My colleague Jeff Cairns blogged about a recent court case confirming the IRS’s position that discounted stock options can be considered noncompliant nonqualified deferred compensation arrangements under Section 409A of the Internal Revenue Code. Unless structured to be exercised only on a fixed date or an allowable 409A event, discounted stock options will result in adverse tax consequences to the employee who receives the options. As Jeff noted in his blog, privately held companies would be well advised to use the safe harbor valuation methods available under the 409A regulations to avoid being viewed as having issued discounted options.
I also found the case interesting because of the time periods involved and the role of the taxpayers in the stock issuance. The case involved actions taken during the 409A transition period, the period of time between January 1, 2005, when the statute became effective, and January 1, 2008, when final regulations became effective. During that transition period, employers and employees had a certain amount of leeway to fix arrangements that had not violated tax laws at inception but now were caught by the broad sweep of Section 409A.
The stock options in the court case had been granted in 2003 (before section 409A had even been passed) at an exercise price that was supposed to have been equal to the fair market value of the stock, and were exercised in January of 2006, just over a year after the statute was effective. The investigation of the corporate stock granting practices was not begun until May of 2006, after the options had been exercised. Some time thereafter the corporation concluded that it had mispriced the options and taxpayers paid an additional amount representing the increased exercise price required so that the option exercise price was the fair market value of the stock on the date the option was granted. Although the taxpayers (husband and wife) were two of the three cofounders of the corporation and the husband had been the president, chief executive officer and chairman of the board of the corporation, it was the executive compensation committee of the board that determined the stock option awards. The committee was comprised solely of independent directors and neither of the taxpayers was a member of the committee. While it is certainly possible that the taxpayers were complicit in the issuance of options that may have been discounted, the process did not directly implicate the taxpayers in the improper grant. Thus, in this situation, despite a relatively new statute, and an option that purportedly was issued at fair market value, the taxpayers will bear the burden if the option was improperly granted.
As Jeff mentioned in his blog, the court has not yet determined whether the options were in fact discounted so the taxpayers may yet win on that point. However, in the meantime, the IRS has won a clear victory that discounted options are subject to Section 409A and executives are on notice that they can be the ones who suffer even if they are not the ones who set the discounted price for the options.