In this recently reported case, one Dr. Sutardja, a recipient of an allegedly discounted option, sued to recover 409A taxes imposed by the IRS. The case does not decide whether the option was discounted, but Dr. Sutardja argued that his option, even if discounted, shouldn’t be subject to 409A.
Essentially, he tried to argue that (1) the grant of the discounted option is not a taxable event, (2) stock options aren’t “deferred compensation,” (3) he didn’t have a legally binding right until he exercised the option, or (4) 409A couldn’t apply to the discounted option. Those familiar with 409A will sigh upon reading the list since clearly none of these arguments holds any water. Discounted options are subject to 409A and must have fixed dates for exercise and payment.
The interesting part of the case, though, was the government arguing that Dr. Sutardja did not have a legally binding right to the supposedly discounted option until it vested. This is an interesting argument for the government to make because the 409A regulations themselves say:
A service provider does not have a legally binding right to compensation to the extent that compensation may be reduced unilaterally or eliminated by the service recipient or other person after the services creating the right to the compensation have been performed. … For this purpose, compensation is not considered subject to unilateral reduction or elimination merely because it may be reduced or eliminated by operation of the objective terms of the plan, such as the application of a nondiscretionary, objective provision creating a substantial risk of forfeiture. 26 C.F.R. 1.409A-(b)(1)
Generally speaking, before an option vests, it is subject to a substantial risk of forfeiture. This means the opportunity to buy stock could be lost if the recipient leaves employment or service with the granting company before it vests. Applying that analysis to the above language, the legally binding right to an option is created when it’s granted, not when it vests.
In the end, the argument doesn’t amount to much because any portion of the option that vested after December 31, 2004 is still subject to 409A and its stringent taxes. However, the case is interesting in that it shows that the IRS has begun enforcing 409A. It will also be interesting to see if the government’s argument in this case is used against it in future cases.