Code Section 409A which was effective in January 1, 2005, provides strict rules that must be applied to most deferred compensation arrangements accruing benefits after the effective date. Failure to comply with the Code and the applicable Treasury Regulations can result in a 20% surtax plus interest on the amounts received under non-compliant deferred compensation arrangements.

The Internal Revenue Service has begun to enforce the Section 409A Rules in examination of employers sponsoring these arrangements. In a recent court case Sutardja v. United States, (Federal Claims No. 11-724T 227-13), the Plaintiff, Dr. Sutardja appealed an IRS assessment of the 20% Section 409A surtax in the amount of $3,172,832 plus another $304,456 in interest in a refund claim filed with the Federal Court of Claims. The assessment resulted from the exercise of a stock option which was found by the IRS to have been issued at a discount below the fair market value on the date of grant. Under the Treasury Regulations, discounted stock options are subject to Code Section 409A and must have fixed dates for exercise and payment and may not contain any discretionary provisions for the time or form of payment.

The Plaintiff contested the application of Section 409A to stock options claiming that as an equity award it was exempt. However, the Court gave deference to an IRS Notice which was issued in 2005 that stated that discounted stock options were to be considered deferred compensation. The Plaintiff argued that because the grant of a stock option was excluded from the definition of “Income” under the FICA Final Regulations, those regulations should also have been applied. However, the Court disagreed as the FICA Regulation was intended to match the FICA taxation with the income tax recognition timing rules under Code Section 83.

Dr. Sutardja argued to the Court that he did not have a legally binding right to the compensation until exercised so there would be no deferral. However, relying on Commissioner v. Smith, (324 U.S. 182) the Court of Claims followed the U.S. Supreme Court which held that the grant of an employee stock option was compensation but the gain was not measured until the option is exercised.

The Court ruled against the Plaintiff’s motion for partial summary judgment but granted the Government’s motion of partial summary judgment. The case was then remanded to trial to determine whether the stock options were in fact granted at a discounted price below fair market value, which is a question of fact.

The 409A regulations have a series of safe harbor methods for non-publicly traded companies to determine “fair market value” of shares subject to options. We encourage employers to use one or more of the regulatory safe harbor methods to avoid disputes with the IRS over the application of Section 409A to employee stock options.