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Tax Bulletin (October 2005)

Stock Compensation Provisions in
Proposed Section 409A Regulations

By Cindy V. Schlaefer, a partner in the Palo Alto office of Pillsbury Winthrop Shaw Pittman LLP. See Material Available On-Line for links to the text of the proposed regulations, Notice 2005-1 and section 409A and its legislative history.

If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our October 2005 Tax Bulletin (a 219K pdf file), containing a printed version of this article and the companion articles Proposed Section 409A Regulations Provide Increased Flexibility for Nonqualified Deferred Compensation Plans and Proposed Regulations Clarify Application of Section 409A to Foreign Benefit Arrangements and also available via ftp at:


This bulletin concerning tax matters is part of the Tax Page, a World Wide Web demonstration project, no portion of which is intended and cannot be construed as legal or tax advice. Comments are welcome on the design or content of this material.

This article discusses the key provisions of the proposed regulations under section 409A applicable to stock compensation and related issues raised by the proposed regulations.

Application of Section 409A to Equity Compensation

As it did in Notice 2005-1, which was issued on December 20, 2004, the IRS confirmed in the proposed regulations that stock options and stock appreciation rights (SARs) may be subject to section 409A as "deferred compensation" if granted at less than fair market value, or if modified or extended after grant or providing other deferral features. Section 409A provides that deferred compensation cannot be paid to the service provider except upon the occurrence of one of six specific events (i.e., fixed date(s), separation from service, death, disability, change of control or hardship), with no general right to accelerate the payment. Stock options and SARs that give the holder the right to decide when to exercise the vested portion of the award would therefore violate the requirements of section 409A, if applicable.

Section 409A applies to stock rights granted after 2004, and stock rights granted before 2005 if not fully earned and vested before this year or if materially modified after October 3, 2004. The consequences of violating section 409A include an immediate income tax imposed on the holder of the stock award upon vesting, an additional income tax of 20 percent and possible interest charges. The employer may also be liable for any failure to comply with applicable withholding and reporting obligations.

Notice 2005-1 provided exceptions from the application of section 409A for stock rights meeting certain conditions, and the proposed regulations expand upon that guidance. The proposed regulations would not become effective before January 1, 2007, but taxpayers may rely upon them, along with the provisions of Notice 2005-1 and a good faith interpretation of the statute, to the extent that an issue is not addressed in the Notice or other published guidance with an effective date prior to 2007.

Certain transition relief provided in Notice 2005-1 for correcting violations of section 409A will not be available after the end of this year. Prompt action may therefore be required, as described below.

General Exception for Stock Options and SARs

A stock option or SAR with an exercise price that can never be less than the fair market value of the stock on the date of grant, and that has no other feature for the deferral of compensation, is generally not subject to section 409A.

  • In addition, section 409A generally does not apply to incentive stock options qualifying under section 422, employee stock purchase plans qualifying under section 423, and transfers of restricted stock under section 83.

New Conditions for General Exception for Stock Options and SARs

While the proposed regulations eased several of the conditions for the general exception for stock options and SARs from section 409A, they would also impose new conditions for the general exception.

Only Common Stock. The proposed regulations would require that the stock subject to the stock option or SAR be common stock having the greatest aggregate value of any class of common stock outstanding and not contain any dividend or liquidation preferences. Thus, compensatory options and SARs on the preferred stock of a corporation will not qualify for the general exception. Dividend equivalent rights may be provided, but may not be contingent on the exercise of the stock right.

Must be a Related Issuer. The stock options and SARs must be issued to service providers of the corporation that issues the stock, or an affiliate in which the issuing corporation has at least a 50 percent interest (or at least a 20 percent interest, such as a joint venture employing former employees of the issuer, when due to legitimate business criteria). Any election to use the 20 percent rather than 50 percent as a threshold interest must be applied consistently to all compensatory stock plans of the company for a minimum of 12 months.

Valuation Methodologies. The proposed regulations place a great deal of importance on the methodology for the valuation of the underlying stock of the stock option or SAR in order for the general exception to apply.

Public Company Stock. The proposed regulations state that the value of public company stock may be determined based on market reported prices. The proposed regulations also provide that valuations based on an average of market prices (as may be required by foreign laws for stock awards) would be permitted under the general exception provided that the average is based on the market prices during a specified time period within 30 days before and 30 days after the date of grant and the terms of the grant are irrevocably fixed before the beginning of the measurement period.

Private Company Stock. The proposed regulations provide that any reasonable method may be used for private company stock, and include a list of factors that will be taken into account in determining whether a valuation method is reasonable.[fn. 1] The proposed regulations also provide that the following valuation methods will be presumed reasonable if consistently applied:

  • Valuations based on an independent appraisal meeting certain requirements will be presumed reasonable for a period of one year.

  • Valuations based on a non-lapse formula which applies to all transactions in the company's stock, both compensatory and non-compensatory, may qualify as reasonable.

  • For start-up companies (less than 10 years in business) with illiquid stock, a valuation may be presumed reasonable if made by someone with significant knowledge and experience or training in performing similar valuations, and evidenced by a written report taking into account the factors described above. However, this presumption is not available if a public offering or change in control is reasonably anticipated within the next 12 months.

At a minimum, these valuation standards suggest the need for more specific information regarding stock valuation than may typically have been included in the minutes of private company board of directors meetings at which grants of stock rights are approved. The proposed regulations may also be read to encourage the use of third party appraisals. However, pending the finalization of the proposed regulations, taxpayers may rely on a good faith interpretation of Notice 2005-1, which simply requires that any reasonable valuation method be used.

For companies undergoing IPOs, the consequences of taking "cheap stock" charges for financial reporting purposes for pre-IPO stock options have added significance under section 409A.

Modifications. Certain modifications that enhance the rights or benefits of an outstanding stock option or SAR may result in a deemed grant of a new stock option or SAR on the modification date. If the modified stock option or SAR is in-the-money, or if the stock option or SAR is renewed or extended, section 409A may become applicable.

The proposed regulations provide that the following modifications will not be considered a new grant:

  • Modifications adverse to the stock option or SAR holder.

  • Acceleration of vesting or exercisability if the stock option or SAR was not immediately exercisable.

  • Extensions of the post-termination exercise period to a date not later than the 15th day of the third month following the date the right otherwise would have expired or, if later, December 31 of the calendar year in which the right would have expired.

  • Extensions of the post-termination exercise period where applicable securities laws would prohibit exercise, but only until 30 days after the date the prohibition lapses.

  • Assumptions or substitutions of stock rights in mergers or other corporate transactions where, among other conditions, there is no increase in the aggregate spread between stock value and exercise price.

  • Amendments to permit transfers.

  • Amendments to permit an exchange of the stock right for a cash amount equal to the amount that would be available if the stock right were exercised.

  • Amendments to permit payment with pre-owned stock or to facilitate payment of taxes on exercise.

  • Modifications based on stock dividends, stock splits or similar changes in capitalization as permitted by incentive stock option tax regulations.

Restricted Stock Units (RSUs) to Benefit From Special Deferral Election Rule

RSUs are contractual promises by a corporation to grant stock in the future if pre-determined vesting requirements are satisfied. RSUs may be treated as deferred compensation subject to section 409A if the shares are not delivered at the time of vesting. Unless the award was performance-based, an election by the service provider to defer the delivery of shares to a later year would generally not be timely unless the deferral election was made in the year prior to the year in which the RSUs are awarded. To address this impractical result, the proposed regulations provide a special rule for initial elections to defer payment of awards such as RSUs. If the award is contingent on the performance of services for a period of at least 12 months, an election to defer will be timely if made no later than 30 days after the date of grant, and at least 12 months before the end of the service vesting period.

Action Required in 2005

Under Notice 2005-1, taxpayers may be permitted to cancel deferral elections before the end of 2005. The proposed regulations do not extend this relief. Stock options that would be subject to section 409A because they were granted at a discount may be exercised this year, and treated as a cancellation of the deferred compensation without violating section 409A. But exercises of those options after this year may violate section 409A. Similarly, if the option is adjusted to increase the exercise price to the fair market value at the grant date and thereby exempt the option from section 409A, the company may compensate the holder for the adjustment but only before the end of this year.

Material Available On-Line

The following material is available with the indicated file sizes:


  1. These factors include the value of tangible and intangible assets, the present value of future cash-flows, the market value of stock of similar entities engaged in substantially similar businesses, and other relevant factors including control premiums or discounts for lack of marketability, provided that all available information material to the value of the company is taken into account. The IRS would also look at whether the valuation method is used for other purposes that have a material economic effect on the company, its stockholders or its creditors. The valuation must be as of a date within the last twelve months, and be updated for any subsequent developments that may materially affect the value of the company. [return to text]

This material is not intended to constitute a complete analysis of all tax considerations. Internal Revenue Service regulations generally provide that, for the purpose of avoiding United States federal tax penalties, a taxpayer may rely only on formal written opinions meeting specific regulatory requirements. This material does not meet those requirements. Accordingly, this material was not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal or other tax penalties or of promoting, marketing or recommending to another party any tax-related matters.

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