New Deferred Compensation Plan Rules Allow Broader Use of Stock Appreciation Rights; Specify Rules for Valuing Stock in Closely Held Companies

On September 29, 2005, the IRS issued proposed regulations under Section 409A of the Internal Revenue Code detailing how companies will need to comply with the deferred compensation rules created by the American Jobs Creation Act. These proposed rules cover all kinds of deferred compensation arrangements, including changes and elaborations for equity compensation plans.

The most significant change for equity plans concerned stock appreciation rights (SARs). The prior rules excluded stock-settled SARs in public companies but covered cash-settled SARs in public companies and all SARs in closely held companies. The newly proposed rules allow SARs in all companies, provided that in closely held companies the award is based on fair market valuations. Considerable space is devoted to defining what qualifies as fair market valuation in a closely held company. A safe harbor would be to follow ESOP valuation rules (these require at least an annual independent appraisal by an appraiser with no other business relationship with the company). Otherwise, the method can be any "fair and reasonable" approach, provided that it is applied on a consistent basis for other equity transactions between employees, including repurchases, and that it takes into account a variety of factors such as asset value, future earnings, market risk, and other elements typically found in business appraisals. For shares with a nonlapse provision (typically, that shares must be sold back to the company), valuation formulas, such as book value or a multiple of earnings, are not alone sufficient but can be used if the same valuation technique is used consistently to determine value for repurchases of shares as well as for other corporate transactions and filings requiring valuation. These same rules would presumably apply to establishing a fair market value for nonqualified options.

Stock appreciation rights, restricted stock, incentive stock options, employee stock purchase plans, and nonqualified options issued at fair market value can now also be excluded for employees of entities that are either at least 50% owned by the issuer or at least 20% owned in a joint venture, provided the award is made for a legitimate business purpose and the employee services are performed primarily for the issuer. This exception is not be used to create investment vehicles or other entities designed to avoid the intent of the law. Prior rules had limited the exclusions to entities at least 80% owned by the issuer.

The next issue of the NCEO newsletter will contain further details on the rules, and a future issue of our legal journal will provide greater depth.