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The Employee Ownership Update

Corey Rosen

October 29, 2007

(Corey Rosen)

409A Deferred Compensation Compliance Rules Delayed Until 2009

In Notice 2007-86 (October 22, 2007), the IRS has extended the time for compliance with the deferred compensation rules under Internal Revenue Code Section 409A through December 31, 2008. This does not mean companies can ignore the law until then. Companies will be considered compliant only if they operate their deferred compensation plans in accordance with the law and with regulations published under it through 2008. So any deferred compensation issued after the Code section's 2005 effective date will have to meet the proposed or final rules that were in effect when the awards were issued, while any deferred awards issued before that date are given through the end of 2008 to be brought into compliance with the final regulations.

Discounted stock options and stock appreciation rights issued prior to 2005 can be exchanged for non-discounted awards through 2008, provided this does not result in the exchange of the award for cash or vested property payable in the year of the transaction. Backdated options, however, are not granted relief. More generally, the deadline for employees to make elections for future deferrals of awards that do not meet the deferred compensation exemptions provided by the law are extended through 2008, although the notice does limit acceleration of deferrals into 2007 and 2008.

The regulation supersedes a ruling two months ago providing only limited documentary compliance relief.

The IRS has also issued Notice 2007-89, which explains wage reporting and withholding under Section 409A.

Rangel Proposal Would Tax Synthetic Equity in S Corporation ESOPs

Congressman Charles Rangel (D-NY) has proposed taxing synthetic equity at exercise in S corporation ESOPs in a way that would reflect their share of the foregone corporate taxes attributable to the ESOP as income. Interest would be charged on any resulting underpayment for the period. In effect, the bill would treat holders of synthetic equity as if they actually owned an equivalent value of the S corporation's stock and would be subject to taxation on corporate profits for their pro-rata share of net income during that period. The law would apply only to grants issued after enactment.

Congressman Rangel claims that the provision would save $606 million over 10 years. The proposal was reportedly sparked by reaction to the pending Tribune Company transaction. If that transaction is completed, however, it would be well in advance of any conceivable time frame for passage of the bill. The proposal is part of a massive overhaul of corporate taxes. It will not be voted on this year and is, like all such sweeping proposals, sure to face strong opposition from many affected parties. Pieces of it, however, could appear in future tax bills. It is notable that the proposal does not seek to undo the basic framework for S corporation ESOP tax benefits.

The language of the proposal can be found in Section 3701. Go here for details.

PricewaterhouseCoopers Survey Shows 19% of Fast-Growing Companies Plan ESOPs as Business Transition Strategy

The 2006 Trendsetters Survey from PricewaterhouseCoopers asked 301 companies identified as very fast-growing about their plans for an exit strategy. Nineteen percent cited an ESOP. Companies could pick more than one choice, so the total percentages for each selected item sum to 146%. The top choice was sale to another company (62%), followed by sale to management (29%), family transition (22%), an ESOP (19%), and an IPO (14%). Half the companies identified themselves as high-tech. The data are very similar to a 2007 Inc. survey of fast-growing companies.

Given that ESOPs tend to be used for business transition more in mature companies than in fast-growing newer companies, the number of companies choosing ESOPs represents a potentially important change in how these plans will be used in the future.

Large Option Grants to CEOs Appear to Hurt Investors

In their new study "Swinging for the Fences: The Effects of CEO Stock Options on Company Risk-Taking and Performance" (Academy of Management Journal, Oct./Nov. 2007), Donald Hambrick of Penn State University and William Gerard Sanders of Brigham Young University report that companies whose CEOs had very large option grants tended to have much more variable stock price performance than other companies and performed much worse than expected. Hambrick and Sanders analyzed 950 randomly selected companies listed in the Standard & Poor's 500, midcap, and small-cap indices. They measured the proportion of CEO compensation paid in stock-option grants over three-year periods, then looked at the size of company investments in R&D, capital investments, and acquisitions in the fourth year and stock price returns in the fifth. Option grant size was calculated as the Black-Scholes value.

They then looked at predicted financial performance based on a variety of control measures versus what they company actually did. They found that the higher the proportion of CEO pay in options, the bigger the investments and the larger the swings in performance. These greater risks might be acceptable to investors except that big losses compared to expectations based on the model were more likely than big gains-40% more likely where options constituted over half the CEO's pay.

The findings support a critique made by many observers (including the NCEO) of outsized equity grants to CEOs: They encourage excessive risk taking. The higher the volatility of stock returns, the more valuable options are (because because executives can "lock in" the value of a short-lived spike in stock price). Coupled with the fact that most CEOs stay in their jobs five years or less, there is tremendous incentive to take large risks.

Erratum

In the November-December issue of the Employee Ownership Report (our newsletter for members), the article on ISO and ESPP reporting indicates that the new reports required by the Tax Relief and Health Care Act of 2006 will be due in 2009. They actually will be due in 2008. We apologize for the error. The PDF version of the newsletter in the members-only area of this site has been corrected.

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