Attorneys Recommend Changes to Proposed Deferred Compensation Regs

We are writing to comment on the definition of "service recipient stock" contained in Prop. Reg. § 1.409A-1 (the "Proposed Regulations"). Under Prop. Reg. § 1.409A-1(b)(5), certain nonqualified stock options and stock appreciation rights (together, "stock rights") are treated as not providing for the deferral of compensation, and hence avoid the § 409A penalties. However, the Proposed Regulations -- imposing a restriction nowhere suggested in the statute or legislative history -- limit this exception to stock rights granted on "service recipient stock."

As discussed below, the definition of service recipient stock contained in the Proposed Regulations is unduly narrow and, unless broadened, would unreasonably impede issuance of stock rights by many non-publicly traded companies. We recommend that the following modifications be made to the provisions of the Proposed Regulations governing stock rights:

The rules governing valuation of partnership interests for § 409A purposes should, however, differ in one respect in order to be consistent with the rules for measuring compensation upon issuance of a partnership equity interest in connection with the performance of services. To the extent taxpayers are permitted to value a partnership interest issued in connection with the performance of services based on a liquidation value approach,¹ the liquidation value approach should apply in valuing a partnership interest for § 409A purposes. In particular, an otherwise qualifying partnership equity right should be not be treated as deferred compensation if the exercise price at grant is not less than the liquidation value (rather than fair market value) of the underlying partnership interest.

The preamble to the Proposed Regulations states that the exception from § 409A for not-in-the-money stock rights "was intended to cover stock rights with respect to service recipient stock the fair market value of which meaningfully relates to the potential future appreciation in the enterprise value of the corporation," and that limiting the exception to stock rights granted with respect to a defined category of service recipient stock is intended to prevent "manipulation of stock valuations, and manipulation of the characteristics of the underlying stock, [that] may lead to abuses." A Treasury Department official recently noted that "an option on preferred stock or any other designer security could very easily approximate in effect the value of nonqualified deferred comp."²

We have no objection to the tax policy concerns described above. However, the definition of "service recipient stock" contained in the Proposed Regulations excludes classes of stock of non-public companies that are commonly used, are not remotely abusive and have a value that meaningfully relates to potential future appreciation in enterprise value.

It is very common for non-public corporations and partnerships to have a capital structure in which one group of equity holders (the "senior holders") is entitled to receive a priority return of their invested capital plus a share of residual proceeds, and for another group of equity holders (the "junior holders") be entitled to receive a share of residual proceeds. Often, the senior holders are venture capital or other private equity investors and the junior holders are founding or other early-stage shareholders or management shareholders. This basic capital structure can have a number of variations. For example, the senior holders may or may not receive a priority yield on their invested capital and the senior holders' right to share in residual proceeds may require them to give up their priority interest (e.g., through a conversion provision), or the senior holders may share in residual proceeds only after the junior holders have received a proportionate share of some or all of the priority distributions received by the senior holders.

Frequently, the equity rights of the senior holders are represented by a single class of equity -- a "participating preferred" stock (e.g., entitled to return of invested capital, plus a yield, plus a share of residual proceeds) or a "convertible preferred" stock (e.g., entitled to a return of invested capital plus a yield, or, if greater, a share of residual proceeds).

In most cases it would be possible to replicate the economic rights represented by participating preferred or convertible preferred stock by bifurcating the rights into shares of nonparticipating preferred stock plus either common stock or warrants to acquire common stock. However, combining the rights in a single class of stock is often the best way to effect the parties' economic deal, and may facilitate the documentation of specific rights and obligations of the senior holders, such as special voting rights, anti-dilution protections, control shifts, "supermajority" veto provisions, mandatory conversion to common stock upon an initial public offering, and other special terms.

Moreover, certain tax rules may penalize any bifurcation of the senior holders' economic rights. For example, bifurcation of corporate participating preferred or convertible preferred stock into nonparticipating preferred stock plus either common stock or a warrant to acquire common stock may cause the bifurcated preferred stock to be treated as "nonqualified preferred stock" (subject to unfavorable rules under Code §§ 351(g), 354(a)(2)(C) and 356(e)) or to be treated as issued with "preferred OID" (resulting in deemed dividend accruals under Code § 305). In the case of equity interests issued by a partnership, it is not clear whether a bifurcation of the senior holders' economic rights into separate classes of partnership equity would be respected for federal income tax purposes given that a partner's entire equity interest in a partnership is generally treated for federal income tax purposes as a unitary asset.³

To qualify as "service recipient stock" under the Proposed Regulations, non-publicly traded stock must be: (a) "common stock," (b) not preferred as to liquidation or dividend rights and (c) part of a class of common stock that has the greatest aggregate value of any class of common stock. Where a non-public corporation (or partnership, assuming that the same principles are extended to partnerships) has a class of participating preferred or convertible preferred stock outstanding as described above, we are concerned that no class of the corporation's stock can qualify as "service recipient stock" under this restrictive definition.

Prop. Reg. § 1.409A-1(b)(5) does not define the term "common stock" for purposes of that section. Presumably, however, it means stock that is not "preferred stock," and the latter term is defined for purposes of several subchapter C provisions. Code § 351(g)(3)(A) defines "preferred stock" as "stock which is limited and preferred as to dividends and does not participate in corporate growth to any significant extent." For purposes of this definition, participation through a right to convert the stock into a different class of stock is generally taken into account. Treas. Reg. § 1.305-5(a) defines "preferred stock" as "stock which, in relation to other classes of stock outstanding enjoys certain limited rights and privileges . . . but does not participated in corporate growth to any significant extent," determined, however, "without regard to any right to convert such stock into another class of stock of the corporation".⁴

If, for purposes of Prop. Reg. § 1.409A-1(b)(5), "common stock" means stock that participates in corporate growth to a significant extent, a company that has issued participating preferred stock or convertible preferred stock may have no class of stock that qualifies as "service recipient stock." The class of participating preferred stock or convertible preferred stock⁵ would be "common stock" but it would not qualify because of its preference as to liquidation or dividend rights. Moreover, if the aggregate value of the class of participating preferred or convertible preferred stock exceeds the aggregate fair value of the class of residual common stock, the shares of the residual common stock also would not qualify. Such an outcome is inappropriate, goes well beyond any antiabuse rule that may be needed to defend the purposes of § 409A, and should be changed.

For example, assume a corporation is capitalized with 800 shares of participating preferred stock and 200 shares of common stock. The stock terms require all distributions to be made to the holders of the participating preferred stock until cumulative distributions total $1,000 per share, plus an 8% yield thereon, and all remaining distributions are made pro rata in proportion to the number of shares outstanding (i.e., 80% to holders of the participating preferred stock and 20% to holders of the common stock).

First, we do not believe that stock that participates in corporate growth to a significant extent -- such as the common stock in the above example -- should be excluded from qualifying as "service recipient stock" merely because another class of participating stock has greater value. In the above example, the value of the common stock meaningfully relates to potential future appreciation in enterprise value and does not approximate the effect of nonqualified deferred compensation. The corporation should not be forced to bifurcate the participating preferred stock into non-participating preferred stock and common stock in order to permit stock rights granted with respect to its common stock to qualify for the § 409A exception.

Second, we do not believe that stock that participates in corporate growth to a significant extent should be excluded from qualifying as "service recipient stock" in all cases in which the stock is preferred as to liquidation or dividend rights. It is not uncommon for a nonpublic company's class of participating preferred or convertible preferred stock -- such as the participating preferred stock in the above example -- to be entitled to receive a high percentage of all residual distributions, so that the preference is over only a small portion of the company's residual value. In this situation, the value of the participating preferred or convertible preferred meaningfully relates to potential future appreciation in enterprise value and does not approximate the effect of nonqualified deferred compensation.

Stock rights should not create the opportunity for abuse of § 409A so long as the value of the underlying stock is principally related to the issuer's enterprise value, rather than to a fixed dollar amount or rate of return. We believe that any antiabuse goals can be achieved by limiting the definition of service recipient stock to any class of corporate stock (or class of partnership equity interest) that (a) participates in corporate growth to a significant extent, which participation is not, directly or indirectly, subject to a limitation that may in the future cause the stock to cease to participate in corporate growth to a significant extent and (b) is not preferred as to liquidation or dividend rights over one or more classes of stock that, in the aggregate, are entitled to a substantial portion of all liquidation or dividend rights that are junior to such preferred rights. Such a definition would ensure that the exception for stock rights not in-the-money at grant is limited to stock the fair market value of which meaningfully relates to potential future appreciation in enterprise value and does not approximate the value of nonqualified deferred compensation.

We believe that subjecting taxpayers to this risk is inappropriate. First, as noted earlier, the service recipient stock limitation on the not-in-the-money-at-grant stock rights exception to § 409A is not suggested in the statute or legislative history, nor is any such limitation contained in Notice 2005-1. Second, as discussed in this letter, the Proposed Regulations' definition of service recipient stock is unreasonably narrow and would impede issuance of stock rights by many non-public companies that have commonly-utilized and non-abusive capital structures. Third, the scope of this definition remains unclear as the Proposed Regulations do not define the key term "common stock." Finally, Notice 2006-4 acknowledges that the Proposed Regulations' definition of service recipient stock is under review.

For these reasons we believe that stock rights options granted prior to the date final regulations are issued should be exempt from the requirement that they be granted on service recipient stock, so long as the stock rights are not materially modified on or after such date.

We appreciate the opportunity to comment on the proposed regulations issued under Section 409A and would be pleased to discuss any of our comments with you in greater detail.

² Daniel Hogans, Doc. 2005-21284, TNT 202-5.

³ See Reg. § 1.704-l(b)(2)(iv)(b) (a partner has a single capital account reflecting all interests in the partnership held by the partner) and Rev. Rul. 84-53, 1984-1 C.B. 159 (a partner holding more than one interest in a partnership has a unitary tax basis in those interests).

⁴ See, e.g., Treas. Reg. § 1.305-5(d), Example 10 (class of stock entitled to a fixed dollar preference on dividends and on liquidation, and approximately 9% of all residual distributions, does not constitute preferred stock for Section 305 purposes where issuer's book value and earnings history indicates it is "reasonable to anticipate that [such stock] would participate in the current and anticipated earnings and growth of the corporation beyond [its] preferred interests"

⁵ Clearly, if the convertible preferred stock participates in common distributions on an as-if-converted basis, and perhaps even if it does not.