Sutardja v. The United States: The Federal Claims Court Applies Code Section 409A to Discontinued Stock Options

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Author, Donna Edwards, Atlanta, +1 404 572 2701, dedwards@kslaw.com

Earlier this year, the U.S. Court of Federal Claims addressed the application of Section 409A of the Internal Revenue Code ("409A") to discounted stock options in Sutardja v. The United States.1 As expected, the court concluded that discounted stock options are a type of deferred compensation to which 409A applies. This case illustrates the importance of carefully structuring the grant of employee stock options to avoid adverse tax consequences under 409A.

If the requirements of 409A are violated with respect to deferred compensation payable to an employee, the amount of the vested deferred compensation is taxed immediately to the employee and is subject to a 20 percent additional tax plus interest. In addition, the employer is subject to income and employment tax reporting and withholding requirements on the deferred compensation.

Background

The Sutardja case arose in connection with Dr. Sutardja's exercise in 2006 of stock options granted by his company. The IRS contended that Dr. Sutardja was subject to additional taxes under 409A as a result of the exercise, but Dr. Sutardja argued that 409A was inapplicable to the exercise of his options for several reasons,2 including that (1) he did not have a "legally binding right" to the shares until exercise of the options and (2) any deferral of compensation attributable to the options was exempted from section 409A taxation under the short-term deferral exception set forth in IRS Notice 2005-1.3

The parties agreed that, if the stock option price was set at or above the fair market value of the underlying stock at grant, 409A would be inapplicable. The parties disagreed, however, as to whether 409A applies to the grant of a stock option with an option price below fair market value at grant - a so-called "discounted option."

Legally Binding Right

Dr. Sutardja argued that even if the stock option grant was discounted, 409A does not apply because he did not have a "legally binding right" to compensation until exercise of the option, and thus no compensation was deferred to a later year. Dr. Sutardja cited California law for the proposition that he had no legally binding right to the stock until exercise of the option.

The IRS, on the other hand, argued that the stock option itself was the compensation, and that Dr. Sutardja had a legally binding right to the compensation upon vesting. Thus, the IRS argued, if granted at a discount, the option constituted deferred compensation from the date of vesting. The court agreed with the IRS and found that the grant itself constituted compensation, and once it vested, the employee had a legally binding right to purchase shares at a designated price.

It is interesting that the IRS and the court identified the vesting date, as opposed to the grant date, as the date the legally binding right to the stock option compensation arose for purposes of 409A. Based on the final 409A Treasury Regulations, we suspect that the IRS today (as well as most practitioners) would argue that the legally binding right to stock options arises on the date the options are granted (even if the options are not vested at grant).

Short-term Deferral Exception

Dr. Sutardja also argued that even if the stock option was granted at a discount and subject to 409A, any deferral of income would be exempted as a short-term deferral under Notice 2005-1.

The short-term deferral exception generally applies to compensation that is paid to an employee within 2½ months after the end of the year in which the compensation is no longer subject to a "substantial risk of forfeiture." Under Notice 2005-1 (as well as the final 409A Treasury Regulations), an amount is generally not considered subject to a substantial risk of forfeiture beyond the date at which the employee otherwise could have elected to receive the amount of compensation.

The court noted that Dr. Sutardja under his stock option agreements could have elected to receive his compensation through a purchase of shares once the option (or portions thereof) vested and thus, under Notice 2005-1, the vested portions of the options were not subject to a substantial risk of forfeiture. The court reasoned that even assuming Dr. Sutardja exercised his options within the 2½ month period after the year in which the options vested, there were no terms within the stock agreements themselves that required him to actually or constructively receive his compensation within this period - in fact, his option agreements allowed for an option term of up to ten years. Thus, the court found that Dr. Sutardja's option agreements failed on their face to satisfy the requirements of a short-term deferral exception.

Although the court ruled in favor of the IRS on these issues, the outcome of the case will ultimately turn on subsequent proceedings to determine whether the stock options were in fact granted to Dr. Sutardja with a discounted option price.

Recommendations

Stock options granted with an option price equal to or greater than the fair market value of the underlying stock on the grant date are exempt from 409A. In light of the IRS's willingness to pursue recovery for 409A violations in the context discounted stock options, we recommend that our clients review their stock option granting practices to ensure that all stock options are either granted with an option price equal to or greater than the fair market value of the underlying stock on the grant date or, if granted at a discount, are structured to comply with 409A.

111 Fed. Cl., No 724T (Feb. 27, 2013).
2Dr. Sutardja also argued, unsuccessfully, that 409A was inapplicable to the exercise of his options because (1) the grant of an employee stock option is not a taxable event and (2) the Treasury Regulations governing the Federal Insurance Contributions Act ("FICA") exclude stock options from treatment as deferred compensation..
3The final 409A Treasury Regulations set forth a substantially similar short-term deferral exception, but because the options at issue in this case were exercised before the effective date of the final 409A Treasury Regulations, the court and parties looked to IRS Notice 2005-1 for guidance.