On June 10, 2014, the IRS issued Revenue Ruling 2014-18, which holds that nonqualified stock options, as well as stock-settled stock appreciation rights (SARs), do not constitute nonqualified deferred compensation subject to taxation under Code Section 457A as long as they are exempt from the requirements of Code Section 409A. This ruling reaffirms interim guidance issued by the IRS in January 2009 in Notice 2009-8. (For more information on Section 457A and Notice 2009-8, please refer to our Client Alert, available here.)
Under Section 457A, compensation that is payable under nonqualified deferred compensation plans of certain foreign corporations and partnerships that are “nonqualified entities” is includible in gross income when the compensation is not subject to a substantial risk of forfeiture. For this purpose, a substantial risk of forfeiture exists only to the extent that a person’s right to the compensation is conditioned on the performance of substantial services by any individual. Where an amount of deferred compensation is not determinable at the time it ceases to be subject to a substantial risk of forfeiture (such as amounts which vest prior to the end of a performance period when the underlying performance measurements are still variable), the amount must be included in gross income when it becomes determinable and at such time, will be subject to an additional penalty tax of 20% plus interest at the underpayment rate plus 1% from the later of the time of deferral and the date when the substantial risk of forfeiture lapses.
Section 457A generally uses the same definition of “nonqualified deferred compensation plan” as is used for Section 409A purposes. Under Section 409A, nonqualified stock options and SARs are generally not considered deferrals of compensation, as long they meet certain specific requirements, including, most notably: (1) having an exercise price not less than fair market value on the date of grant; (2) being in respect of service recipient stock; and (3) not having any feature providing for the deferral of compensation.
Unlike Section 409A, however, Section 457A specifically includes in its definition of deferred compensation plans any plan that “provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient.” In Notice 2009-8, the IRS indicated that nonqualified and incentive stock options exempt from Section 409A are also exempt from Section 457A. Further, Notice 2009-8 noted that stock-settled SARs exempt from Section 409A are generally excluded from Section 457A. However, since the release of Notice 2009-8, the IRS has not issued further guidance under Section 457A.
In Revenue Ruling 2014-18, the IRS reaffirmed the interim guidance under Notice 2008-8 as to stock-settled SARs. By specifically noting that stock-settled SARs exempt from Section 409A are functionally identical to nonqualified stock options with a “net exercise” feature (i.e., a right to exercise the option by withholding shares subject to the option having a fair market value equal to the applicable exercise price on the date of exercise), the IRS concluded that these SARs are also exempt from Section 457A. The Revenue Ruling confirms that SARs that could be settled other than in stock – such as in cash – are not exempt from Section 457A, even if exempt from Section 409A.
Revenue Ruling 2014-18 puts to rest any uncertainty regarding the application of Section 457A to SARs generally and serves as a useful reminder of the Code’s nuanced treatment of equity-based compensation. However, Revenue Ruling 2014-18 does not address other areas of the Code that may impact tax treatment of stock options and SARs granted by nonqualified entities, such as the applicability of the “passive foreign investment company” rules.