Deferred Compensation Guidance Issued

In Notice 2005-1, the IRS has issued guidance on the new deferred compensation plan rules under Section 409(a) of the Internal Revenue Code. The guidance covers a broad range of issues, including some specifically concerning equity compensation.

There had been uncertainty about whether stock appreciation rights (SARs) would be subject to the new rules. The guidance states they will not be if:

• The company is publicly traded, and stock is delivered to settle the right.
• The exercise price is never less than the fair market value at grant.
• There is no additional deferral provision.
• The SAR is not part of a tandem arrangement with a stock option under which the SAR is paid in cash; in that case, the option will be considered deferred compensation.

SARs granted before Oct. 3, 2004, are excluded for closely held companies as well if they meet the last three rules.

Restricted stock is not considered deferred compensation for these purposes if no deferral arrangement is made as part of the grant. Discounted options and SARs settled in cash that are not fully vested by December 31, 2004, can be replaced by December 31, 2005, with awards qualifying under the rules. The substitution can be structured according to the same rules as for mergers or consolidations (that is, providing for equivalent value). SARs can be converted into options.

The law stated that nonqualified options would be excluded from the new rules provided they were not granted at a discount. The guidance provides that any reasonable valuation method may be used to determine fair market value.