Discounted Stock Options and Tax Code Section 409A: A Cautionary Tale

Caution tax code aheadGuest Post By Scott Usher of Bader Martin, P.S.

In the startup ecosphere, stock options are commonplace. They’re one way young companies can compensate for sweat equity and lower-than-market salaries or consulting fees, and generally provide recipients with a performance or retention incentive in the form of a stake in the company’s future.

The tax rules for most options are relatively straightforward. But when options are intentionally or unintentionally offered at a discount—meaning with an exercise price less than fair market value on the date the options are granted—it’s another story. And one that companies should consider carefully to avoid adverse tax consequences.

The Impact of Internal Revenue Code Section 409A

According to the IRS, discounted stock options fall under Section 409A of the federal tax code governing nonqualified deferred compensation plans—i.e., those nonqualified plans that provide for a deferral of compensation. Stock options with an exercise price that is equal to or above fair market value when granted are exempt from 409A.

409A was enacted in 2004 to ensure that recipients of discounted options and other forms of deferred compensation comply with strict guidelines regarding the timing of their deferrals. Otherwise, they must recognize the income when they have a legally binding right to receive it, even if they don’t actually receive it until sometime in the future. The fine print includes an exception for short-term deferrals where the compensation is actually received within two and a half months of the end of the year in which there is no longer a substantial risk of forfeiture. Such short-term deferrals are not subject to 409A.

For stock options that are subject to 409A, option recipients have limited flexibility in when they can exercise their options without violating the rules. The rules allow recipients to exercise options based on a limited number of triggering events, including retirement or other separation of service, a change in control of the business, disability, death, an unforeseen emergency or at a previously specified date or year.

For those who run afoul of 409A’s rules, the penalties are onerous. In general, the entire amount of compensation that has been deferred for the current and all previous tax years becomes taxable. That compensation is also subject to a 20 percent penalty, plus interest.

Many of the uncertainties in applying 409A have stemmed from the fact that the law doesn’t specifically define deferral of compensation. The IRS’s rules and pronouncements have consistently interpreted the phrase to include discounted stock options. However, those rules were not tested in the courts—until this year, when the U.S. Court of Federal Claims granted a partial summary judgment in Sutardja v United States. This ruling addresses various legal arguments with regard to the application of 409A, leaving the factual issue of whether the options were actually discounted to be determined at trial.

Consequences of the Sutardja Ruling

Sutardja is particularly significant because it is the first court ruling on the application of 409A to discounted stock options. As a result of Sutardja, we now have judicial affirmation of the following IRS positions:

  • Discounted stock options are subject to Section 409A treatment as nonqualified deferred compensation
  • The date an option is granted determines when compensation is considered to be earned.
  • The date an option vests, not the date it is exercised, determines when the recipient has a legally binding right to the compensation. The date it vests also establishes the time at which the option is no longer considered to have a substantial risk of forfeiture.
  • The relevant period for applying the short-term deferral exclusion is not based on the date the options are actually exercised, but rather based on the period of time the options can be exercised under the terms of the plan.

The Cautionary Part of the Tale

409A occupies some 80 pages of the federal tax regulations, which gives an indication of just how complicated it can be to either avoid it altogether or comply with its requirements. A few strategies can help.

To Discount or Not to Discount: Fair Market Value

409A hinges on whether or not a stock option is discounted. If an option’s exercise price is equal to the fair market value at the date the option is granted, the option is not discounted and 409A does not apply.If your company does not intend to discount the exercise price of its stock options, properly valuing them is central to avoiding the negative tax consequences of 409A. In the Sutardja case, the company intended to grant its stock options at fair market value. A combination of lack of oversight and poor execution led the company to grant those options at less than fair market value, which may cost the recipients of those options many millions of dollars.Establishing fair market value can be problematical for startups and other privately held companies. Perhaps the safest way—and generally the most expensive way—to determine fair market value is to hire a qualified independent appraiser to perform the valuation. The appraisal must be performed within 12 months of the option transaction to satisfy the first of three valuation safe harbor rules under 409A. Under the second safe harbor rule, startup companies can use someone other than an independent appraiser to perform the valuation, as long as the person has the requisite knowledge and experience and the valuation satisfies other criteria under 409A. The third safe harbor involves the use of a formula to determine the valuation, as prescribed under Section 83 of the federal tax code.Separate from the safe harbor approaches, companies are allowed to use a reasonable application of a reasonable valuation method based on specific factors identified in 409A. Unlike properly implemented safe harbor approaches, this valuation method is subject to challenge by the IRS, so it’s critical to develop and save detailed documentation of the method used in determining the valuation.

Properly Establishing the Grant Date

In the Sutardja case, the company’s compensation committee approved the option grant and established the options’ fair market value at on same date. But the committee did not formally ratify that grant until nearly a month later, when the fair market value was higher.The court determined that the date of ratification was the grant date, so the options were actually granted at a discounted price. By the time the company and recipient attempted to fix the error, it was too late as the options had been exercised.Because of the impact that the grant date—and other elements of the process— can have on determining fair market value and general compliance with 409A rules, companies must develop and follow well-thought-out procedures governing the issuance of stock options.

Remedial Actions

It’s always better to prevent compliance problems than to try and correct them later. But for those companies that find themselves out of compliance with 409A, the IRS has published guidance (in Notices 2008-113, 2010-6 and 2010-80) on certain allowed corrective actions.

Ultimately, whether the problem can be corrected—and, if so, how much relief is available—is as complex as the rest of 409A. It depends on a number of factors, including the nature of problem and the timing of the correction.

For stock options that were erroneously granted at less than fair market value, it may be possible to amend the option agreement to eliminate the discount. Generally, the exercise price can be increased to the fair market value (as of the grant date) in the year the options were granted. For option recipients who are not considered company insiders, that period is extended to include the following year. Under proposed regulations, it may also be possible to amend the option agreement prior to the year the options vest. Regardless, no corrective action is permitted for options that have been exercised.

409A is a particularly complex area of the federal tax code and, as Sutardja clearly demonstrates, the cost of noncompliance can be onerous. If you’re considering stock options or other alternative forms of compensation, get great advice.

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