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Nearly two years after taking effect, a sweeping tax code regulating many deferred compensation plans favored by private companies has confused attorneys and increased legal costs for mergers and acquisitions work. Both tax and corporate attorneys say the law is strewn with pitfalls and complexities that hinder corporate dealmaking and expose executives to expensive penalties. 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 December 31, but lawyers are concerned about delays in the release of final regulations. The American Bar Association Section of Taxation, acting on its own, asked Congress for hearings and reconsideration of the law. In a July 31 letter to members of the House Committee on Ways and Means and the Senate Finance Committee, the ABA Taxation Section said the Internal Revenue Service 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, who leads Pillsbury Winthrop Shaw Pittman’s executive compensation and benefits practice and also is chair-elect of the taxation section, coauthored the letter. She says that the committee rarely requests hearings or reconsideration of a law, but 409A went too far. “We’re trying to say that because of the way [this law] was drafted, it should be rethought and potentially rewritten, or at least more generous transition rules should be applied,” she says. The taxation section said that the 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 law far outweighs the benefit of curbing abuses at a small number of failing companies. Since deferred compensation rules did not previously apply to many equity-based compensation plans, private companies are scrambling, says Greenberg Traurig shareholder Tim Jessell. 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 to value their stock options and asking lawyers to review the results. The outside experts may 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 says he’s currently involved in negotiating a $50 million deal involving two private companies where 50 percent 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 time for lawyers on both sides. Restrictions on amending and terminating compensation plans add a cautionary note to corporate deals, says Pillsbury Winthrop’s Serota. “It’s almost ‘buyer beware,’ ” she says. “ There’s limited ability on the part of buyers to terminate plans after a change in control.” A version of this article first appeared in The National Law Journal, a sibling publication of Corporate Counsel.

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