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Understanding IRC 409(a)

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To continue our series on equity compensation, this week we will look at Internal Revenue Code Section 409(a).  IRC 409(a) which has been in existence for the last 10 years or so recently added a new and potentially expensive wrinkle to those who hold non-qualified options (NSO’s).  In a nutshell, the IRS is looking to limit NSO’s granted with an exercise price lower than the fair market value on the date of grant (discounted options). The application is very tricky in privately held companies because the “fair market value” of the options is often not easy to define.

In our last post we touched on the concept of an “ascertainable” FMV which can trigger taxes and penalties if the exercise price is lower on date of grant to the recipient.   For example, if the fair market value is $5 per share on grant date and the exercise price is $3 per share you have an issue.

Recently, a Bloomberg tax arm, BNA, covered this is detail. We’ve included the highlights below:


Section 409A was enacted in 2004 as part of the American Jobs Creation Act. Section 409A applies to “non-qualified deferred compensation,”which is broadly defined to potentially cover many types of compensation arrangements, including discounted stock options (i.e., an option granted with an exercise price less than fair market value on the grant date). Prior to the issuance of regulations under Section 409A, the IRS issued Notice 2005-1, which stated that if a stock option is granted with an exercise price of less than the fair market value of the company’s stock on the grant date, the option is “deferred compensation” and subject to Section 409A. Importantly, this same rule regarding the scope of Section 409A was confirmed by its inclusion in Section 1.409A-1(b)(5) of the final regulations.

In addition, Notice 2005-1 provided that taxpayers should apply a “good-faith,”reasonable interpretation of the statute and the notice during the transition period, pending the issuance of further guidance. Even under this seemingly more flexible compliance standard, Sutardja confirms that not even discounted stock options granted prior to the enactment of the statute are immune from the adverse tax consequences associated with a violation of Section 409A.

Section 409A Rules

Deferred compensation under Section 409A is defined to include, unless an exception applies, any right to a payment in a future tax year. Typically, a non-qualified stock option is structured to be exercised during its term at any time after vesting, and upon exercise, the option holder recognizes income equal to the difference between the exercise price and the fair market value of the underlying stock on the exercise date. Due to this ability to exercise in more than one year, a stock option that is subject to Section 409A generally will not be compliant.

If the requirements of Section 409A are violated, all amounts deferred by the participant under that type of plan (e.g., all nonexempt stock options and stock appreciation rights) are taxed immediately or upon the lapse of a substantial risk of forfeiture (i.e., vesting), if later. In addition to immediate taxation, Section 409A imposes a 20 percent additional tax on the amount of compensation that is required to be included in income, plus interest at the IRS underpayment rate plus one percent (hereinafter the Adverse Tax Consequences).

Fortunately, Section 409A specifically provides an exception from its definition of deferred compensation for stock options that meet certain requirements. Essentially, the grant of a non-statutory stock option (also known as a non-qualified stock option) is exempt from Section 409A if, among other requirements, the exercise price may never be less than the fair market value of the underlying stock on the grant date. To establish a Section 409A-compliant exercise price, a company must properly (1) identify the grant date of the option, and (2) establish the fair market value of the underlying stock on that date.

Recent Development: Sutardja v. United States confirming NSO’s are subject to the rules of 409(a).

 Important Considerations:

Going forward, based on this added pressure to make grants at fair market value, employers should carefully document the process for determining the fair market value of their stock and related option exercise prices in accordance with the final regulations under Section 409A, and establish and consistently follow stock option grant procedures to avoid any potential disputes in the future.


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Any tax advice contained in this message is subject to the following limitations: Nothing herein is intended to convey an expression of an opinion as to the likelihood a tax position would ultimately prevail if challenged by the IRS. This advice was not written nor can it be used by the person to whom it is addressed (or anyone else) for protection from penalties that might be imposed by the IRS. This advice is intended solely for the person to whom it is addressed; no one else should rely on the tax advice provided herein. The person to whom this advice is addressed is under no obligation to keep the advice or matters related to the advice confidential.