n-06-04.pdf

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Part III - Administrative, Procedural, and Miscellaneous

Interim Guidance with Respect to the Application of Section 409A to Outstanding
Stock Rights

Notice 2006-4

# I. Background

Section 409A was added to the Internal Revenue Code as part of the American
Jobs Creation Act of 2004, Pub. Law No. 108-357, 118 Stat. 1418. Section 409A
generally provides that all amounts deferred under a nonqualified deferred
compensation plan for all taxable years are currently includible in gross income
to the extent not subject to a substantial risk of forfeiture and not previously
included in gross income, unless certain requirements are met. The IRS issued
Notice 2005-1, 2005-2 I.R.B. 274, on December 20, 2004 (published as modified
on January 6, 2005) and issued proposed regulations under section 409A on
September 29, 2004 (70 Fed. Reg. 57930 (Oct. 4, 2005)). The proposed
regulations are proposed to be effective on January 1, 2007, and do not limit the
application of the guidance provided in Notice 2005-1.

# II. Stock Options and Stock Appreciation Rights Granted before January 1, 2005

# A. Application of the Reasonable Valuation Standard

Commentators expressed concern with respect to the application of section 409A
to stock options and stock appreciation rights (collectively, stock rights) issued
before January 1, 2005. Specifically, commentators expressed concern that
although the issuers of the stock rights intended to establish an exercise price
not less than the fair market value of the stock at the time of grant, the issuers of
the stock right may not be able to demonstrate that the exercise price of the
stock right was determined using a reasonable valuation method in accordance
with the requirements set forth in Notice 2005-1, Q&A-4(d) or § 1.409A-
1(b)(5)(i)(B) of the proposed regulations. Commentators noted further that at the
time such stock rights were granted, section 409A had not been enacted and
thus no guidance with respect to the application of section 409A to stock rights
was available.

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B. Application of the Good Faith Standards of § 1.422-2(e)(2)

Section 1.422-2(e)(1) generally provides that except as provided by § 1.422-
2(e)(2), the option price of an incentive stock option must not be less than the fair
market value of the stock subject to the option at the time the option is granted.
Section 1.422-2(e)(2) generally provides that if a share of stock is transferred to
an individual pursuant to the exercise of an option which fails to qualify as an
incentive stock option merely because there was a failure of an attempt, made in
good faith, to meet the option price requirements of § 1.422-2(e)(1), those option
price requirements are considered to have been met. Whether there was a
good-faith attempt to set the option price at not less than the fair market value of
the stock subject to the option at the time the option was granted depends on the
relevant facts and circumstances.

Until further guidance is issued, with respect to a stock right issued before
January 1, 2005, for purposes of determining whether the stock option results in
a deferral of compensation pursuant to Notice 2005-1, Q&A-4(d)(ii), or the stock
appreciation right results in a deferral of compensation pursuant to § 1.409A-
1(b)(5)(i)(B) of the proposed regulations, principles similar to those set forth in
§ 1.422-2(e)(2) will be applied. Accordingly, where there was a good-faith
attempt to set the exercise price of a stock right granted before January 1, 2005,
at a price not less than the fair market value of the stock subject to the stock right
at the time the stock right was granted, then such exercise price will be treated
as being not less than the fair market value of the stock at the time of grant for
purposes of determining whether the stock right is excluded from the
requirements applicable to deferred compensation under section 409A.

III. Stock Rights Issued on or after January 1, 2005 and Continued Application of
Notice 2005-1, Q&A-4(d)(ii)

With respect to stock options granted on or after January 1, 2005 and before the
effective date of final regulations, Notice 2005-1, Q&A-4(d)(ii) remains applicable
guidance. Taxpayers may also rely on § 1.409A-1(b)(5)(i)(B) of the proposed
regulations during this period. With respect to stock appreciation rights issued on
or after January 1, 2005 and before the effective date of final regulations,
taxpayers may rely on § 1.409A-1(b)(5)(i)(B) of the proposed regulations. In
applying the provisions of the proposed regulations relating to stock appreciation
rights, and specifically § 1.409A-1(b)(5)(i)(B)(1) and (2), taxpayers may apply the
rule set forth in Notice 2005-1, Q&A-4(d)(ii) that, for purposes of determining the
fair market value of the stock at the date of grant, any reasonable valuation
method may be used. Accordingly, where a taxpayer can demonstrate that the
exercise price of a stock right, granted on or after January 1, 2005, and before
the effective date of final regulations, is intended to be not less than the fair
market value of the stock at the date of grant and that the value of such stock
was determined using a reasonable valuation method, then that valuation will

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meet the requirements of Notice 2005-1, Q&A-4(d)(ii) regardless of whether that
determination satisfies the valuation requirements in § 1.409A-1(b)(5)(i)(B) of the
proposed regulations.

# IV. Request for Additional Comments regarding Application of Final Regulations to Outstanding Stock Rights

Final regulations may establish more detailed standards for valuation in the
context of stock rights than those provided in this Notice and Notice 2005-1. The
Treasury Department and the IRS continue to request comments with respect to
the proposed regulations, and specifically how the standards proposed with
respect to the determination of the fair market value of stock subject to stock
rights may be improved both to meet commentators' requests for more certainty
with respect to the valuation requirement, and the legislative intent that only stock
rights with exercise prices that may not be lower than the fair market value of the
underlying stock on the date of grant be excluded from coverage under section
409A. See H.R. Conf. Rep. No. 108-755, at 735 (2004).

In addition, commentators have expressed concerns relating to the definition of
service recipient stock for purposes of the exclusions from coverage under
section 409A for certain stock rights, and the treatment of modifications,
extensions and renewals of otherwise excluded stock rights. The Treasury
Department and the IRS are considering comments on these issues, and invite
further comments with respect to the rules proposed under the proposed
regulations, as well as any additional transitional relief that may be appropriate in
conjunction with the implementation of the final regulations. For information
regarding the submission of comments, see the "Comments and Public Hearing"
section of the preamble to the proposed regulations.

# V. Drafting Information

The principal author of this guidance is Stephen Tackney of the Office of Division
Counsel/Associate Chief Counsel (Tax Exempt and Government Entities).
However, other personnel from the Treasury Department and the IRS
participated in its development. For further information regarding this notice,
contact Stephen Tackney at (202) 927-9639 (not a toll-free call).