Employers are generally aware that Section 409A of the Internal Revenue Code of 1986 (“Section 409A”) applies to deferred compensation but may not be aware that it can also apply to certain stock option programs, which could result in compliance problems. A non-qualified stock option[1] is not treated as deferred compensation under Section 409A if three conditions are met:

  1. The exercise price can never be less than the fair market value of the underlying stock on the date of grant and the number of shares subject to the option is fixed on the grant date;
  2. The exercise of the option is taxable under Code Section 83; and
  3. The option does not include any feature allowing the grantee to defer compensation, other than the deferral of income until the later of (a) the exercise of the option; or (b) the date the stock acquired through exercise of the option becomes vested.

A “discounted” stock option is an option with an exercise price that is less than fair market value. A discounted option can be created:

  • At the grant date; or
  • At a later date, if the option term is extended when the exercise price is less than the fair market value of the underlying stock.

In either of these events, the option would be treated as deferred compensation under Section 409A. To comply with Section 409A, the option could only be exercised on one or more of the Section 409A triggering events:

  1. Separation from service;
  2. Death;
  3. Disability;
  4. Financial hardship;
  5. On a specified date; or
  6. Upon a change in control.

Further, the exercise date and applicable triggering event must be specified at the date of grant or extension to comply with Section 409A’s deferral election rules.

The Section 409A restrictions on the ability to exercise an option differ from normal option exercise rules, under which the grantee can exercise at his/her choice once the option is vested and before it expires.

Under certain circumstances, there are legitimate business reasons why an employer would want to adopt a discounted stock option program even though doing so brings Section 409A into play. For example, if a privately-held company believes that the only time an employee will want to exercise an option is upon a sale of the company, then the company could issue the option with a discounted exercise price and provide that the only time the option could be exercised is in connection with a change in control. In this event, care should be taken to ensure that the definition of “change in control” is Section 409A-compliant.