IRC § 409A and Changes in Control: Must Option Cash-Outs Be “All-or-Nothing”?

IRC § 409A and Changes in Control: Must Option Cash-Outs Be “All-or-Nothing”?

IRC Section 409A was enacted post-Enron to stem the abuse of corporate executives who accelerated payments under their deferred compensation plans before the company went bankrupt. IRC Section 409A sets strict guidelines for private companies issuing stock options and other forms of non-qualified deferred compensation.  Noncompliance results in immediate taxation of benefits and steep penalties.  IRC Section 409A also addresses how to handle options in the context of corporate transactions involving a change in control.  The issue of option cash-out, particularly on a delayed basis, is the subject of this Lexis® Tax Law Staff Commentary.

IRC Section 409A Defines Change in Control Event

Under IRC Section 409A, a deferred compensation agreement can provide for distributions only at specified times or upon certain defined events.  A "change in control event" is one of those circumstances.  A "change in control event" is defined as a change in: 

  • ownership of a corporation;
  • effective control of a corporation; or
  • ownership of a substantial portion of the assets of a corporation.

(See Treas. Reg. Section 1.409A-3(i)(5).)

Provided that the value of options is not increased in connection with an adjustment of options, a corporation may substitute a new option for an outstanding option, or assume an old option in a corporate transaction involving a change of control under IRC Section 409A.

Cashing Out Options Under IRC Section 409A

Cashing out options is also a possibility when there is a change in control event. Whether cash-out on a delayed basis will meet IRC Section 409A  requirements is the subject of some debate.  Tax advisors have counseled that IRC Section 409A  does not apply to the proceeds of a delayed payment transaction, so long as any payments made to those option holders are made on the same schedule and under the same terms and conditions as payments to stockholders generally, and any such payments are made within five years of the transaction.  See A. William Caporizzo and Kimberly A. Wethly, "Structuring Stock Options and Severance Payments after Section 409A:  Practical Advice for Venture-backed Companies" (WilmerHale LLP).  However, informal remarks by Treasury led some practitioners to conclude that payment of option cash-outs on a delayed basis could be a violation under IRC Section 409A.   Most recently, a Treasury representative stated on October 10, 2012 that the government is currently reconsidering its position with respect to delayed cash-out option payments.  See Amy Elliott, "Treasury Addresses Change-in-Control Cash-Out Provisions," taxanalysts® Tax Notes Today (Oct. 15, 2012).

Proceed with Caution When Considering a Delayed Cash-Out

At this point it is difficult to reconcile the informal guidance proffered by Treasury to date.  Whether there will be official guidance in this area is uncertain.  As a result, practitioners should approach IRC Section 409A situations involving the delayed cash-out of options with caution.  We will continue to keep you informed in this evolving area of law, so stay tuned for further Lexis® Tax Law Community staff updates.

RELATED LINKS:

...

Discover the features and benefits of LexisNexis® Tax Center

For quality Tax & Accounting research resources, visit the LexisNexis® Store