Application of Section 409A to Nonqualified Deferred Compensation Plans, 19234-19325 [07-1820]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 72, Number 73 (Tuesday, April 17, 2007)]
[Rules and Regulations]
[Pages 19234-19325]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 07-1820]



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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Application of Section 409A to Nonqualified Deferred Compensation 
Plans; Final Rule

Federal Register / Vol. 72, No. 73 / Tuesday, April 17, 2007 / Rules 
and Regulations

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9321]
RIN 1545-BE79


Application of Section 409A to Nonqualified Deferred Compensation 
Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations regarding the 
application of section 409A to nonqualified deferred compensation 
plans. The final regulations are necessary to clarify and explain the 
rules governing the application of section 409A to nonqualified 
deferred compensation plans. The regulations affect service providers 
receiving amounts of deferred compensation and the service recipients 
for whom the service providers provide services.

FOR FURTHER INFORMATION CONTACT: Stephen Tackney, (202) 927-9639 (not a 
toll-free number).

DATES: Effective Date: These regulations are effective April 17, 2007.
    Applicability Dates: For dates of applicability, see Sec.  1.409A-
6(b).

SUPPLEMENTARY INFORMATION:

Background

    Section 409A was added to the Internal Revenue Code (Code) by 
section 885 of the American Jobs Creation Act of 2004, Public Law 108-
357 (118 Stat. 1418). Section 409A generally provides that unless 
certain requirements are met, amounts deferred under a nonqualified 
deferred compensation plan for all taxable years are currently 
includible in gross income to the extent not subject to a substantial 
risk of forfeiture and not previously included in gross income. Section 
409A also includes rules applicable to certain trusts or similar 
arrangements associated with a nonqualified deferred compensation plan, 
where such arrangements are located outside of the United States or are 
restricted to the provision of benefits in connection with a decline in 
the financial health of the sponsor.
    On December 20, 2004, the IRS issued Notice 2005-1 (published as 
modified on January 6, 2005, in 2005-1 CB 274), setting forth initial 
guidance with respect to the application of section 409A, and supplying 
transition guidance pursuant to a statutory directive. A notice of 
proposed rulemaking (REG-158080-04, 2005-2 CB 786 [70 FR 57930]) was 
published in the Federal Register on October 4, 2005. See Sec.  
601.601(a)(3). A public hearing was conducted on January 25, 2006. In 
addition, the IRS received written and electronic comments responding 
to the notice of proposed rulemaking. After consideration of all the 
comments, the proposed regulations are adopted as amended by this 
Treasury decision. The amendments are discussed in this preamble.
    The Treasury Department and the IRS have also issued six additional 
notices providing transition guidance with respect to section 409A: (1) 
Notice 2005-94, 2005-2 CB 1208 (transition guidance with respect to 
2005 reporting and withholding obligations); (2) Notice 2006-4, 2006-3 
IRB 307 (transition guidance with respect to certain outstanding stock 
rights); (3) Notice 2006-33, 2006-15 IRB 754 (transition guidance with 
respect to the application of section 409A(b)); (4) Notice 2006-64, 
2006-29 IRB 88 (interim guidance regarding payments necessary to meet 
Federal conflict of interest requirements); (5) Notice 2006-79, 2006-43 
IRB 763 (additional transition relief); and (6) Notice 2006-100, 2006-
51 IRB 1109 (transition guidance with respect to 2005 and 2006 
reporting and withholding obligations). See Sec.  601.601(d)(2). For a 
discussion of the continued applicability of these notices, see the 
Effect on Other Documents section of this preamble.

Explanation of Provisions and Summary of Comments

I. Structure and Format of Regulations

    The final regulations generally adopt the structure and format of 
the proposed regulations. A table of contents has been included in the 
final regulations, as well as several additional sets of examples 
addressing various topics.

II. Definition of Nonqualified Deferred Compensation Plan

A. Excluded Plans
    The final regulations exclude the types of plans described in 
section 409A(d)(1) from the definition of a nonqualified deferred 
compensation plan, as well as certain other arrangements that were also 
set forth in the proposed regulations. Accordingly, the final 
regulations generally provide that a nonqualified deferred compensation 
plan for purposes of section 409A does not include a qualified plan, a 
bona fide sick leave or vacation plan, a disability plan, a death 
benefit plan, or certain medical expense reimbursement arrangements.
    The final regulations clarify that the exemption from coverage 
under section 409A for certain welfare plans does not apply to medical 
expense reimbursements that constitute taxable income to the service 
provider. The coverage exemption applies only to arrangements that 
provide benefits that are excludable from gross income under section 
105 or section 106.
    Several commentators requested clarification of when a leave 
program will be treated as a bona fide sick leave or vacation leave 
plan for purposes of section 409A. Another commentator requested a 
clarification of the definition of a compensatory time plan. Because 
the definitions of these terms may raise issues and require 
coordination with the provisions of section 451, section 125, and, with 
respect to certain taxpayers, section 457, the final regulations do not 
address these issues.
    Notice 2005-1, Q&A-6 provides that, until further guidance, 
taxpayers whose participation in a nonqualified deferred compensation 
plan would be subject to section 457(f) may rely on the definitions of 
bona fide vacation leave, sick leave, compensatory time, disability 
pay, or death benefit plan applicable for purposes of section 457(f) as 
also being applicable for purposes of section 409A. Until further 
guidance, such taxpayers may continue to rely on such definitions for 
purposes of section 409A.
    One commentator requested that a qualified employer plan for 
purposes of the exclusion from section 409A include certain plans 
covered by section 402(d) (certain plans with a foreign-situs trust 
treated as qualified plans with respect to the taxation of the 
participants and beneficiaries) and retirement plans described in 
section 1022(i)(2) of the Employee Retirement Income Security Act of 
1974, as amended (certain Puerto Rican retirement plans). The final 
regulations adopt this suggestion.
B. Section 457 Plans
    The final regulations provide that section 409A is not applicable 
to an eligible deferred compensation plan under section 457(b), but may 
be applicable to a deferred compensation plan that is subject to 
section 457(f). Commentators requested clarification of the application 
of the exception in the proposed regulations from the definition of 
deferred compensation referred to as the short-term deferral rule 
(described in section III.C.1 of this preamble) to a section 457(f) 
plan. As discussed below, a right to deferred compensation

[[Page 19235]]

generally refers to a legally binding right in one taxable year to 
compensation that is or may be payable in a subsequent taxable year. 
For purposes of determining the time of payment, the term ``payment'' 
generally refers to an actual or constructive payment of cash or 
property. However, the final regulations provide that for purposes of 
the short-term deferral rule, an amount is treated as paid when it is 
included in income under section 457(f) whether or not an actual or 
constructive payment occurs. Accordingly, where the income inclusion 
under section 457(f) stems from the lapse of a substantial risk of 
forfeiture that is also treated as a substantial risk of forfeiture for 
purposes of section 409A, the amount included in income will be 
considered a short-term deferral for purposes of section 409A. However, 
the right to earnings on amounts that have previously been included 
under section 457(f) will be deferred compensation for purposes of 
section 409A unless the right to the earnings independently satisfies 
the requirements for an exclusion.
C. Arrangements With Independent Contractors
    The final regulations provide that section 409A generally does not 
apply to an amount deferred under an arrangement between a service 
provider and an unrelated service recipient if during the service 
provider's taxable year in which the service provider obtains a legally 
binding right to the deferred amount the service provider is actively 
engaged in the trade or business of providing services (other than as 
an employee or as a director of a corporation), and provides 
significant services to two or more service recipients to which the 
service provider is not related and that are not related to one 
another.
    The final regulations retain the safe harbor in the proposed 
regulations, under which a service provider is deemed to be providing 
significant services to two or more such service recipients for this 
purpose if the revenues generated from the services provided to any 
service recipient or group of related service recipients during such 
taxable year do not exceed 70 percent of the total revenues generated 
by the service provider from the trade or business of providing such 
services. Commentators expressed concern that the safe harbor did not 
permit independent contractors to know in advance whether the 
arrangements under which an independent contractor deferred 
compensation during a taxable year would be subject to section 409A. 
Commentators requested certain look-back periods, including the ability 
to use averaging over the previous three to five years, or to satisfy 
the 70 percent threshold over a certain portion of the previous three 
to five years. The Treasury Department and the IRS are concerned that 
the suggested rules would allow service providers to engage in 
strategic behavior to ensure that activity in certain years would be 
exempt from section 409A. Accordingly, the final regulations adopt an 
additional safe harbor that provides that a service provider that has 
actually met the 70 percent threshold in the three immediately previous 
years is deemed to meet the 70 percent threshold for the current year, 
but only if at the time the amount is deferred the service provider 
does not know or have reason to anticipate that the service provider 
will fail to meet the threshold in the current year.
    In response to comments, the final regulations provide that if an 
independent contractor qualifies for the safe harbor for exclusion from 
coverage under section 409A with respect to arrangements with unrelated 
service recipients, an arrangement between the independent contractor 
and a service recipient related to the independent contractor will not 
be subject to section 409A if the arrangement, and the practices under 
the arrangement, are bona fide, arise in the ordinary course of 
business, and are substantially the same as the arrangements and 
practices (such as billing and collection practices) applicable to one 
or more unrelated service recipients to whom the independent contractor 
provides substantial services and that produce a majority of the total 
revenue that the independent contractor earns from the trade or 
business of providing such services during the year.
    The final regulations further clarify that if at the time the 
legally binding right to the payment arose, the arrangement was not 
subject to section 409A because the service provider was an independent 
contractor that was eligible for this exclusion from coverage under 
section 409A, the amount deferred under the arrangement during that 
taxable year (and earnings credited to the deferred amount) will not 
become subject to section 409A in a later year if the service provider 
becomes an employee, independent contractor, or other type of service 
provider subject to the rules of section 409A.
    Commentators also requested that a service recipient be permitted 
to rely upon a representation of an independent contractor that the 
independent contractor meets the exclusion requirements, so that a 
service recipient will know whether it is subject to the reporting 
requirements with respect to amounts deferred subject to section 409A. 
The Treasury Department and the IRS are continuing to study this issue.
D. Anti-Abuse Rule
    If a principal purpose of a plan is to achieve a result with 
respect to a deferral of compensation that is inconsistent with the 
purposes of section 409A, the Commissioner may treat the plan as a 
nonqualified deferred compensation plan for purposes of section 409A.

III. Definition of Nonqualified Deferred Compensation Plan

A. In General
    The final regulations provide that a nonqualified deferred 
compensation plan is a plan that provides for the deferral of 
compensation. The final regulations further provide that a plan 
generally provides for the deferral of compensation if, under its terms 
and the relevant facts and circumstances, a service provider has a 
legally binding right during a taxable year to compensation that, 
pursuant to its terms, is or may be payable to (or on behalf of) the 
service provider in a later year. For this purpose, an amount generally 
is payable at the time the service provider has a right to currently 
receive a transfer of cash or property, including a transfer of 
property includible in income under section 83, the economic benefit 
doctrine or section 402(b). Accordingly, a taxable transfer of an 
annuity contract is treated as a payment for purposes of section 409A.
    The definition of deferral of compensation in the final regulations 
excludes the condition that the amount not be actually or 
constructively received and included in income during the taxable year, 
because that language might cause confusion with respect to the 
applicable rules governing deferral elections and the prohibition on 
the acceleration of payments. For example, if a service provider has 
made an irrevocable election to defer an amount of his or her salary to 
a future year, that amount is treated as deferred compensation 
regardless of whether the service recipient actually pays such amount 
to the service provider during the year in which the services are 
performed. Any early payment of the deferred compensation (or any right 
to receive such an early payment) generally would constitute an 
impermissible acceleration of the payment of the deferred amount.

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    For this purpose, a plan will be treated as providing for a payment 
to be made in a subsequent year whether the plan explicitly so provides 
(including through a service provider election) or the deferral 
condition is inherent in the terms of the contract. Where the parties 
have agreed that a payment will be made upon an event that could occur 
after the year in which the legally binding right to the payment 
arises, the plan generally will provide for a deferral of compensation 
(unless otherwise excluded under a specific exception, such as the 
short-term deferral rule).
    For example, if a plan provides a service provider a right to a 
payment upon separation from service, the plan generally will result in 
a deferral of compensation regardless of whether the service provider 
separates from service and receives the payment in the same year as the 
grant, because under the plan the payment is conditioned upon an event 
that may occur after the year in which the legally binding right to the 
payment arises. Similarly, if an arrangement such as a stock option or 
stock appreciation right not otherwise excluded from coverage under 
section 409A provides a right to a payment for a term of years where 
the payment could be received during the short-term deferral period or 
a subsequent period but is not otherwise includible in income until 
paid, the arrangement will provide for deferred compensation even 
though the service provider could receive the payment during the short-
term deferral period (for example, by exercising the stock option or 
stock appreciation right). However, where a plan does not specify a 
payment date, payment event or term of years (or specifies a date or 
event certain to occur during the year in which the services are 
performed), the plan generally will not provide for the deferral of 
compensation if the service provider actually or constructively 
receives the payment within the short-term deferral period.
    The proposed regulations provided that earnings on deferred amounts 
are generally treated as deferred compensation for purposes of section 
409A. Under the final regulations, whether a deferred amount 
constitutes earnings on an amount deferred, or actual or notional 
income attributable to an amount deferred, is determined under the 
principles defining income attributable to the amount taken into 
account under Sec.  31.3121(v)(2)-1(d)(2).
    A commentator requested clarification of whether a payment for a 
noncompetition agreement could be subject to section 409A. Because such 
a payment would occur in connection with the performance or 
nonperformance of services, and a covenant not to compete does not 
create a substantial risk of forfeiture for purposes of section 409A, a 
legally binding right obtained in one year to a payment in a subsequent 
year in connection with a noncompetition agreement generally would 
constitute deferred compensation.
B. Legally Binding Right
    The regulations define deferral of compensation in the context of a 
legally binding right to a payment of compensation in a future taxable 
year. Commentators requested clarification of the standard that would 
be used to determine whether a service provider has a legally binding 
right. A legally binding right includes a contractual right that is 
enforceable under the applicable law or laws governing the contract. A 
legally binding right also includes an enforceable right created under 
other applicable law, such as a statute.
    One commentator suggested that no legally binding right exists 
where the payment is made only upon the realization of gain from a 
particular investment. For example, the commentator argued that a bonus 
payable based upon the amount that a service provider obtains in 
selling property should not be treated as granting the service provider 
a legally binding right to the payment until the property is sold. In 
such a situation, however, the requirement that the property be sold is 
a condition to the right to the payment, but the right to the payment 
is still a legally binding right. The service recipient could not 
simply revoke the promise, sell the property, and not pay the bonus. 
However, the condition that the property be sold before the service 
provider becomes entitled to payment may constitute a substantial risk 
of forfeiture, depending on the specific facts and circumstances.
C. Short-Term Deferrals
1. In General
    Subject to the modifications described in this section III.C of the 
preamble, the final regulations generally adopt the short-term deferral 
rule that was contained in the proposed regulations. Under the short-
term deferral rule, a deferral of compensation does not occur for 
purposes of section 409A if the arrangement under which a payment is 
made does not provide for a deferred payment and the payment is made no 
later than the 15th day of the third month following the later of the 
end of the service provider's taxable year or the end of the service 
recipient's taxable year in which occurs the later of the time the 
legally binding right to the payment arises or the time such right 
first ceases to be subject to a substantial risk of forfeiture (subject 
to certain extensions for unforeseeable events). For this purpose, an 
arrangement provides for a deferred payment if it provides for a 
payment that will be made or completed after a date or an event that 
will or may occur later than the end of the 2\1/2\ month period 
described in the preceding sentence, either because of an affirmative 
election on the part of the service provider or service recipient or a 
deferral condition inherent in the terms of the contract (for example, 
that the amount will be paid upon the service provider's separation 
from service, which may occur in a future year).
    Several commentators requested that additional flexibility be 
provided to allow payments to be short-term deferrals. By analogy to 
the rules in the proposed regulations concerning when payments of 
deferred compensation amounts are considered timely for purposes of the 
payment date rules, the commentators suggested that payments should 
qualify as short-term deferrals if made by the end of the year after 
the year in which a substantial risk of forfeiture lapses, rather than 
by the 15th day of the third month of that year. The final regulations 
do not adopt this suggestion. The short-term deferral rule is based on 
the historical treatment of certain payments paid within a short period 
following the end of a taxable year as not constituting deferred 
compensation. See Sec.  1.404(b)-1T, Q&A-2(b). That short period has 
been defined as ending on the 15th day of the third month following the 
end of the year, subject to certain extensions for unforeseeable 
events. Extending the payment date by which a short-term deferral could 
be paid would be inconsistent with this approach and the legislative 
history of section 409A (H.R. Conf. Rep. No. 108-755, at 735 (2004)), 
and accordingly is not adopted in the final regulations. However, the 
final regulations liberalize the standard under which a payment can be 
a short-term deferral even if it is delayed due to unforeseeable 
events. The proposed regulations provided generally that payment could 
be delayed if the payment would jeopardize the service recipient's 
solvency and such insolvency was unforeseeable at the time the service 
provider obtained the right to the payment. By contrast, the final 
regulations provide generally that payment may be delayed where the

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payment would jeopardize the ability of the service recipient to 
continue as a going concern.
    Commentators asked how the short-term deferral rule applies to a 
series of payments scheduled to commence following the lapse of a 
substantial risk of forfeiture. The final regulations provide that the 
short-term deferral rule applies separately to each payment, applying 
the technical definition of ``payment'' set out in the regulations, 
provided that the entire payment is made during the short-term deferral 
period. Accordingly, where a payment has been designated as a separate 
payment, it may qualify as a short-term deferral (and thus not deferred 
compensation) even where the service provider has a right to subsequent 
payments under the same arrangement. In contrast, where a payment has 
not been designated as a separate payment (such as, for example, a life 
annuity payment or a series of installment payments treated as a single 
payment), any initial payments in the series will not be treated as a 
short-term deferral even if paid within the short-term deferral period. 
For a discussion of the definition of payment, see Sec.  1.409A-3.
    Commentators suggested that a right to a reimbursement be treated 
as potentially subject to the short-term deferral rule, arguing that 
the right to the reimbursement payment is subject to a substantial risk 
of forfeiture that the service provider will not incur the expense. 
Commentators argued that the short-term deferral rule then could apply 
if the reimbursement payment were made within a short period following 
the occurrence of the expense. Generally, the risk that a service 
provider will fail to incur a reimbursable expense will not qualify as 
a substantial risk of forfeiture, so the short-term deferral rule will 
not be applicable. However, the final regulations provide considerable 
additional flexibility with regard to structuring reimbursement 
arrangements to meet the requirements of section 409A. For a discussion 
of these provisions, see section VII.B.2 of this preamble.
2. Application to Event-Based Payments
    Some commentators asked whether any payments based on a legally 
binding right arising in the year of a separation from service are 
excluded from coverage under section 409A, if paid by the end of the 
relevant short-term deferral period. For example, where an employee had 
accrued benefits under a defined benefit supplemental executive 
retirement plan (SERP) during his career that was payable immediately 
upon a separation from service, including an amount accrued in the year 
of separation from service, commentators asked whether the payment of 
the portion of the benefits accrued in that final year is excluded from 
coverage under section 409A if paid by March 15 of the year following 
the separation from service, because the amount is paid within a short 
period following the year the service provider obtains a vested legally 
binding right to the additional benefit accrual. (This generally would 
be of most concern to specified employees subject to the requirement of 
a six-month delay in payment following a separation from service.)
    The analysis that applies in this situation is similar to that 
applied to the general definition of deferral of compensation, 
discussed in section III.A of this preamble. The short-term deferral 
rule does not provide an exclusion from the requirements of section 
409A for such current-year benefit accruals because the rule does not 
apply to amounts of compensation subject to a deferral election. For 
this purpose, an election to defer includes either an affirmative 
election on the part of the service provider or a deferral condition 
inherent in the terms of the contract. Where the parties have agreed 
that a payment will be made upon an event that does not necessarily 
coincide with the lapsing of the substantial risk of forfeiture, and 
could occur at a time beyond the short-term deferral period, the 
arrangement provides for a deferral election such that the short-term 
deferral rule does not apply. Accordingly, in this example, because the 
benefits accrued in the final year of the SERP could have been paid 
upon an event occurring after the short-term deferral period (if, for 
example, the individual had not separated from service until a later 
year), the payment of the benefit accrued in the final year is subject 
to section 409A and is not a short-term deferral, even if paid by March 
15 of the year following the separation from service.
    Also, for example, if a plan that is not subject to section 457(f) 
provides that an amount is subject to a substantial risk of forfeiture 
until the completion of three years of service, and is payable upon a 
separation of service following the three years of service, the right 
to the amount is not a short-term deferral even if the service provider 
separates from service immediately after vesting in the right, because 
under the plan the payment is based upon an event other than the 
lapsing of the substantial risk of forfeiture and such event may occur 
in a year subsequent to the year in which the risk of forfeiture 
lapses.
    Conversely, where a plan specifies no payment date or payment 
event, or specifies only the date at which the substantial risk of 
forfeiture lapses, the plan may qualify for the short-term deferral 
rule if the payment is made within the applicable short-term deferral 
period. However, such a plan generally would violate section 409A if 
the payment were made after the short-term deferral period.
    As discussed in this preamble with respect to the general 
definition of deferred compensation, to implement the statutory scheme, 
including the applicable reporting and form requirements, taxpayers 
generally must be able to determine whether an arrangement provides for 
a deferral of compensation at the time the service provider obtains a 
legally binding right to the compensation. Although a plan need not 
specify a payment date to be a short-term deferral that is excluded 
from coverage under section 409A, the short-term deferral exclusion 
does not apply if the payment event or date is specified and will or 
may occur after the end of the short-term deferral period.
    The preamble to the proposed regulations explained that where a 
plan requires that a payment be made on a date within the short-term 
deferral period, but the payment is made after the specified date and 
after the end of the short-term deferral period, the arrangement will 
be treated as a nonqualified deferred compensation plan, but the 
payment date will be treated as a specified date. Thus, under such an 
arrangement, if the service provider receives the payment after the 
specified date, but not later than the end of the year in which the 
specified date occurs, the payment generally will comply with section 
409A. However, taxpayers should note that a provision requiring only 
that a payment be made on or before the end of the short-term deferral 
period may not qualify as a permissible specified date for this 
purpose, if under the facts and circumstances the payment could have 
been made in more than one taxable year. For a discussion of the 
application of the definition of a specified payment date to this type 
of plan, see section VII.B of this preamble.
    For a discussion of when rights to compensation upon a separation 
from service for good reason may be treated as rights to compensation 
upon an involuntary termination, and the potential application of the 
short-term deferral exception to these arrangements, see section 
III.J.3 of this preamble.

[[Page 19238]]

D. Stock Options and Stock Appreciation Rights
1. In General
    Subject to the modifications described in this preamble, the final 
regulations adopt the provisions of the proposed regulations excluding 
from coverage under section 409A statutory stock options and certain 
other stock rights. Generally under the regulations, nondiscounted 
stock options and nondiscounted stock appreciation rights issued on 
service recipient stock that do not include any additional deferral 
feature are excluded from section 409A.
2. Statutory Stock Options
    The final regulations adopt the exclusion from coverage under 
section 409A for statutory stock options, including incentive stock 
options described in section 422 of the Code and options granted under 
an employee stock purchase plan described in section 423 of the Code. 
This exclusion applies regardless of whether the statutory stock option 
would be excluded if the same option were not treated as a statutory 
stock option. For example, an employee stock purchase plan described in 
section 423 offering a discounted purchase price is not a deferred 
compensation plan for purposes of section 409A.
    Commentators requested clarification, however, of the treatment of 
a statutory stock option that is modified, or otherwise becomes 
ineligible to be treated as a statutory stock option. The final 
regulations adopt the rule set forth in the proposed regulations, and 
provide that at the time of such modification or event, the 
modification or other event is treated as the grant of a new option, or 
causes the option to be treated as having had a deferral feature from 
the date of grant, as applicable, for purposes of section 409A only if 
such modification or other event would have been so treated had the 
option been a nonstatutory stock option immediately before such 
modification or other event. For example, where an incentive stock 
option is modified through an extension of the option's term, the 
extended option will be treated as having had an additional deferral 
feature from the date of grant for section 409A purposes only if the 
same extension of a nonstatutory stock option would have resulted in 
such treatment.
    Commentators also requested that the exclusion from coverage under 
section 409A for certain stock rights issued under plans meeting the 
requirements of section 423 (employee stock purchase plans) be extended 
to employee stock purchase plans offered by foreign employers that do 
not meet such requirements, where the shares are made available for 
purchase at a discount and substantially all of the participants are 
nonresident aliens. The legislative history does not provide a basis 
for extending the exception applicable to options meeting the 
requirements of section 423 to grants of discounted stock options not 
meeting the requirements of section 423. Accordingly, this suggestion 
is not adopted in the final regulations.
3. Definition of Service Recipient Stock
    The final regulations adopt the requirement in the proposed 
regulations that for the exclusion for certain stock rights to apply, 
the stock right must relate to service recipient stock. Commentators 
criticized the definition of service recipient stock contained in the 
proposed regulations as too restrictive. Generally such criticisms 
centered on two different aspects of the definition of service 
recipient stock in the proposed regulations--the classes of stock that 
may qualify as service recipient stock, and the issuer or issuers whose 
stock may constitute service recipient stock, where the service 
recipient is comprised of more than one entity.
a. Classes of Stock That May Qualify as Service Recipient Stock
    Commentators requested clarification and expansion of the classes 
of stock of a corporation that may constitute service recipient stock. 
Commentators generally focused on two issues. First, with respect to 
stock of a particular service recipient corporation, commentators 
requested that the stock right be permitted to relate to any class of 
common stock, regardless of whether another class of common stock of 
that corporation was publicly traded, and regardless of whether that 
class of common stock had the greatest aggregate value of all classes 
of common stock issued by that corporate entity. Subject to the 
restrictions governing certain preferences as to distributions, the 
final regulations generally provide that any class of common stock may 
be used, regardless of whether another class of common stock that could 
qualify as service recipient stock is publicly traded or has a higher 
aggregate value outstanding, and regardless of whether the class of 
stock is subject to transferability restrictions or buyback rights 
(provided such buyback rights reflect the fair market value of the 
stock at the time of purchase).
    Second, commentators suggested narrowing the types of preferences 
on a class of common stock that would prohibit that class from being 
treated as service recipient stock. One commentator requested that the 
classes of stock permitted as service recipient stock include any class 
of stock that is widely held by non-service recipients. While it may be 
unlikely that a widely-held class of stock was created to facilitate an 
abusive avoidance of section 409A, it does not follow that service 
recipient stock rights issued on such stock necessarily would be 
consistent with the intended application of section 409A if, for 
example, holders of such class enjoyed preferences that would make such 
stock rights a suitable substitute for nonqualified deferred 
compensation.
    To be treated as service recipient stock under the final 
regulations, a class of stock must qualify as common stock under 
section 305 of the Code. Accordingly, the final regulations provide 
that stock that is not common stock under section 305 is not service 
recipient stock for purposes of section 409A. However, the mere 
classification of a class of stock as common stock under section 305 is 
not sufficient for such stock to be treated as service recipient stock 
for purposes of section 409A. The Treasury Department and the IRS are 
concerned that classes of stock that are common stock under section 305 
may provide preferences that could permit stock rights with respect to 
such stock to resemble traditional nonqualified deferred compensation, 
such that exclusion of such stock rights would permit the avoidance of 
section 409A.
    Commentators suggested that a preference with respect to 
liquidation rights, without any other preferences such as a 
preferential right to dividends, should be permitted under the 
definition of service recipient stock. A holder of this class of stock 
would not be guaranteed any return, but rather would simply be 
guaranteed preferred distribution rights upon a complete liquidation of 
the service recipient. The final regulations generally adopt this 
suggestion.
    With respect to other preferential rights, commentators were unable 
to provide a workable standard under which permissible preferences 
could be distinguished from impermissible preferences. Accordingly, the 
final regulations do not treat any stock including such preferences as 
service recipient stock. However, the Treasury Department and the IRS 
continue to study this area, and the final regulations authorize the 
publication of other additional guidance, should a workable standard be 
developed.

[[Page 19239]]

b. Entities the Stock of Which May Qualify as Service Recipient Stock
    Commentators also requested an expansion of the class of entities 
the stock of which can qualify as service recipient stock where the 
service recipient is comprised of multiple entities. The Treasury 
Department and the IRS believe that the stock right exception under 
section 409A was intended to cover stock rights directly reflecting the 
enterprise value of the entity for which the service provider is 
providing services. Consistent with this approach, the final 
regulations provide that service recipient stock may include the stock 
of the corporation for which the service provider was providing 
services at the date of grant. In addition, the final regulations 
provide that service recipient stock may include stock of any 
corporation in a chain of organizations all of which have a controlling 
interest in another organization, beginning with the parent 
organization and ending with the organization for which the service 
provider was providing services at the date of grant of the stock 
right. Similarly to the proposed regulations, the final regulations 
provide that the term ``controlling interest'' has the same meaning as 
provided in Sec.  1.414(c)-2(b)(2)(i), except that where that 
regulation requires at least an 80 percent interest, the final 
regulations generally require only a 50 percent interest. In addition, 
where the use of such stock with respect to the grant of a stock right 
to such service provider is based upon legitimate business criteria, 
the final regulations generally require only a 20 percent interest. For 
purposes of determining ownership of an interest in an organization, 
the attribution rules of Sec.  1.414(c)-4 apply, and the exclusion 
rules of Sec.  1.414(c)-3 also apply. For example, under the final 
regulations, with respect to an employee of a subsidiary corporation, 
the common stock of the ultimate parent corporation, or of a subsidiary 
corporation anywhere in the chain of corporate ownership between the 
subsidiary that employed the employee and the ultimate parent 
corporation (a higher tier subsidiary), could qualify as service 
recipient stock for purposes of determining whether a stock right 
issued to such employee with respect to such stock was excluded from 
coverage under section 409A, provided that the 50 percent or 20 percent 
ownership standard, as applicable, was satisfied by each corporation in 
the chain.
    The proposed regulations contained many requirements for using an 
ownership level of less than 50 percent. Commentators requested several 
simplifications of these requirements. In response, the final 
regulations no longer require a formal election by any corporation. 
Rather, each individual grant of a stock right is analyzed to determine 
whether the stock qualifies as service recipient stock with respect to 
a service provider at the time the stock right is granted. If a 
corporation owns at least 50 percent of the stock of one corporation 
and owns less than 50 percent of the stock of another corporation, and 
it intends to treat its stock as service recipient stock with respect 
to employees of both corporations, there is no requirement that a 
legitimate business criteria exist with respect to the issuance of 
stock rights on the parent corporation stock to service providers of 
the first such corporation. The legitimate business criteria standard 
applies only to stock rights issued to service providers of 
subsidiaries that are not majority-owned, because the test of 
legitimate business criteria relates to the actual issuance of a stock 
right to a particular service provider. Accordingly, a subsidiary may 
have more than one shareholder corporation the stock of which qualifies 
as service recipient stock with respect to a subsidiary employee such 
as, for example, where three entities each own a one-third interest in 
the subsidiary. However, with respect to each grant of a stock right on 
stock of a particular non-majority shareholder corporation to a service 
provider of a particular subsidiary, there must exist legitimate 
business criteria for issuing such a stock right. Even if legitimate 
business criteria exist with respect to the issuance of a stock right 
on stock of a particular shareholder corporation to a particular 
service provider, legitimate business criteria may or may not exist 
with respect to the issuance of a stock right to the same service 
provider on stock of another shareholder corporation.
    The legitimate business criteria requirement is a facts and 
circumstances test, focusing generally on whether there is sufficient 
nexus between a particular service provider and the entity, the stock 
of which underlies the stock right granted to the service provider, for 
the grant to serve a legitimate non-tax business purpose. As provided 
in the preamble to the proposed regulations, if a corporation issued a 
stock right on its stock to a current employee of a joint venture in 
which the corporation was a venturer, and the employee was a former 
employee of the corporate venturer, generally the issuance would be 
based on legitimate business criteria. Similarly, if the corporate 
venturer issued such a right to an employee of the joint venture who it 
reasonably expected would become an employee of the corporate venturer 
in the future, generally the legitimate business criteria requirement 
would be met. By contrast, where an employee has no real nexus with a 
corporate venturer, such as generally happens when the corporate 
venturer is a passive investor in the service recipient, the use of the 
investor corporation stock as the stock underlying a stock right grant 
to that employee generally would not be based upon legitimate business 
criteria. Similarly, where a corporation holds only a minority interest 
in an entity that in turn holds a minority interest in the entity for 
which the employee performs services, such that the corporation holds 
only an insubstantial indirect interest in the entity receiving the 
services, legitimate business criteria generally would not exist for 
issuing a stock right on the corporation's stock to the employee.
    The Treasury Department and the IRS remain concerned that the 
manipulation of the structure of a related group of corporations may be 
used to allow stock options or stock appreciation rights to mimic the 
characteristics of nonqualified deferred compensation, by compensating 
holders based on predictable amounts and investment returns unrelated 
to the enterprise value of an operating entity. Accordingly, the 
exception contained in the proposed regulations under which the stock 
of a corporation serving as investment vehicle is not considered 
service recipient stock has been retained. In addition, an anti-abuse 
rule has been added to address corporate structures, transactions, or 
stock right grants, a principal purpose of which is the avoidance of 
the application of section 409A to an arrangement otherwise providing 
deferred compensation. These corporate structures, transactions, and 
stock right grants generally will occur where the structure, 
transaction, or grant is intended to provide enhanced security for the 
value of the stock right as a means of providing deferred compensation, 
rather than as compensation related to an increase in the true 
enterprise value of the service recipient. The regulations provide that 
if an entity becomes a member of a group of corporations or other 
entities treated as a single service recipient, and the primary source 
of income or value of such entity arises from the provision of 
management services to other members of the service recipient group, if 
any stock rights are issued with respect to such entity it is presumed 
that such

[[Page 19240]]

structure was established for purposes of avoiding the application of 
section 409A.
c. Equity Interests in Certain Non-Corporate Entities
    The final regulations permit certain equity interests in a non-
stock mutual company to be treated analogously to equity interests in a 
corporation. Commentators requested that the definition of service 
recipient stock be expanded to cover interests in cooperatives and 
interests in the value of an Indian tribal enterprise. The regulations 
do not include such interests in the definition of service recipient 
stock, but provide the IRS authority to provide guidance expanding the 
definition of service recipient stock. For a discussion of the 
application of the exclusion for certain stock rights to rights issued 
on equity interests in entities taxed as partnerships, see section 
III.G of this preamble.
4. Valuation
a. In General
    The final regulations provide that for the exclusion for stock 
rights to apply, the stock right must specify an exercise price of the 
stock right that may never be less than the fair market value of the 
underlying stock on the date the stock right is granted. For purposes 
of this discussion and the final regulations, the exercise price of a 
stock appreciation right refers to the base stock value from which the 
appreciation is measured for purposes of determining the compensation 
payable under the stock appreciation right (for example, a stock 
appreciation right providing for a payment of the excess of the fair 
market value of 100 shares over $100 would have a $1 per share exercise 
price).
    Several commentators expressed concerns regarding the determination 
of the fair market value of the underlying stock. Some commentators 
requested that the valuation rules applicable to incentive stock 
options be applied for purposes of the exclusion from section 409A. 
Under those rules, if the stock option would otherwise fail to be an 
incentive stock option solely because the exercise price was less than 
the fair market value of the underlying stock as of the date of grant, 
generally the option is treated as an incentive stock option if the 
issuer attempted in good faith to set the exercise price at fair market 
value. See section 422(c)(1). The Treasury Department and the IRS 
believe that this is not the appropriate standard for determining 
whether stock rights are subject to section 409A. Incentive stock 
options are subject to strict limitations on the amount of such options 
that may be granted to a particular employee. See section 422(d). In 
contrast, there are no such limits applicable to nonstatutory stock 
options, and grants of nonstatutory stock options often far exceed the 
limitation applicable to incentive stock options. In addition, section 
422(c)(1) explicitly provides for the good faith standard with respect 
to incentive stock options, while no such provisions exist within 
section 409A or its legislative history.
    Commentators requested clarification of the consistency standard 
with respect to the use of a valuation method. Specifically, 
commentators asked whether one valuation method could be used for 
purposes of establishing the exercise price while another method could 
be used for purposes of determining the fair market value of the stock 
at the time of the payment (for example, to determine the amount of 
payment in the case of a stock appreciation right or a stock option 
where the stock is subject to repurchase by the service recipient). The 
final regulations clarify that consistency is not required, provided 
that each valuation method used otherwise meets the requirements of the 
final regulations. Accordingly, a service recipient may use one 
valuation method for purposes of establishing an exercise price, but 
another valuation method for purposes of establishing the payment 
amount (in the case of a stock appreciation right) or the buyback 
amount (in the case of a stock option where the underlying stock is 
subject to a buyback arrangement). However, once an exercise price has 
been established, the exercise price may not be changed through the 
retroactive use of another valuation method. In addition, where after 
the date of grant, but before the date of exercise, of the stock right, 
the service recipient stock to which the stock right relates becomes 
readily tradable on an established securities market, the service 
recipient must use a valuation method for stock readily tradable on an 
established securities market for purposes of determining the payment 
amount (in the case of a stock appreciation right) or the buyback 
amount (in the case of a stock option where the underlying stock is 
subject to a buyback arrangement).
b. Valuation--Stock Readily Tradable on an Established Securities 
Market
    The final regulations adopt the rules under the proposed 
regulations governing valuation of stock readily tradable on an 
established securities market, generally requiring that the valuation 
of such stock be based upon the contemporaneous prices established in 
the securities market, subject to the modifications discussed in this 
preamble. Some commentators requested additional guidance with respect 
to when a stock will be treated as readily tradable. The final 
regulations adopt the same standard as that set forth in Sec.  1.280G-
1, Q&A-6(e), that stock is treated as readily tradable if it is 
regularly quoted by brokers or dealers making a market in such stock.
    With respect to the rules governing the valuation of stock that is 
readily tradable on an established securities market, commentators 
generally focused on the provision of the proposed regulations 
permitting the use of an average selling price during a specified 
period that is within 30 days before or 30 days after the date of 
grant. Specifically, comments concentrated on the requirement that the 
commitment to grant the stock right with an exercise price set using 
such an average selling price be irrevocable before the beginning of 
the specified period. Commentators questioned both the purpose of the 
requirement of the commitment to the valuation method, as well as the 
actions required to satisfy the rule if averaging were being used.
    The rule was intended to prohibit the use of an average price, set 
on a look-back basis, to ensure a discounted exercise price. For 
example, if a corporation decided to grant a stock option on July 1, 
and it could set the exercise price using an average selling price for 
any period falling within the prior 30 days without having had a prior 
commitment to a specific averaging period, the corporation could simply 
look for the lowest price that occurred during the prior June. 
Furthermore, if the corporation were not committed to grant the stock 
option on July 1, the corporation could wait until its stock price 
began to rise and then grant an option using the selling price on a 
given day during the previous 30 days to provide a particular discount. 
Accordingly, the final regulations require that the commitment to grant 
the stock right with an exercise price set using such an average 
selling price be irrevocable before the beginning of the specified 
period. To satisfy this requirement, the service recipient must 
designate the recipient of the stock option, the number of shares the 
stock option will permit the holder of the stock option to purchase, 
and the method for determining the exercise price including the period 
over which the averaging will occur, before the beginning of the 
specified averaging period.

[[Page 19241]]

    One commentator stated that the requirement of an irrevocable 
commitment to the averaging period could not be met under French law, 
because French law requires that the stock option exercise price be set 
based on the average trading price over the preceding 20 days and the 
commitment to the grant before the beginning of the period may be 
viewed as violating that requirement. The final regulations provide 
that where applicable foreign law requires that the compensatory stock 
right granted by the issuer must be priced based upon a specific price 
averaging method and period, a stock right granted in accordance with 
such applicable foreign law will be treated as meeting the requirement, 
provided that the averaging period may not exceed 30 days.
c. Valuation--Stock Not Readily Tradable on an Established Securities 
Market
i. In General
    The final regulations adopt the provisions in the proposed 
regulations relating to the valuation of stock not readily tradable on 
an established securities market, subject to the modifications 
discussed in this section III.C.4.c. Accordingly, a valuation of stock 
based upon a reasonable application of a reasonable valuation method is 
treated as reflecting the fair market value of the stock. To meet this 
standard, it is not necessary that a taxpayer demonstrate that the 
value was determined by an independent appraiser. Where the taxpayer 
can otherwise demonstrate that the valuation was determined by the 
reasonable application of a reasonable valuation method, the standard 
will be met.
    One commentator requested that the factors to be considered in 
determining the fair market value of the stock should be modified to 
include consideration of any recent equity sales made by the 
corporation in arm's-length transactions. The final regulations adopt 
this suggestion.
    The final regulations continue to require that in the case of a 
stock right issued with respect to stock that was not publicly traded 
at the time the right was issued, but becomes publicly traded before 
the right is exercised, the stock value for purposes of calculating the 
payment amount (in the case of a stock appreciation right) or the 
buyback amount (in the case of a stock option where the underlying 
stock is subject to a buyback agreement) must be based upon the rules 
governing stock that is publicly traded. This does not mean that the 
initial exercise price determined under the rules governing stock that 
is not publicly traded must be reset. Rather, this means only that the 
value at the time of exercise used to determine the payment amount or 
the buyback amount must be determined under the rules governing stock 
that is publicly traded. For example, if a service provider holds an 
excluded stock appreciation right with an exercise price of $1 that was 
fixed based on a valuation of the closely-held corporate stock at the 
time of grant, and before exercise the stock becomes readily tradable 
on an established securities market, the amount payable upon exercise 
must be the excess of the value of the stock based on its trading price 
over the $1 exercise price.
ii. Safe Harbor Presumptions
    The final regulations adopt a presumption in specified 
circumstances that, for purposes of section 409A, a valuation of stock 
reflects the fair market value of the stock, rebuttable only by a 
showing that the valuation is grossly unreasonable. The presumption 
applies where the valuation is based upon an independent appraisal, a 
generally applicable repurchase formula (applicable for both 
compensatory and noncompensatory purposes) that would be treated as 
fair market value under section 83, or, in the case of illiquid stock 
of a start-up corporation, a valuation by a qualified individual or 
individuals applied at a time that the corporation did not otherwise 
anticipate a change in control event or public offering of the stock.
    Many of the comments with respect to these presumptions related to 
the presumption applicable to illiquid stock of start-up corporations. 
As set forth in the proposed regulations, the start-up corporation 
presumption would not apply if the service recipient or service 
provider could reasonably anticipate, as of the time the valuation is 
applied, that the service recipient would undergo a change in control 
event or make a public offering of securities within the 12 months 
following the event to which the valuation is applied. Commentators 
suggested that a 12-month period is too long, because changes occur so 
rapidly in the business world that it often is difficult or impossible 
to predict so far in advance whether such an event will occur. 
Commentators suggested that the service provider should retain the 
benefit of the presumption unless the issuing corporation entered into 
a definitive agreement or filed its registration statement with the 
Securities and Exchange Commission within a period of 15 or 30 days 
after issuing the stock right.
    The Treasury Department and the IRS believe that a 15-day or a 30-
day period is too short. Although there is always a risk that a public 
offering will fail or that a corporate transaction will not occur, the 
Treasury Department and the IRS also believe that a person should 
reasonably be able to anticipate whether such a transaction will occur 
during a reasonable period before the transaction.
    Accordingly, the final regulations provide that the start-up 
corporation presumption will not apply if at the time the valuation is 
made, the service recipient or service provider may reasonably 
anticipate that the service recipient will undergo a change in control 
event in the next 90 days or an initial public offering within the next 
180 days. As under the proposed regulations, the rule in the final 
regulations is concerned with what the parties may reasonably 
anticipate at the time the stock right is issued.
    Other comments requested examples of persons with sufficient 
knowledge, experience, and skill in valuing illiquid stock of a start-
up corporation. Because knowledge, skill, and training may be obtained 
in different ways, the final regulations do not provide specific 
examples. However, the regulations clarify that the standard to be 
applied is whether a reasonable individual, upon being apprised of such 
person's relevant knowledge, experience, education, and training, would 
reasonably rely on the advice of such person with respect to valuation 
in deciding whether to accept an offer to purchase or sell the stock 
being valued. The final regulations also clarify that significant 
experience generally means at least five years of relevant experience 
in business valuation or appraisal, financial accounting, investment 
banking, private equity, secured lending, or other comparable 
experience in the line of business or industry in which the service 
recipient operates.
    With respect to the presumption based upon a generally applicable 
buyback formula, some commentators requested that the presumption apply 
where the formula is applicable to all compensatory stock transactions, 
but not also applicable to all noncompensatory stock transactions. The 
final regulations do not adopt this suggestion. However, the final 
regulations clarify that to meet the requirements of the presumption, 
the buyback formula is required to be applicable to compensatory and 
noncompensatory transactions with the issuer or a person owning 10 
percent or more of the stock of the issuer, but is not

[[Page 19242]]

required to be applicable to transactions with other persons or 
transactions that are part of an arm's length transaction constituting 
the sale of all or substantially all of the stock of the issuer to an 
unrelated purchaser.
5. Modification of a Stock Right
    The final regulations continue to apply certain rules addressing 
modifications, extensions and renewals of stock rights. Although these 
rules in many respects resemble the rules applicable to statutory stock 
options, the rules are not intended to incorporate the rules applicable 
to statutory stock options except where explicitly provided.
    The final regulations generally retain the rules in the proposed 
regulations that generally treat extensions of the exercise period of a 
stock right as an additional deferral feature as of the date of grant 
of the right, with an exception for certain limited extensions 
following a separation from service. Commentators characterized these 
rules as unnecessarily restrictive. Specifically, commentators argued 
that the extension of a stock option upon the occurrence of a 
separation from service (often in connection with a program of layoffs) 
or a corporate transaction is a common practice, and that often these 
extensions cover periods longer than the limited period provided in the 
proposed regulations. In addition, commentators argued that the same 
substantive results could be obtained by specifying a longer term for 
the stock right and providing the service recipient the discretion to 
shorten the term, rather than providing discretion to extend a shorter 
term, and that the former approach would be permissible under the 
proposed regulations. In response, the final regulations provide that 
the extension of an option exercise period generally is not treated as 
an additional deferral feature or a modification of the stock option 
for section 409A purposes if the exercise period is not extended beyond 
the earlier of the original maximum term of the option or 10 years from 
the original date of grant of the stock right.
    Many commentators also requested that the extension of the exercise 
period of a stock right not be treated as an additional deferral 
feature for purposes of section 409A, where at the time of the 
extension the fair market value of the underlying stock does not exceed 
the exercise price (an ``underwater'' option). Because the issuance of 
an otherwise identical option with an exercise period ending after the 
end of the exercise period of the underwater option would be excluded 
from coverage under section 409A, the final regulations provide that 
such an extension does not constitute an additional deferral feature.
    The final regulations adopt the provisions in the proposed 
regulations regarding substitution or assumption of stock rights due to 
a corporate transaction, which are generally in accordance with the 
corresponding provisions governing incentive stock options. The final 
regulations clarify that the applicable corporate transactions for this 
purpose include only those transactions described in Sec.  1.424-
1(a)(3). One commentator requested that the provision permitting 
substitutions of stock options be modified to reflect that a holder of 
a nonstatutory stock option is not required to be employed by the 
successor entity. The final regulations adopt this suggestion, so that 
a substituted nonstatutory stock option may be treated as a 
continuation of the initial option even where the holder of the option 
is not employed or otherwise providing services to the successor 
entity, provided the substitution otherwise meets the rules provided in 
the regulations.
6. Other Stock Right Issues
    The final regulations adopt certain definitions from the 
regulations governing statutory stock options, modified as appropriate 
for purposes of applying the rules under section 409A. These include 
the time and date of grant of an option (Sec.  1.421-1(c)), and the 
definitions of option (Sec.  1.421-1(a)), stock (Sec.  1.421-1(d)), 
exercise price (Sec.  1.424-1(e)), exercise (Sec.  1.421-1(f)), and 
transfer (Sec.  1.421-1(g)). These definitions apply by analogy to 
stock appreciatio