If your company is transferring employees to the U.S., be sure to review any outstanding equity grants and other awards of compensation (such as deferred bonuses) that they previously received under home country compensation plans that vest and are payable after they arrive in the U.S. In many cases, a company must amend the terms of such awards to comply with the Internal Revenue Code’s deferred compensation rules (Internal Revenue Code Section 409A) no later than the last day of the first year in which the transferred employees become U.S. tax residents. Failing to do so could result in a big tax bill for these employees down the road, which companies often end up paying, as well as a tax gross-up.
Enacted in 2004 in the wake of the Enron scandal and generally effective January 1, 2005, Section 409A of the Internal Revenue Code imposes complex and burdensome requirements on deferrals and distributions of amounts considered “deferred compensation.” Unfortunately, under Section 409A’s very broad definition of “deferred compensation,” a surprising array of compensation is or has the potential to constitute deferred compensation. Stock options, restricted stock units, phantom stock, severance pay, and bonuses are all potentially subject to Section 409A. If they are, payments in settlement of these awards are limited to certain “permissible distribution” events, such as termination of employment, a specified date, a change of control or death. An IPO is usually not a permissible Section 409A distribution event for compensation that vests prior to the IPO.
Failure to comply with Section 409A can result in the affected employees being heavily penalized: an award will be includible in income upon vesting (even if the applicable plan or award agreement specifies a later payment date), the affected employees will owe a 20% additional tax, and in some cases, “premium interest” at the federal underpayment rate plus 1%. It can be hideous.
Section 409A can a huge unwelcome surprise, particularly for companies located outside the U.S. that are assigning employees to the U.S. from abroad for the first time. If an employee has brought with him or her outstanding, unvested options or other unvested awards that will vest after the employee becomes a U.S. tax resident, these awards should be reviewed to determine if they comply with Section 409A or if an exception applies. The exceptions to the application of Section 409A to a compensation arrangement generally relate to compensation arrangements covered by a tax treaty and broad-based retirement arrangements. Equity awards generally do not fall within an exception (but like anything in tax, it’s difficult to make generalizations).
As noted above, the deadline for amending the awards to comply with Section 409A is last day of the year in which the employee becomes a resident alien for U.S. tax purposes.
Just what you need for the holidays!