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Nearly two years after taking effect, a sweeping tax code regulating many deferred-compensation plans favored by private companies-including stock options-has confused attorneys and increased legal costs for mergers-and-acquisitions work. Both tax and corporate attorneys add that the new law is strewn with pitfalls and complexities that hinder corporate deal-making and expose executives to many costly and unnecessary penalties. But the news isn’t all bad. The new code is a cash cow for corporate law firms coordinating merger-and-acquisition deals, which often bestow on executives deferred compensation such as stock-options cashouts. The regulations took effect in January 2005. Section 409A of the Internal Revenue Code regulates various types of deferred-compensation arrangements allowed under the tax laws. While the plans can be offered to anyone, corporate executives generally receive a wider array of deferred compensation than the average worker. The law-which is widely viewed as a congressional reaction to executive cashouts at Enron Corp. before the company’s collapse-has been marred by incomplete proposed regulations and sparse governmental guidance since it went into effect as part of the American Job Creation Act of 2004. All companies must comply by Dec. 31. Lawyers are concerned about delays in the release of final regulations. The American Bar Association (ABA) Section of Taxation-acting on its own and not on behalf of the entire bar association-asked Congress for a reconsideration of the law and for hearings. Law ‘went too far’ In a July 31 letter to four key members of the House Committee on Ways and Means and the Senate Finance Committee, the ABA Taxation Section said the Internal Revenue Service (IRS) and the U.S. Department of the Treasury “have yet to publish guidelines on a number of critical subjects, including the section 409A penalty regime, the application to partnerships, and the reporting and withholding requirements.” Susan Serota, a New York-based lawyer who leads Pillsbury Winthrop Shaw Pittman’s executive compensation and benefits practice, co-authored the letter in her role as chair-elect of the taxation section. Serota said that the committee rarely requests hearings or reconsideration of a law, but 409A “went too far.” “We’re trying to say this was a law passed in light of some abuses and perceived abuses, [yet] because of the way it was drafted, it should be rethought and potentially rewritten or at least more generous transition rules should be applied,” Serota said. The ABA Taxation Section said that the far-reaching law requires companies to rewrite and often renegotiate “countless” compensation plans and agreements to avoid overly stringent penalties for employees. The group also said that the cost of complying with the extensive law far outweighs the benefit of curbing abuses at a small number of failing companies where executives might cash in their deferred-compensation plans and leave little or no assets for workers’ plans. While tax lawyers tangle with Congress, corporate lawyers are simultaneously dodging tax traps and capitalizing on the flow of 409A-related work attached to merger-and-acquisition deals, particularly those involving private companies. Since deferred-compensation rules did not previously apply to many equity-based compensation plans, private companies are scrambling, said Greenberg Traurig shareholder Tim Jessell, a corporate lawyer in the firm’s Tysons Corner, Va., office. Private company stock-option plans are exempt from 409A rules if their exercise price is at “fair market value,” so many private companies are calling in appraisers and investment banks to value their stock options, and asking lawyers to review the results. The outside experts can also help companies decide whether a new stock-option exercise price is necessary. Stock options are also typically a much higher proportion of equity at private companies, which widens the scope of 409A compliance that must occur before a merger. Jessell said that he’s currently involved in negotiating a $50 million deal involving two private companies where 50% of the value of the target company is tied up in stock options to executives and management. Since a sizable portion of the purchase price will go toward paying the executives for options, 409A issues are eating up significant time for lawyers on both sides, he said. Private company deals often involve key employees that the buying company wants to reward with stock-option incentives to stay with the new entity, said Nixon Peabody’s Jonathan Karis, a Boston lawyer who chairs the firm’s business practice group. “So, [409A] added a layer of complication and expense in the negotiation of private company mergers and acquisitions,” Karis said. Deals are much more complex and irksome, particularly on the buyer side, said Gary Quintiere, a tax and employee benefits lawyer at Washington-based Miller & Chevalier. “It’s virtually ubiquitous, you bump into it everywhere you turn,” Quintiere said. Companies involved in mergers are undertaking “line by line” review of all kinds of contracts with employees, including employment agreements, severance agreements and executive retirement plans, to avoid 409A tangles, Quintiere said. McDermott, Will & Emery corporate dealmaker John Hession said that some buyers are demanding a lower purchase price to compensate for 409A problems. What’s more, mistakes that trigger penalty taxes for employees can alienate executives from the target company that the purchasing company wants to court. Nonqualified deferred compensation that violates 409A triggers a 20% penalty tax plus interest and regular tax that kicks in when deferred compensation is vested-regardless of when the executive is paid. If an acquiring company doesn’t fix a 409A violation before the deal is closed, an executive could be subject to such a penalty tax. The executive may also claim that the penalty breaches his or her contract and demand that the acquiring company absorb the cost of the penalty. “If the executive is becoming a buyer’s employee and they’re having a problem, then the buyer has a problem,” said Hession, who practices in Boston. Corporate and tax lawyers say companies, particularly smaller, privately held entities, are often unaware that severance agreements and employment agreements are considered nonqualified deferred compensation. Restrictions on amending and terminating compensation plans adds a cautionary note to corporate deals, added Pillsbury Winthrop’s Serota. “It’s almost ‘buyer beware,’ ” Serota said. “ There’s limited ability on part of buyers to terminate plans after a change in control.” A taxing controversy When deferred compensation became a political football after Enron collapsed, the Senate Committee on Finance commissioned the Joint Committee on Taxation to investigate and report on tax and compensation issues at Enron Corp. Following the 2003 report, the Treasury Department sought input into the process, but Congress rebuffed those requests and instead “create[d] a federal regulatory system that is largely unnecessary,” wrote Serota in the July 31 ABA letter. Instead of a new law, the taxation section favors rescinding a congressional moratorium on new Treasury Department guidance on deferred compensation that dates back to 1978. Serota’s committee believes that Treasury Department guidance would gradually generate proposals when new regulations are necessary. “The problems that have surfaced since 1978 could adequately have been addressed by the publication of timely administrative guidance,” Serota wrote. The result is that 409A layers new regulations on top of existing rules that determine when deferred compensation becomes taxable income, Serota said. “It will impose enormous administrative burdens on taxpayers, their advisers, employers and others, as well as on the IRS and Treasury, and is not a measured response to the underlying problems,” wrote Serota. Although 409A addresses Enron-style executive-compensation abuses, it applies to all deferred-compensation plans, including retirement plans for low-level workers, small-company employees, nonprofit employees and U.S.-company employees working abroad, Serota said. Corporate attorneys are worried because private companies that drive the economy, and need legal work as they grow, are harmed by Section 409A. Nixon Peabody’s Karis said that many growing private companies rely on deferred compensation to attract key employees. “It makes it difficult for privately held, usually tech-based, usually venture-backed companies to attract and retain high-quality individuals and ultimately sell themselves in the market,” Karis said. “The laws and regulations hurt the people you want to hurt the least.” The result is a broad law where a narrower regulatory tweaking may have been enough to curb abuses, said McDermott, Will & Emery’s Andrew Liazos, who practices in the firm’s employee benefits and executive compensation group in Boston. “It would have made a certain amount of sense to give the regulators an opportunity to update the regulations as opposed to having Congress come in and change rules of game completely,” Liazos said. The provision was enacted without a hearing “like so many others in recent years,” so its not surprising that technical problems have surfaced, said Matthew Beck, a spokesman for Democrats on the House Ways and Means Committee. “However, these technical problems shouldn’t be used as an excuse to prevent efforts to level the playing field between pensions given to executives and those of rank-and-file workers,” Beck said. The other congressmen named on the letter did not respond to requests for comment. Through a spokesman, the Treasury Department deflected questions about its position. “Treasury and the IRS are working within the parameters of the regulatory and rule-making process to ensure companies will have the guidance they need to comply with the new 409A rules as effectively and efficiently as possible,” said Sean Kevelighan in a statement.

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