If your company has been cavalier about Internal Revenue Code Section 409A, you should reconsider. In a recent opinion by the United States Court of Federal Claims, the IRS scored the first points – more than $5 million of them – in a high stakes game of 409A "gotcha." In this case, Sutardja v. United States, the IRS demonstrates it is willing to pursue what appears to be even innocent, hyper-technical 409A failures.
Dr. Sehat Sutardja was the president, CEO and chairman of the board of directors of a publicly traded corporation. On December 26, 2003, the compensation committee approved a grant to Dr. Sutardja of an option to purchase 1.5 million shares, with an exercise price of $36.50 per share: the closing price for that day. The approval was ratified on January 16, 2004. By then, the stock price had increased to $43.64 per share, but the exercise price remained at $36.50. Dr. Sutardja exercised portions of the option prior to 2006, and again exercised in 2006.
Later that year, in May 2006, the board reviewed the company's option practices and concluded the appropriate grant date should have been January 16, 2004. Accordingly, the exercise price should have been based on the higher $43.64 per share instead of $36.50. To make up the difference, Dr. Sutardja paid $5.3 million as an additional exercise price. Thus, in operation, it appears Dr. Sutardja's exercise price was no less than the fair market value of the underlying shares on the date of grant (either $36.50 on December 26, 2003 or $43.64 on January 16, 2004).
The IRS asserted that the exercise price was less than the fair market value of the stock on the date of grant. To the IRS, this meant the option was a discounted stock option that failed to comply with 409A. Presumably, the position of the IRS was that the option failed to comply in form with the exception under 409A for non-discounted stock options, even though the option complied, albeit belatedly, in actual operation.
The IRS issued a notice of deficiency demanding additional taxes equal to 20 percent of the option spread Dr. Sutardja realized on exercise, as well as an additional interest penalty, both of which were due for the purported failure to comply with 409A. The total amount of taxes that Dr. Sutardja allegedly owes is $5,282,125, plus interest.
Dr. Sutardja argued that his option was not subject to 409A, even if the exercise price were discounted. The Court of Federal Claims disagreed, and set the case for trial on the factual issue of whether the exercise price equaled fair market value on the date of grant.
On its surface, the opinion demonstrates that companies should monitor their option grant practices carefully to ensure that each option's exercise price is based on the appropriate date of grant, given applicable principles of contract and corporate law. Reading between the lines, it shows the IRS may pursue hyper-technical 409A violations in court. Companies should review their equity-based and deferred compensation arrangements for any hidden "gotchas," and correct them with any available 409A correction program. Finally, deferred compensation and other 409A consultants should ensure that their malpractice insurance covers 409A penalties.
For more information about 409A, feel free to contact the author or any member of the Labor, Employment and Employee Benefits practice.