RESEARCH TRIANGLE PARK, N.C. – Section 409A of the Internal Revenue Code, setting forth new rules regarding the taxation of what is termed “non-qualified deferred compensation,” was adopted in October of 2004. Two years later the Internal Revenue Service is still struggling with issues related to how to interpret and enforce its provisions, which affect all types of deferred compensation arrangements, such as severance plans, long-term incentive plans and other bonus plans, as well as equity compensation arrangements, including stock options and stock appreciations rights.

Non-statutory stock options, for example, are subject to Section 409A if they are granted at an exercise price that is less than fair market value. (Incentive stock options are not subject to Section 409A because, by definition, they must be issued with an exercise price of not less than fair market value.)

Last month the IRS announced that it is giving employers and employees an additional year, until December 31, 2007, to amend most existing deferred compensation arrangements to comply with Section 409A’s requirements. The additional time has been granted because the IRS has not yet issued final regulations telling taxpayers and their advisors how to comply with the rules.

Consequences of Not Complying With New Rules Are Heavy

Complying with Section 409A is a big deal, because the consequences of not complying are severe. The provisions of Section 409A apply to nonqualified deferred compensation that is payable to employees, corporate directors, and certain consultants (essentially those who provide services only to one major client).

If any of these employees is granted nonqualified deferred compensation, she owes ordinary income taxes on the value of the compensation from the date the right to receive the compensation is vested — even if she might not get the actual compensation for years. This stays in place for every year the nonqualified deferred compensation is owed, so as the value of the amount owed to her rises, she owes more taxes on the amount of the increase.

Worse, not only does she owe ordinary income taxes on her phantom income — she owes a 20% penalty tax, and there are interest obligations as well. In other words, no one wants to be an employee who is owed deferred compensation that does not comply with the regulations (nonqualified deferred compensation)!

Existing Non-Complying Arrangements Can Still Be Fixed

Most employers are now aware of Section 409A and, with the help of their advisors, are designing their new deferred compensation plans, including option grants, to comply with the Section, proposed regulations, and other guidance that has been issued by the IRS.

One issue that is still out there for many employers is going back and fixing existing plans that are now subject to the new rules. In particular, many employers still need to amend some of their old non-statutory stock options, because options that were granted before Section 409A came into effect but which were not vested prior to the end of 2004 are subject to the new rules. If a non-statutory stock option that wasn’t vested at the end of 2004 was granted at an exercise price that was below the fair market value of the underlying stock at the time the option was granted, the stock option is subject to Section 409A and the optionee is subject to the Section 409A taxes and penalties on the difference between the exercise price and the current fair market value of the stock.

These non-complying options can be amended in a couple of ways to fit within Section 409A’s requirements. One way is to amend the non-complying option to provide for an exercise price that is equal to the fair market value of the stock at the time the option was originally granted. In the cases of appreciating stock, this can still leave the optionee with a significant spread between the value at the date of grant and the current fair market value.

The other way to amend the option would be to amend it so that it is only exercisable at the times and in the manner permitted under Section 409A, which places strict limitations on the time periods in which the option can be exercised and the ability of an employer to accelerate the vesting of the option.

IRS Gives Employers Additional Year To Fix Options

Until the IRS’s announcement last month, employers and optionees only had until December 31, 2006 to amend these non-complying options. Many employers have held off on amending pre-existing deferred compensation plans, including non-complying options, while waiting for the IRS to issue final regulations interpreting Section 409A and telling employers in detail how to comply with its requirements. The IRS has encountered significant delay in getting this done.

While the service still hopes to issue the final regulations before the end of this year, it recognized that employers and employees would be hard-pressed to study and internalize the final rules in time to amend all outstanding non-complying arrangements by December 31. Accordingly, the IRS granted these parties an additional year, until December 31, 2007, to amend non-complying arrangements, including non-complying stock options, before Section 409A taxes and penalties begin to apply.

Exercising a non-complying option during 2007 does not solve the problem; if the option is exercised without the parties having first made reasonable, good-faith efforts to bring it into compliance with Section 409A, then the Section 409A tax and penalties will apply.

Backdated Options Aren’t Eligible for Relief

There is one key exception to this in the non-complying option arena. Companies that are caught up in the options backdating scandal cannot use the extra year to fix their non-complying options, and must do so by December 31, 2006. This limitation applies only to options granted by public companies to officers and directors.

If these options were backdated or otherwise manipulated so that they were granted below their true fair market value, such that the company is required to restate its financial statements to account properly for the option, then the extended transition period is not available.

Employers should review their outstanding deferred compensation arrangements, including stock options, with their attorneys and accountants in order to spot non-complying arrangements and get them fixed within the additional grace period. This is the IRS’s second extension of the grace period and the service is unlikely to offer employers any more time to comply once December 31, 2007 passes.

Editor’s Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, taxation and securities matters. Questions or comments can be sent to