notice 2005-1, issued on December 20, 2004: Definitions Transition relief through (including a plan amendment deadline of) December 31, 2005 Proposed regulations under Section 409A were issued on September 29, 2005: Clarifications/modifications of definitions Guidance on operational rules relating to timing of elections and distributions Extension of the plan amendment deadline and certain other transition relief through December 31, 2006 Background (cont’d) Definition of NQDC Subject to Section 409A:  Definition of NQDC Subject to Section 409A Definition of NQDC:  Definition of NQDC A plan provides for the deferral of compensation if: The service provider has a legally binding right during a taxable year to compensation That has not been actually or constructively received and included in income And that is payable in a later year A right can be legally binding even if subject to a substantial risk of forfeiture Definition of NQDC (cont’d):  Definition of NQDC (cont’d) NQDC does not include: A qualified employer plan A bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan ISOs and ESPP options Restricted stock Nonstatutory stock options (NSOs) in service recipient stock if granted at FMV Stock appreciation rights (SARs) in service recipient stock if granted at FMV Definition of NQDC (cont’d):  Definition of NQDC (cont’d) NQDC does include: SERPs, excess plans, top-hat plans Phantom stock plans Restricted stock units Discounted nonstatutory options and stock appreciation rights (SARs) Programs that allow deferral of option income Certain severance arrangements Short-Term Deferral Rule:  Short-Term Deferral Rule Notice 2005-1 provided an exclusion from Section 409A for certain short-term deferrals Under the Notice, compensation falls in this exclusion if, absent an election to defer payment to a later date, at all times the terms of the plan require payment by (and an amount is actually or constructively received by) the later of: 2½ months after the end of the employee’s first tax year in which the compensation is no longer subject to a substantial risk of forfeiture, or 2½ months after the end of the employer’s first tax year in which the compensation is no longer subject to a substantial risk of forfeiture Short-Term Deferral Rule (cont’d):  Short-Term Deferral Rule (cont’d) The proposed regulations clarify that the arrangement is not required to provide in writing that payment must be made within this 2½-month period However, if a plan does not specify a payment date, then failure to pay within the 2½-month period triggers an automatic violation of Section 409A Short-Term Deferral Rule (cont’d):  Short-Term Deferral Rule (cont’d) Examples of the short-term deferral rule: An annual bonus for calendar year 2005 vested on December 31, 2005, and is paid out by a September 30 fiscal year employer by December 15, 2006 Long-term incentive compensation becomes substantially vested on the last day of a three-calendar-year period and is paid by a calendar year employer no later than March 15 of the following year Discounted NSOs or SARs that must be exercised no later than March 15 of the calendar year following the calendar year of vesting Timing of NQDC Distributions:  Timing of NQDC Distributions NQDC may only be distributed upon one of the following permissible distribution events: Separation from service Disability Death A specified time or pursuant to a fixed schedule Change in control Unforeseeable emergency Options and SARs that are subject to Section 409A will typically not satisfy the timing of distribution rules because options and SARs are generally exercisable any time after vesting Stock Rights under the Regulations:  Stock Rights under the Regulations The term “stock rights” includes SARs and nonstatutory stock options As under the Notice, both stock options and SARs must be in “service recipient” stock in order to be exempt from Section 409A: Must be granted at no less than FMV Cannot have any additional deferral feature Who Is the “Service Recipient”?:  Who Is the “Service Recipient”? Apply the rules of Sections 414(b) and (c) by using 50% instead of 80% but only if the stock right plan or arrangement so provides The 50% threshold can be dropped to 20% if so provided in the plan or arrangement but only if there are legitimate business criteria The use of the 50% or 20% threshold must be applied consistently, and any change cannot be effective until 12 months after adoption of the change Other Rules Relating to Stock Rights:  Other Rules Relating to Stock Rights The service recipient stock on which stock rights are based must be common stock that is readily tradable on an established market, or if none, the class of common stock that has the highest aggregate value of any class of common stock of the corporation outstanding, or a class of common stock substantially similar to such class of stock Service recipient stock also does not include any stock that provides a preference as to dividends or liquidation rights Service recipient stock may include American Depositary Receipts (ADRs) if the stock to which the ADRs relate would qualify as service recipient stock Equity appreciation rights with respect to mutual company units are covered by the SAR exemption Fair Market Value of Readily Tradable Stock:  Fair Market Value of Readily Tradable Stock For stock that is readily tradable on an established market: Last sale before or the first sale after the grant The closing price on the trading day before, or the trading day, of the grant Any other reasonable basis using actual transactions and consistently applied Also can set the exercise price based on an average of the price of the stock over a specified period within the 30 days before and after the grant date, provided the commitment to grant is irrevocably established before the measurement period Fair Market Value of Other Stock:  Fair Market Value of Other Stock Reasonable application of a reasonable valuation method: Valuation of tangible and intangible assets Present value of future cash-flows Market value of stock or equity interests in similar entities engaged in substantially similar trades or businesses Other relevant factors such as control premiums or discounts for lack of marketability Whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders, or its creditors Fair Market Value of Other Stock (cont’d):  Fair Market Value of Other Stock (cont’d) A valuation is not reasonable if: It does not take into account all available information that is material to value, It fails to take into account information available after the date of the calculation, or The value was calculated as of a date that is more than 12 months earlier than the date on which the valuation is being used The value will not be presumed reasonable if it was calculated within 12 months of a public offering Fair Market Value of Other Stock (cont’d):  Fair Market Value of Other Stock (cont’d) The following valuation methods are presumed to be reasonable: Valuation by an independent appraisal that meets the ESOP valuation requirements and that is no more than 12 months old A valuation based on a formula that would be a non-lapse restriction under Section 83, provided the stock is valued in the same manner for all other compensatory and non-compensatory purposes A valuation made reasonably and in good faith, and evidenced by a written report that takes into account the factors discussed previously, of an illiquid stock of a start-up corporation Fair Market Value of Other Stock (cont’d):  Fair Market Value of Other Stock (cont’d) Notice 2006-4 provides relief for stock rights granted (and not vested) before 2005: If there was a “good faith” attempt to set the exercise price at not less than FMV on date of grant, that price will be treated as being not less than FMV on date of grant in determining whether 409A applies to the stock right Other stock rights are subject to the requirement of Notice 2005-1 that a reasonable valuation method be used to determine FMV on date of grant Valuation Issue:  Valuation Issue For private companies, determination of the fair market value of the stock will require an appraisal The appraisal exercise will need to be undertaken for each option grant date as the value of the stock will likely have changed with the passage of time In this regard, independent 3rd party appraisals will offer the most assurance of compliance IRS Guidance – Valuation:  IRS Guidance – Valuation Private Companies – Factors to be Considered: Value of tangible and intangible assets Present value of future cash flows Market value of stock or equity interests in similar companies and other entities engaged in “trades or businesses substantially similar to those engaged in by the corporation whose stock is to be valued” Trading prices for public companies Arm’s length private transactions Control premiums/minority interest discounts or marketability discounts Should use all available information material to the value of the company Should be consistent with valuations performed for other purposes (such as financial reporting) IRS Guidance – Valuation (cont’d):  IRS Guidance – Valuation (cont’d) If a company does not want to take on the risk of performing a valuation themselves, the proposed regulations set forth several safe harbors as to the fair market value of an option: The safest is to obtain an independent professional appraisal If a buy-sell formula applies to all transactions involving the company’s stock, then the buy-sell formula can be used to value stock as of a given date For illiquid start-up companies (within ten years of formation), an individual who is familiar with the valuation of private companies can prepare a report which takes into account factors relevant to the company's valuation. This does not rise to the level of an independent appraisal, but could be done, for example, by an employee of a VC fund whose work-functions regularly include stock valuations IRS Guidance – Valuation (cont’d):  IRS Guidance – Valuation (cont’d) “A valuation will not be treated as made reasonably and in good faith unless the valuation is performed by a person or persons with significant knowledge and experience or training in performing similar valuations.” (excerpt from proposed regulations on deferred compensation under Section 409A – September 29, 2005) Inter-relationship with Financial Accounting:  Inter-relationship with Financial Accounting Cheap stock issues for pre-IPO companies: Significant scrutiny by the SEC of registration statement AICPA Practice Aid – Valuation of Privately-Held-Company Equity Securities Issued as Compensation: Describes three valuation methodologies that should be considered in the valuation of a pre-IPO company Valuations methodologies required under the Practice Aid can be complicated Consistency between valuations performed for 409A and financial reporting for compensation is typically expected This is not just a tax issue – it is an accounting issue too Extensions or Renewals of Stock Rights:  Extensions or Renewals of Stock Rights If a stock right is extended or renewed, it is treated as having had an additional deferral feature from the date of grant Exception if the extension goes no later than the later of the 15th day of the third month following the date on which the right would have expired, or December 31st of the year, the right would have expired Exception if the stock right is unexercisable because exercise would violate securities laws Other Modifications of Stock Rights:  Other Modifications of Stock Rights If a stock right is modified in any other way, the modification is treated as the grant of a new stock right as of the date of modification A modification (other than an extension or renewal) means any change in the terms that may provide the holder with a direct or indirect reduction in the exercise price or an additional deferral feature, regardless of whether the holder in fact benefits Other Rules Relating to Stock Rights:  Other Rules Relating to Stock Rights If stock rights are substituted in a corporate transaction, the substitution will not be treated as a new grant if the requirements of Section 424 are satisfied The exercise price and number of shares can be proportionally adjusted to reflect a stock split or stock dividend – as long as the aggregate exercise price is not less than before the stock split or stock dividend Other Compensation Generally Subject to Section 409A:  Other Compensation Generally Subject to Section 409A Separation pay Payments made upon a change in control Foreign NQDC plans – with respect to U.S. taxpayers only (including resident aliens, as well as U.S. citizens or green card holders) Substantive Rules of Section 409A:  Substantive Rules of Section 409A Initial Elections to Defer:  Initial Elections to Defer An initial election generally must be made and irrevocable by the close of the calendar year preceding the year in which the services are performed: These rules apply regardless of whether the plan is “elective” Exception for performance-based compensation Subsequent Elections:  Subsequent Elections If a plan allows a subsequent election to delay a payment or to change the form of payment: The plan must specify that the election cannot take effect until at least 12 months after the election For an election relating to payments other than those on account of disability, death, or unforeseeable emergency, the plan must specify that the payment be deferred for a period of at least five years The plan must require that any election relating to a payment at a specified time or pursuant to a fixed schedule be made at least 12 months prior to the scheduled payment date Permitted Payment Events:  Permitted Payment Events Separation from service Disability Death A time or fixed schedule specified under the plan A change in control Occurrence of an unforeseeable emergency Issue for Discounted Options and SARs:  Issue for Discounted Options and SARs Section 409A applies to discounted options and SARs (and to options and SARs that are not in service recipient stock) Issue: Such options and SARs will typically not satisfy the timing of distribution rules of Section 409A because they are generally exercisable at the discretion of the employee at any time after vesting Potential Strategies for New Discounted Option and SAR Grants:  Potential Strategies for New Discounted Option and SAR Grants Require exercise upon one or more permitted events (e.g., at the earlier of ten years from grant or separation from service) Require exercise no later than March 15th of the calendar year following the calendar year of vesting Transition Rules and Opportunities:  Transition Rules and Opportunities Transition Rules:  Transition Rules Plan amendment deadline extended to December 31, 2006, if the plan is operated in good faith compliance until then: Good faith compliance with the statute and Notice 2005-1 is required The proposed regulations do not have to be followed, but compliance with them will nonetheless constitute good faith compliance Q&A-19(c) is extended through December 31, 2006, provided that in 2006, a service provider: Cannot change a payment election for payments that would otherwise be received in 2006 or Accelerate payments into 2006 Transition Rules (cont’d):  Transition Rules (cont’d) Q&A-18(c) is not extended beyond 2005. Thus, an employer that wishes to terminate a plan and distribute all deferred compensation balances had to do so in 2005 Q&A-20 is not extended. Thus, after 2005, participants can no longer be given the option to cancel participation or deferral elections without violating Section 409A The March 15, 2005 deadline for deferral elections in Q&A-21 was not extended. Thus, initial deferral elections must now be made in accordance with Section 409A Q&A-23, providing relief to NQDC plans linked to qualified plans is extended through December 31, 2006 “Curing” Discounted Stock Rights in 2006:  “Curing” Discounted Stock Rights in 2006 What you clearly can do in 2006 under Notice 2005-1 and the Proposed Regulations: Eliminate the discount and make up for the lost discount with deferred compensation that complies with Section 409A with restricted stock, additional FMV stock rights, etc. Fix the exercise date(s) for 2007 or later What you may be able to do in 2006: If the stock right vests in 2006, amend it into a short-term deferral by requiring exercise by March 15, 2007; if it vested in 2005, require exercise by March 15, 2006 Fix the exercise date for a date in 2006 Slide39:  ERNST & YOUNG LLP www.ey.com © 2006 Ernst & Young LLP. All Rights Reserved. Ernst & Young is a registered trademark.

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