Congress enacted Section 409A of the Internal Revenue Code in 2004. Given the statute’s complexity, the expense associated with compliance and its iron-fisted results, I’ve been amazed that there hasn’t been a greater clamor for its repeal.

Just how harsh Section 409A can be is illustrated by the case of Dr. Sutardja and Weili Dai, Sudartja v. U.S., 109 Fed. Cl. 358 (2013). In 2006, these two joint filers, received a notice from the Internal Revenue Service claiming that they owed an additional tax of over $3 million under Section 409A as a result of stock options granted to them by their employer. After paying that tax, they received another notice demanding an interest payment of over $700,000.

The taxpayers duly paid the amounts claimed by the IRS and then filed a complaint for a refund in the U.S. Court of Federal Claims. Thereafter, they moved for summary judgment, arguing among other things that even if Dr. Sutardja had received a discounted stock option, Section 409A did not apply because the plaintiffs had no “legally binding right” to compensation until the option was exercised. Although the case ultimately involved federal tax law, the court looked to California law to determine the plaintiffs’ rights. Thus, the question became whether under California law the plaintiffs had a legally binding right to purchase shares.

While the plaintiffs may not have had a legally binding on grant, what about vesting? The plaintiffs cited Barton v. Elexsys Int’l, Inc., 62 Cal. App. 4th 1182 (1998) for the proposition that a “mere right of election” does not establish a legally binding right to compensation. Judge Thomas C. Wheeler found, however, that options create legally binding rights “as once a condition precedent has been satisfied, a failure to deliver stocks upon demand ‘constitute[s] a breach of [a] contractual obligation”. Id. at *367 citing Robinson v. Raquet, 36 P.2d 821, 825 (Cal. Ct. App. 1934). Having established that California law established that vested options give the optionee a legally binding right to exercise, the court then concluded (applying tax law) that the right to purchase constitutes a legally binding right to compensation.

For those not familiar with the Court of Federal Claims (fka U.S. Claims Court), it was created in 1982 when Congress abolished the Court of Claims. Federal Courts Improvement Act of 1982 (96 Stat. 25). The court was established under Article I (not III) of the U.S. Constitution. Judges on the court serve for 15 year terms.