On February 8, 2007, the IRS announced a compliance resolution program (IRS Announcement 2007-18) permitting employers to pay the additional taxes arising under Section 409A of the Internal Revenue Code on behalf of rank-and-file employees who exercised discounted stock options and stock appreciation rights during 2006. While it is not clear how beneficial this Program will be to employers, it is important for employers to carefully review the terms of the Program. As discussed below, employers that wish to participate in the Program must notify the IRS by February 28, 2007.
Section 409A requires nonqualified deferred compensation plans to comply with various election and distribution rules. Failure to comply with Section 409A results in amounts deferred becoming currently includible in an employee’s income (to the extent not subject to a substantial risk of forfeiture and not previously included in gross income) as well as imposing an additional 20% penalty tax and interest charge on the employee.
Discounted stock rights – stock options and stock appreciation rights that were granted with an exercise price less than the fair market value of the underlying stock on the date of grant and not vested as of December 31, 2004 – constitute deferred compensation subject to Section 409A. Unless the discounted stock rights had a fixed exercise date or were exercised in good faith compliance with Section 409A, employees who exercised discounted stock rights in 2006 could be subject to the additional Section 409A taxes.
The IRS Program
The Program is designed to permit employers to pay the Section 409A tax and interest charge on behalf of non-executive employees who exercised discounted stock rights during 2006. Employees who are or were subject to the disclosure requirements of Section 16(a) of the Securities Exchange Act of 1934 (whether at the date the stock rights were granted or the date when the employer provides notice to the IRS of its intent to participate in the Program) are not eligible for this relief.
In order to participate in the Program, the employer must take the following actions:
- Not later than February 28, 2007, the employer must submit to the IRS a notice of its intent to participate in the Program. The notice must include a specific statement of intent (contained in the Announcement) and be executed under penalties of perjury.
- Not later than 15 days after the employer submits its initial notice to participate to the IRS, the employer must provide a notice to each employee that the employer reasonably anticipates may be affected by the employer's participation in the Program.
- Not later than 15 days after the employer submits its initial notice to participate to the IRS, the employer must provide a second notice to the IRS, stating the number of employees to whom the employee notice was provided.
- By June 30, 2007, the employer must make a further submission of information to the IRS, including full payment of all Section 409A taxes. The further submission must include detailed information about the affected employees (name and taxpayer ID number), the identification of each discounted stock right, including the date of exercise, the exercise price, the fair market value of the underlying stock on the date of exercise, and the specifics on how the Section 409A taxes were calculated. The Program describes how to calculate the Section 409A taxes, including the amount of the interest owed.
- Not later than July 15, 2007, the employer must provide a second notice to affected employees informing them that the employer has made the further submission and has paid all Section 409A taxes (or the employer has not made the further submission and the employees are responsible for paying the Section 409A taxes). The employer retains the right to withdraw its notice of intent to participate in the Program or modify a further submission on or before June 30, 2007.
Tax Effects to Employees
Employees of participating employers will not be required to pay the Section 409A taxes arising from their 2006 exercise of discounted stock rights. However, the employer's payment of the Section 409A taxes under the Program will constitute additional compensation income to the employees in 2007 and must be reported as such. These payments also will constitute wages for purposes of FICA, FUTA and federal income tax withholding. Employers should consider whether to provide additional "gross-up" payments to affected employees.
Relief for Employers
Employers participating in the Program will not be required to report the Section 409A violation in Box 12 on the employees' Forms W-2 for 2006. If the employer previously provided Forms W-2 containing this information, it may provide Forms W-2c that did not report the Section 409A amounts.
The Program offers limited relief for those employers attempting to alleviate the consequences of discounted stock rights for non-executive employees. It shifts the compliance burden onto the employer and permits employers to pay the Section 409A taxes for 2006 on a group-wide basis rather than individually to each employee.
From a tax perspective, however, the Program does not reduce or abate the amount of the Section 409A taxes. It does not address any potential issues relating to non-Section 409A tax issues, such as ISO compliance or Section 162(m) deductibility, and does not relieve employers from state or local tax reporting or payment requirements. Furthermore, employers wishing to pay the Section 409A taxes on behalf of Section 16 persons cannot rely on the relief afforded by the Program.