Fixing Section 409A: Legislative and Administrative Options

This symposium contribution to the Villanova Law Review describes the legislative calamity that is section 409A of the Internal Revenue Code. Section 409A manages, all at once, to (i) fail to better neutralize the tax treatment of deferred compensation with that of current compensation, (ii) impose significant compliance costs on sophisticated taxpayers, and (iii) provide a dangerous trap for unsophisticated taxpayers. Ideally, Congress should repeal section 409A and replace it with a system that taxes deferred compensation more neutrally vis-a-vis current compensation. Failing that, Congress should either replace section 409A with a broad grant of authority to the Treasury and IRS to strengthen the constructive receipt and economic benefit doctrines or amend section 409A to limit its scope to employee compensation paid by public companies. If Congress fails to act, the Treasury should interpret the term “compensation” as used in section 409A to include only compensation paid by public companies to their employees or directors. This arguably counter-textual interpretation of the statute creates the potential for whipsaw of the IRS by nonpublic companies and their employees, but this problem is outweighed by the benefits from cleaning up section 409A

Time to Start Over on Deferred Compensation

Government regulators would do well to follow simple heuristics like that. Writing good regulations-- good in the sense of promoting the public interest--always presents challenges. Regulators must hit a small but important target where private conduct is brought within appropriate government control, but unnecessary compliance burdens and other deadweight costs are minimized. Even if they see the government\u27s objectives clearly, regulators often have only a limited understanding of the underlying private activities. Moreover, regulators may be unaware of how their rules disrupt or distort those activities in socially harmful ways. Regulators occasionally hit the target exactly. More often, they miss--though not by an intolerably wide margin (good enough for government work, as the saying goes). However, sometimes regulators miss the mark so badly that the only responsible next step is to acknowledge the failure. That is the case with the final regulations under Internal Revenue Code (Code) section 409A. Those regulations are irreparably flawed--so flawed that the best members of the practicing bar cannot make sense of them for basic transactions. When the government issues rules that even experts cannot understand, the government should start over

Recent Developments for the Third Quarter 2007

[Excerpt] This letter summarizes developments around the world that affect global stock plans and that, for the most part, occurred between July and September 2007. In some cases, we expand on topics mentioned in previous updates

Employee Stock Options: Tax Treatment and Tax Issues

[Excerpt] The practice of granting a company’s employees, officers, and directors options to purchase the company’s stock has become widespread among American businesses. According to Information Technology Associates, 15% to 20% of public companies offer stock options to employees as a part of their compensation package, and over 10 million employees receive them. During the technology company boom of the 1990s, they were especially important to start-up companies, allowing them to avoid paying large cash salaries to attract talent. Employee stock options have been extolled as innovative compensation plans benefitting companies, stockholders, and employees. They have been condemned as schemes to enrich insiders at the expense of ordinary stockholders and as tax avoidance devices. This report explains the tax treatment of various types of employee stock options recognized by the Internal Revenue Code, examines some of the issues that have arisen because of the real and perceived tax benefits accorded employee stock options, and describes key laws and regulations concerning stock options, and discusses the “book-tax” gap as it relates to stock options and S. 1375 (Ending Excessive Corporate Deductions for Stock Options Act)

Section 409A Deferred Compensation Issues for Domestic and International Businesses

Internal Revenue Code (the “Code”) §409A creates special rules for nonqualified deferred compensation plans, including discounted stock options, severance arrangement, and even some expense reimbursement arrangements.  The primary themes of Section 409A are restrictions that it places upon operation of the deferred compensation plan.  In general, it places restrictions on the elections necessary to defer compensation, restrictions on the funding of the plan, and restrictions on the distributions from the plan.   If the requirements of Code §409A and its regulations are not met, all amounts that had been excluded from gross income under the deferred compensation plan are currently included in gross income.  Additionally. there is interest due from the original deferral that is one percentage point higher than the regular rate of interest for underpayments, plus a crushing additional 20 percent penalty.[1] Accordingly it is of paramount importance to understand how these rules apply, and how to avoid the severe penalties. [1] Code §409A(a)

Stock Options: The Backdating Issue

[Excerpt] Employee stock options are contracts giving employees the right to buy the company’s common stock at a specified exercise price, at a specified time or during a specified period, and after a specified vesting period. The value of the option when granted lies in the prospect that the market price of the company’s stock will increase by the time the option is exercised (used to purchase stock). At the grant date for the options, rather than selecting an exercise price based on the current market price for the stock, officials at some companies have selected a prior date with a lower market price; that is, they backdated stock options to an earlier grant date. If this backdating occurred without public disclosure, the recipient of the stock options received increased compensation in violation of Securities and Exchange Commission (SEC) regulations, generally accepted accounting rules, and tax laws. Some backdating is said to involve “sloppiness,” not fraud. The backdating of stock options has imposed costs on shareholders, employees, bondholders, and taxpayers. A corporate official who has profited from undisclosed backdating of stock options may not be responsible or even knowledgeable of the backdating. “Nonqualified” stock options, which have no special tax criteria to meet, are the focus of the backdating controversy primarily because they can be granted in unlimited amounts. The magnitude of stock option grants grew dramatically in the 1990s, subsequent to passage of the Omnibus Budget Reconciliation Act of 1993, a stock market boom, and revised accounting rules. Recent corporate disclosure changes have reduced the opportunities and rewards for backdating stock options. Empirical studies about backdating have been done by academics and investigative journalists. Four recent regulatory actions may have reduced the backdating of stock options, but problems persist. On December 16, 2004, the Financial Accounting Standards Board issued new rules requiring companies to subtract the expense of options from their earnings. After August 29, 2002, the Sarbanes-Oxley Act required that companies notify the SEC within two business days after granting stock options. In 2003, the SEC required increased disclosure of stock option plans. The SEC issued enhanced option grant disclosure rules effective December 15, 2006. Policy options to further reduce backdating and other timing manipulation include changes in SEC regulations and a change in the tax law. The SEC, various state prosecutorial, and Department of Justice (DOJ) probes into backdating abuses are ongoing. In addition, many firms have mounted their own internal probes into possible abuses. By November 2007, the SEC’s investigation caseload had fallen from a peak of 160 to about 80, and the SEC had brought civil enforcement actions against seven companies and 26 former executives associated with 15 firms. And according to reports from the DOJ, there were at least 10 criminal filings against defendants for backdating. As of January 2, 2008, the only CEO to be convicted of charges related to backdating was Greg Reyes, former Brocade CEO. This report will be updated as issues develop or new legislation is introduced

The Regulation of Employee Stock Options after Code Section 409A: A Proposal for Reform and a Survival Kit for the Interim

Article published in the Michigan State University School of Law Student Scholarship Collection