stock rights under final section 409a regulations · · 2012-02-08client alert april 2007 stock...

CLIENT ALERT APRIL 2007

STOCK RIGHTS UNDER FINAL SECTION 409A REGULATIONS

AUSTIN NEW YORK PALO ALTO SALT LAKE CITY SAN DIEGO SAN FRANCISCO SEATTLE SHANGHAI WASHINGTON, D.C.

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After much anticipation, on April 10, 2007, theInternal Revenue Service (IRS) issued finalregulations under Section 409A of the InternalRevenue Code. Earlier this week, we provideda summary of the highlights of the finalSection 409A regulations in a Client Alert thatis accessible at http://www.wsgr.com/WSGR/Display.aspx?SectionName=publications/PDFSearch/clientalert_409Aregulations.htm.

This Client Alert focuses on how these finalregulations impact stock rights (e.g.,nonstatutory stock options (NSOs) and stockappreciation rights (SARs)). Additional ClientAlerts will be provided over the next couple ofweeks that will discuss additional Section409A topics in greater detail.

Background

Section 409A was added to the InternalRevenue Code in October 2004 by theAmerican Jobs Creation Act. In December2004, the IRS issued Notice 2005-1, settingforth initial guidance with respect to Section409A. Proposed regulations under Section409A were released in October 2005 and sixadditional notices providing transitional reliefsubsequently were issued.

Under Section 409A, unless certainrequirements are satisfied, amounts deferredunder a nonqualified deferred compensationplan (as defined in the regulations) currentlyare includible in gross income unless suchamounts are subject to a substantial risk offorfeiture. In addition, such deferred amountsare subject to an additional 20 percent federalincome tax, interest, and penalties. Certainstates also have adopted similar taxprovisions. (For example, California imposes anadditional 20 percent state tax, interest, andpenalties.)

Stock Rights in General

1. What are stock rights under Section409A?

A stock right means a NSO or a SAR.

2. Are incentive stock options (ISOs) andemployee stock purchase plans subject toSection 409A?

No. The final regulations generallyexclude ISOs (within the meaning ofSection 422 of the Internal Revenue Code)and options granted under an employeestock purchase plan (described in Section423 of the Internal Revenue Code).

However, if an ISO later loses its ISOstatus, it may become subject to Section409A. An option might, for instance, loseits ISO status and become subject toSection 409A if it is modified after it isgranted (for example, if the post-termination exercise period of an ISO isextended).

3. Are NSOs subject to Section 409A?

No, under the final regulations (as underthe proposed regulations), NSOs generallywill be exempt from Section 409A if:

• the shares covered by the optionqualify as “service recipient stock” (seequestion 5 below);

• the exercise price of the option at leastequals 100 percent of the fair marketvalue of the covered shares on the datethe option is granted;

• the option covers a fixed number ofshares as of the date of grant;

• the option is subject to the typical taxtreatment under Section 83 of theInternal Revenue Code (in other words,the option is a “garden variety” option);and

• the option does not provide for thedeferral of compensation past theexercise date.

4. Are SARs subject to Section 409A?

No, as with NSOs, SARs generally will beexempt from Section 409A if:

• the shares covered by the SAR qualifyas service recipient stock;

• the exercise price of the SAR at leastequals 100 percent of the fair marketvalue of the covered shares on the datethe SAR is granted;

• the SAR has the typical structure thatprovides for a payment equal to theamount of the excess of the fair marketvalue of a share of stock on the date ofexercise over the exercise price,multiplied by a fixed number of shares;and

• the SAR does not provide for thedeferral of compensation past theexercise date.

5. What is service recipient stock?

The proposed regulations defined servicerecipient stock very narrowly as commonstock of a corporation that is publiclytraded, or if none, that class of commonstock having the highest aggregate valueof such corporation’s issued andoutstanding common stock.

The final regulations significantly expand thedefinition of service recipient stock. Under thefinal regulations, service recipient stock iscommon stock (as defined in Section 305 ofthe Internal Revenue Code) that does nothave any distribution preferences (other thanpreferences with respect to stock dividends orliquidation distributions). This rule applieseven if there is another class of publiclytraded common stock that would qualify asservice recipient stock. Service recipient stockalso may include American depositaryreceipts and American depositary shares.

Only the corporation for which the recipient isproviding direct services on the date of grant,or any corporation in a chain of a controlledgroup of corporations (beginning with theparent and ending with the corporation that isreceiving services from the recipient), canissue stock rights. For example, a stock rightreflecting the stock of a parent corporationmay be granted to an employee of theparent’s subsidiary. In certain circumstances,a joint venture can be considered to be partof a controlled group if there is a legitimatebusiness reason for using its stock ascompensation.

Under the final regulations (as under theproposed regulations), the stock of acorporation that is an investment vehiclecannot be service recipient stock. The finalregulations also add an anti-abuse rule thatprovides that service recipient stock does notinclude stock of any corporation within acontrolled group if a purpose of establishingthe group, or a purpose of a significanttransaction between two or morecorporations within the group, is to providedeferred compensation not subject to Section409A. If the primary source of income orvalue of an entity in a controlled group isfrom the provision of management service toother members of the controlled group andany stock rights are issued for such entity’sstock, it will be presumed that the corporatestructure was established for purposes ofavoiding Section 409A.

6. When does a stock right include adeferral feature?

A stock right includes a deferral feature(and thus is subject to Section 409A) tothe extent that it provides a right otherthan the right to receive cash or stock onthe date of exercise, and that thisadditional right would allow the deferralof compensation beyond the date ofexercise. A deferral feature does notinclude the right to receive substantiallynonvested stock upon exercise of thestock right or the right to pay theapplicable exercise price with previouslyacquired shares.

In response to questions regarding theproper treatment of stock rights thatinclude deferral features, the preambleto the final regulations provides that astock right, regardless of whether thedeferral feature is actually utilized, willbe subject to Section 409A. Similarly, if adeferral feature is added to a preexistingstock right, the stock right will be treatedas having included a deferral feature asof the original date of grant, which willgenerally result in a violation of Section409A.

7. Does the right to receive dividendssubject a stock right to Section 409A?

Maybe. Under the final regulations (asunder the proposed regulations), a rightto receive dividends or other distributionsthat is contingent upon the exercise of astock right generally will be treated as areduction in the exercise price of thestock right, causing it to be deferredcompensation under Section 409A.However, if the right to dividends orother distributions is not contingentupon, or otherwise payable on, theexercise of a stock right, the right todividends or distributions will not causethe stock right to become subject toSection 409A. In that situation, the rightto dividends or distributions will betreated as deferred compensation subjectto Section 409A, but such adetermination will not affect theunderlying stock right.

8. Does the exclusion of certain stock rightsunder Section 409A apply to tandemrights?

The exclusion of certain stock rightsunder Section 409A potentially applies totandem rights (a stock right thatcombines a stock option with a SAR suchthat the exercise of one right terminatesthe other right), as well as thesubstitution of a stock option for a SAR,or vice versa, where all of the termsexcept the mode of payment uponexercise are similar.

9. Is restricted stock subject to Section409A?

Generally, no. The final regulations (asunder the proposed regulations) providethat a grant of restricted stock generallywill not constitute deferredcompensation under Section 409A. Thefinal regulations also clarify that a legallybinding right to receive an award ofstock in a future year, which will besubject to vesting conditions whengranted, generally will not constitutedeferred compensation.

Modifications, Extensions, Substitutions,and Assumptions of Stock Rights

Modification of a Stock Right

10. What is a modification of a stock right?

Under the final regulations, a stock rightis modified if any change in the terms ofthe stock right (including any change tothe plan under which the stock right wasgranted) may result in a reduction in theexercise price, regardless of whether theholder of the stock right actually benefitsfrom the changed terms. An extension ofthe term of an underwater stock right(i.e., where the exercise price of the stockright equals or exceeds the fair marketvalue of the underlying stock) also isconsidered a modification. Extensions ofstock rights are discussed in greaterdetail in questions 15 –18 below.

2AUSTIN NEW YORK PALO ALTO SALT LAKE CITY SAN DIEGO SAN FRANCISCO SEATTLE SHANGHAI WASHINGTON, D.C.

Stock Rights . . .Continued from page 1...


11. What is not a modification of a stockright?

The final regulations provide that thefollowing are not modifications of a stockright:

• shortening the exercise period of thestock right;

• adding the ability to use previouslyacquired stock to pay the exerciseprice;

• adding the ability to withhold stock tosatisfy the exercise price and/or tax-withholding obligations;

• exercising discretion to allowtransferability specifically permittedunder the stock right;

• accelerating the vesting andexercisability of a stock right; and

• delaying the vesting and exercisabilityof a stock right.

If the vesting and exercisability of astock right subject to Section 409A iseither accelerated or delayed, it mayconstitute an impermissible accelerationof a payment date or a subsequentdeferral under the final regulations.

12. What is the result of a modification of astock right?

The proposed and final regulationsprovide that a modification of a stockright is considered the grant of a newstock right. The stock right is analyzed asof the deemed new grant date todetermine if it constitutes a deferral ofcompensation subject to Section 409A(see question 3 above).

13. Can a modification of a stock right berescinded?

Yes. The proposed and final regulationsprovide that a change to a stock rightthat would result in its modification may

be corrected. The proposed regulationsindicated that an inadvertentmodification would need to be correctedby the date that the stock right isexercised or by December 31 of thecalendar year during which the changeoccurred, whichever date is earlier. Thefinal regulations allow for the rescisionof a modification by the earlier of thedate that the stock right is exercised orthe last day of the holder’s taxable yearin which the modification originallyoccurred.

14. What happens to stock rights that areassumed or substituted in a merger oracquisition?

Stock rights that are assumed orsubstituted in a corporate transaction,such as a merger or acquisition, will notbe considered either modified (as to theform of payment) or the grant of a newstock right, so long as the requirementsof Section 424 of the Internal RevenueCode are satisfied, except that the holderof the stock right need not be employedor otherwise provide services to thesuccessor corporation.

Extension of a Stock Right

15. What is an extension of a stock right?

The final regulations provide that anextension of a stock right is:

• the provision of additional time toexercise the stock right beyond itsoriginal term;

• the conversion or exchange of a stockright for a legally binding right tocompensation in a future taxable year;or

• the addition of any deferral featurebeyond the exercise date, other thanat a time when the stock right isunderwater.

The final regulations give additionalflexibility to extend stock rights. The

proposed regulations provided that therewas no extension of a stock right if itwas extended to a date no later than: (a)the 15th day of the third month followingthe date on which the stock rightotherwise would have expired, or (b)December 31 of the year in which thestock right otherwise would haveexpired. The final regulations providethat an extension does not occur:

• if the exercise period is not extendedbeyond the earlier of: (a) the stockright’s original expiration date, or (b)the 10th anniversary of its original dateof grant;

• if the exercise period is extendedwhen the stock right is underwater. Inthis situation, the stock right istreated as having been modifiedrather than extended; or

• if the expiration of the stock right istolled while the holder cannotexercise the stock right because theexercise would violate applicable lawor would jeopardize the ability of thecompany to continue as a goingconcern, provided that the period isextended no more than 30 days afterthe exercise would no longer violateapplicable law or would notjeopardize the ability of the servicerecipient to continue as a goingconcern.

16. What is the result of an extension of astock right?

The proposed and final regulationsprovide that if there is an extension of astock right, the stock right is treated ashaving had an additional deferral featurefrom the date of grant. Consequently,since most stock rights may be exercisedat any time, they would not comply withSection 409A’s rigid restrictions on thepayment of deferred compensation andwould be subject to Section 409A’s taxconsequences (see the backgroundsection above).




17. Can an extension be rescinded?

Yes. The final regulations provide that anextension can be rescinded in the samemanner as a modification of a stockright, as discussed in question 13 above.

18. What if a stock right was extended beforeApril 10, 2007?

The final regulations provide a broadexemption from Section 409A for anyextension of a stock right which occurredbefore April 10, 2007, and was madesolely to provide the holder an additionalperiod of time beyond its original term toexercise the stock right.

Valuation of Stock Subject to Stock Rights

Public Company Stock

19. How can a public company determine thefair market value of its stock?

The final regulations provide that apublic company may base the fair marketvalue of its stock on:

• the last sale before or the first saleafter the grant;

• the closing price on the trading daybefore or the trading day of the grant;

• the arithmetic mean of the high andlow prices on the trading day beforeor the trading day of the grant (thisfactor was not in the proposedregulations); or

• any other reasonable method usingactual transactions in the stock asreported by the market.

The proposed and final regulationsprovide that fair market value also maybe determined using an average sellingprice during a specific period of time.Under the final regulations, the specificperiod of time in which the fair marketvalue may be determined must be within

30 days before or 30 days after anapplicable valuation date (instead of thedate of grant, as was required by theproposed regulations). The finalregulations require that the decision orcommitment to base the fair marketvalue on the average selling pricemethod must be irrevocably made beforethe specific time period begins, and thecompany must designate at the sametime the following items:

• the recipient of the stock right;

• the number and class of sharescovered by the stock right; and

• the method that will be used todetermine the exercise price(including the length of time that willbe used to determine the averageselling price).

Where foreign law requires that theexercise price of a stock right must bebased upon a specific price averagingmethod and period that is different fromthe above averaging method (forexample, as required in France for thepreferential tax treatment of options), astock right that is granted in accordancewith such foreign law will be treated asmeeting the above requirements if theperiod of time that is used for theaveraging is less than 30 days.

Private Company Stock

20. How can a private company determinethe fair market value of its stock?

The proposed and final regulationsrequire that a private company determinethe fair market value of its stock by thereasonable application of a reasonablevaluation method (as further explainedbelow). Whether a valuation method isreasonable will depend on the facts andcircumstances surrounding the valuation.To be considered reasonable, the methodmust take into consideration all availableinformation material to the value of thecompany.

The final regulations set forth thefollowing factors to be considered, asapplicable, under a reasonable valuationmethod:

• the value of tangible and intangibleassets;

• the present value of future cash flows(the final regulations have clarifiedthat this should be anticipated futurecash flows);

• the readily determinable market valueof similar entities engaged in asubstantially similar business;

• recent arm’s length transactionsinvolving the sale or transfer of suchstock or equity interests (this factorwas not in the proposed regulations);and

• other relevant factors such as controlpremiums or discounts for lack ofmarketability.

21. Is there a presumption of reasonablenessthat applies to the valuation of privatecompany stock?

Yes. Both the proposed and finalregulations provide that thedetermination of the fair market value ofa private company’s stock will bepresumed to be reasonable in any of thefollowing situations:

• if an independent appraiserdetermines the fair market value ofthe stock and the appraisal is used tovalue the stock within 12 months of the valuation;

• where the valuation is based on abuy-back formula that is applicable forboth compensatory andnoncompensatory purposes and wouldbe treated as fair market value underSection 83 of the Internal RevenueCode (subject to certain rules); or


Stock Rights . . .Continued from page 3..


• if the valuation is of illiquid stock of astart-up corporation and is madereasonably, in good faith, evidencedby a written report, and takes intoaccount the relevant valuation factorsdescribed above.

22. Can the presumption of reasonablenessbe rebutted?

The IRS may rebut the presumption if itcan show that the method or its use wasgrossly unreasonable.

23. When is stock considered issued by anilliquid start-up corporation?

The final regulations provide that stock isconsidered issued by an illiquid start-upcorporation if the following requirementsare met:

• the company has not conducted(directly or indirectly through apredecessor) a trade or business for aperiod of 10 years or more;

• the company does not have a class ofsecurities that are traded on anestablished securities market;

• the stock is not subject to a put, call,or other rights or obligations topurchase such stock (other than aright of first refusal or other lapserestriction, such as the right topurchase unvested stock at its originalcost);

• the company is not reasonablyexpected to undergo a change incontrol within 90 days or conduct apublic offering within 180 days of thedate the valuation is used (under theproposed regulations, the companycould not reasonably expect toundergo such events within 12 monthsof the date the valuation was used); and

• the valuation is performed by a personor persons that the corporationreasonably determines is qualified toperform the valuation based on theperson or persons’ significantknowledge, experience, education, or

training. The final regulations clarifythat significant experience generallymeans at least five years of relevantexperience in business valuation orappraisal, financial accounting,investment banking, private equity,secured lending, or other comparableexperience in the line of business orindustry in which the corporationoperates.

Action Items

As a result of the final regulations,companies should perform the followingaction items within the next several months:

• Review existing equity incentive plandocuments and form equity awardagreements and amend as necessary toensure compliance with the finalregulations.

• Review outstanding equity awards todetermine whether they are subject toSection 409A and amend as necessary toensure compliance with the finalregulations.

• Assess whether the company’s method forvaluing the fair market value of itscommon stock complies with the finalregulations.



For More Information

This Client Alert is intended only as a general summary of the impact of the final Section 409Aregulations on stock rights. We strongly advise you to seek professional assistance with respectto your specific issues.

If you have any questions regarding this Client Alert, please contact Scott McCall at (650) 320-4547, Heather Aune at (858) 350-2213, or Thuy Le at (650) 849-3329, the principalauthors of this alert, or any other member of the Employee Benefits & Compensation practice atWilson Sonsini Goodrich & Rosati:

NAME PHONE NUMBER E-MAIL

John Aguirre . . . . . . . . . . . . . . . .(650) 565-3603 . . . . . . . . . . . . [email protected] Aune . . . . . . . . . . . . . . . .(858) 350-2213 . . . . . . . . . . . . [email protected] Baker . . . . . . . . . . . . . . .(650) 565-3902 . . . . . . . . . . . . [email protected] Barker . . . . . . . . . . . . . . .(415) 947-2029 . . . . . . . . . . . . [email protected] Barry . . . . . . . . . . . . . . . . .(858) 350-2344 . . . . . . . . . . . . [email protected] Bliss . . . . . . . . . . . . . . . .(650) 849-3470 . . . . . . . . . . . . [email protected] Boshart . . . . . . . . . . .(415) 947-2057 . . . . . . . . . . . . [email protected] Flaherty . . . . . . . . . . . . . . .(650) 849-3268 . . . . . . . . . . . . [email protected] Janov . . . . . . . . . . . . . . .(858) 350-2351 . . . . . . . . . . . . [email protected] Le . . . . . . . . . . . . . . . . . . . . .(650) 849-3329 . . . . . . . . . . . . [email protected] Ludlum . . . . . . . . . . . . . . . .(801) 993-6410 . . . . . . . . . . . . [email protected] McCall . . . . . . . . . . . . . . . .(650) 320-4547 . . . . . . . . . . . . [email protected] Palao-Ricketts . . . . . . . . . .(650) 565-3617 . . . . . . . . . . . . [email protected] Stern . . . . . . . . . . . . . . . . .(650) 320-4818 . . . . . . . . . . . . [email protected] Thomas . . . . . . . . . . . . . . .(650) 849-3261 . . . . . . . . . . . . [email protected] Tokuda . . . . . . . . . . . . . . .(650) 565-3904 . . . . . . . . . . . . [email protected] Wallin . . . . . . . . . . . . . .(650) 565-3620 . . . . . . . . . . . . [email protected]

Circular 230 Compliance: To ensure compliance with requirements imposed by the IRS, we inform you thatany U.S. federal tax advice contained in this memorandum is not intended or written to be used, and cannotbe use, for the purpose of: (a) avoiding penalties under the Internal Revenue �, or (b) promoting, marketing,or recommending to another party any transaction or matter addressed herein.


This Client Alert was sent to our clients andinterested parties via email on

April 19, 2007. To receive future Client Alerts and newsletters via email,

please contact Marketing [email protected]

and ask to be added to our mailing list.

This communication is provided for yourinformation only and is not intended toconstitute professional advice as to any

particular situation.

650 Page Mill RoadPalo Alto, CA 94304-1050

Tel: (650) 493-9300 Fax: (650) 493-6811 email: [email protected]

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stock rights under final section 409a regulations · · 2012-02-08client alert april 2007 stock...

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