rr-14-18.pdf

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Section 457A.—Nonqualified Deferred Compensation from Certain Tax Indifferent
Parties

(Also: Section 409A; 1.409A-1: Stock Rights)

Rev. Rul. 2014-18

ISSUE
Whether a nonstatutory stock option or a stock-settled stock appreciation right
with respect to common stock of a nonqualified entity is a nonqualified deferred
compensation plan subject to taxation under section 457A of the Internal Revenue Code
(Code).

FACTS
Service Recipient is a foreign corporation and a nonqualified entity for purposes
of section 457A(b). Service Provider is a limited liability company organized under state
law and treated as a partnership for U.S. income tax purposes. Income of Service
Provider is allocated to persons subject to U.S. income tax. Service Provider provides
services to Service Recipient. Service Recipient and Service Provider are not at any
time treated as a single employer under section 414(b) or (c).

As incentive compensation for Service Provider, Service Recipient grants a
nonstatutory stock option and a stock appreciation right (in each case, a stock right) to
Service Provider, each with respect to a fixed number of common shares of Service
Recipient, which qualify as service recipient stock (as defined under Treas. Reg.
§1.409A-1(b)(5)(iii)). Each stock right has an exercise price per share that is not less
than the fair market value of a common share of Service Recipient on the date of grant,
determined pursuant to Treas. Reg. §1.409A-1(b)(5)(iv). The stock rights do not include
any feature for the deferral of compensation (as defined under Treas. Reg. §1.409A-

1(b)(5)(i)(D)) and otherwise comply with the requirements of Treas. Reg. §1.409A-
1(b)(5)(i)(A) or (B), as applicable. The terms of the stock appreciation right at all times
provide that it must be settled in service recipient stock, and the stock appreciation right
is settled in service recipient stock. Service Provider has the same redemption rights
with respect to common shares acquired upon exercise of the stock rights as other
shareholders have with respect to their common shares of Service Recipient.

LAW AND ANALYSIS
Section 457A(a) provides that any compensation that is deferred under a
nonqualified deferred compensation plan of a nonqualified entity shall be includible in
gross income when there is no substantial risk of forfeiture of the rights to such
compensation.

Section 457A(b) provides that the term “nonqualified entity” means (1) any
foreign corporation unless substantially all of its income is (A) effectively connected with
the conduct of a trade or business in the United States, or (B) subject to a
comprehensive foreign income tax, and (2) any partnership unless substantially all of its
income is allocated to persons other than (A) foreign persons with respect to whom
such income is not subject to a comprehensive foreign income tax, and (B)
organizations which are exempt from tax under the Code.

Section 457A(d)(3)(A) provides that the term “nonqualified deferred
compensation plan” has the meaning given such term under section 409A(d), “except
that such term shall include 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.”
Section 409A(d) provides that the term “nonqualified deferred compensation plan”
means any plan that provides for the deferral of compensation other than certain
enumerated exceptions.

Section 1.409A-1(b)(5)(i)(A) provides that a nonstatutory stock option to
purchase a fixed number of shares of service recipient stock does not provide for the
deferral of compensation for purposes of section 409A if the exercise price is not less
than the fair market value of the underlying stock on the date the stock option is
granted, the stock option does not include any feature for the deferral of compensation,
and the other requirements of §1.409A-1(b)(5)(i)(A) are met. Section 1.409A-
1(b)(5)(i)(B) provides that “a right to compensation based on the appreciation in value of
a specified number of shares of service recipient stock occurring between the date of
grant and the date of exercise of such right (a stock appreciation right)” does not
provide for the deferral of compensation for purposes of section 409A if the exercise
price is not less than the fair market value of the underlying stock on the date the right is
granted, the right does not include any feature for the deferral of compensation, and the
other requirements of §1.409A-1(b)(5)(i)(B) are met.

A stock right that meets the requirements of either §1.409A-1(b)(5)(i)(A) or (B)
and is therefore exempt from section 409A is therefore also exempt from section 457A,
unless it constitutes, as set forth under section 457A(d)(3)(A), “a right to compensation
based on the appreciation in value of a specified number of equity units of the service
recipient." Section 457A was added to the Code by section 801(a) of the Tax Extenders
and Alternative Minimum Tax Relief Act of 2008, Pub. L. No. 110-343 (Div. C), 122 Stat.
3929 (2008) (TEAMTRA), more than one year after the issuance of final Treasury
Regulations under section 409A. The language quoted above from section
457A(d)(3)(A) is substantially the same as the language set forth under §1.409A-
1(b)(5)(i)(B) describing a stock appreciation right exempt from section 409A. The
House Committee Report on TEAMTRA confirms that the quoted language is
specifically intended to refer to a stock appreciation right and that a nonstatutory stock
option that meets the requirements of §1.409A-1(b)(5)(i)(A) is intended to be exempt
from section 457A:

Under the provision, nonqualified deferred compensation includes any
arrangement under which compensation is based on the increase in value
of a specified number of equity units of the service recipient. Thus, stock
appreciation rights (SARs) are treated as nonqualified deferred
compensation under the provision, regardless of the exercise price of the
SAR. It is not intended that the term nonqualified deferred compensation
plan include an arrangement taxable under section 83 providing for the
grant of an option on employer stock with an exercise price that is not less
than the fair market value of the underlying stock on the date of grant if
such arrangement does not include a deferral feature other than the
feature that the option holder has the right to exercise the option in the
future.

H.R. Rep. No. 110-658, at 195 (2008).

Although stock appreciation rights are generally subject to section 457A, a stock
appreciation right that at all times by its terms must be settled, and is settled, in service
recipient stock is functionally identical in all material respects to a nonstatutory stock
option to purchase service recipient stock with a net exercise feature, and the stock
transfer under such an arrangement, like the stock transfer pursuant to the exercise of a
nonstatutory stock option, is taxable under section 83.

Accordingly, a nonstatutory stock option exempt from section 409A is exempt
from section 457A. In addition, a stock appreciation right exempt from section 409A
that at all times by its terms must be settled, and is settled, in service recipient stock is
exempt from section 457A. A stock appreciation right that may be or is settled other
than in service recipient stock is not exempt from section 457A, regardless of whether
the stock appreciation right is a nonqualified deferred compensation plan for purposes
of section 409A.

Applying these principles, neither stock right with respect to common shares of
Service Recipient granted to Service Provider is a nonqualified deferred compensation
plan for purposes of section 457A(a) because each is either a nonstatutory stock option
that meets the requirements of §1.409A-1(b)(5)(i)(A) or a stock appreciation right that
meets the requirements of §1.409A-1(b)(5)(i)(B) and at all times by its terms must be
settled, and is settled, in service recipient stock. The stock rights granted to Service
Provider are accordingly exempt from section 457A.

HOLDING
Neither the nonstatutory stock option nor the stock-settled stock appreciation
right granted to Service Provider with respect to common shares of Service Recipient is
a nonqualified deferred compensation plan subject to taxation under section 457A.

EFFECT ON OTHER REVENUE RULING(S)
Notice 2009-8, 2009-4 I.R.B. 347, Interim Guidance under Section 457A, is
amplified.

DRAFTING INFORMATION
The principal author of this revenue ruling is Gregory Burns of the Office of
Associate Chief Counsel (Tax Exempt & Government Entities). For further information
regarding this revenue ruling, contact Gregory Burns at (202) 317-5600 (not a toll-free
call).