The United States Court of Federal Claims recently issued an opinion confirming that § 409A of the Internal Revenue Code of 1986, as amended (“Code § 409A”), applies in the context of discount stock options.1 The case, Sutardja v. United States, is one of the first cases to interpret the complex Code § 409A regulations, and involved a potential tax penalty in excess of $5 million. Although certain aspects of the case remain to be litigated, the ruling puts employers and employees on notice that the IRS is willing to aggressively pursue recovery for what it views as Code § 409A violations and that companies must be diligent in their grant award procedures in order to avoid potential 409A issues.

Background of Code § 409A

Code § 409A, which became effective January 1, 2005, imposes a comprehensive set of deferral and payment rules relating to the taxation of nonqualified deferred compensation. The provision was enacted to impose penalties on certain types of deferred compensation that were considered abusive tax shelters. The concept of deferred compensation is extremely broad under Code § 409A. Any promise (even if contingent) to pay compensation in future years is potentially caught unless an exemption applies or the payment is structured to meet complex IRS § 409A rules. As outlined in Internal Revenue Service (“IRS”) guidance2, stock options granted with a per share exercise price below the fair market value of the underlying stock on the grant date are deemed deferred compensation subject to Code § 409A.

Code § 409A sets forth severe penalties to the taxpayer (that is, the employee) if violated, including a 20% additional income tax, interest on underpaid taxes (at the federal underemployment rate plus 1%) and the acceleration of taxable income once the award is no longer subject to a substantial risk of forfeiture. Although the tax consequences apply to the employee or other service provider, and not the employer, companies must still be careful to design compensation plans and arrangements that either comply with, or are exempt from, Code § 409A because of potential related exposure, e.g., due to employee claims against the employer, employer withholding and reporting noncompliance and the allocation of Code § 409A risks/costs in future M&A or other transactions.

Sutardja v. United States

In Sutardja v. United States, Dr. Sutardja, a co-founder and Chief Executive Officer and Chairman of the Board of Marvell Technology Group, Ltd., was granted an option to purchase shares of Marvell’s common stock (which he subsequently exercised in part). The IRS found this stock grant to be nonqualified deferred compensation subject to penalties under Code § 409A because the stock price rose between the grant date and the date the grant was ratified. Most concerning is that the IRS chose to litigate this grant - the grant occurred prior to the enactment of Code § 409A and was exercised at a time when there were no regulations under Code § 409A – only Notice 2005-1. A summary of events follows:

  • December 10, 2003: Executive Compensation Committee authorized the grant of up to 2 million stock options to Dr. Sutardja; the stock price on this date was $36.19.
  • December 26, 2003: Executive Compensation Committee approved the grant of 1.5 million stock options to Dr. Sutardja with an exercise price of $36.50 per share, representing the fair market value.
  • January 16, 2004: The grant was ratified (the Court does not indicate whether it was the Board or the Executive Compensation Committee); the fair market value of the Company’s stock was $43.64.
  • January 2006: Mr. Sutardja exercised a portion of the stock option grant.
  • May 2006: A “special committee” of the Board reviewed the stock option granting practices of the company and determined that the appropriate grant date of Dr. Sutardja’s option for financial accounting purposes was January 16, 2004. Mr. Sutardja consequently entered into a Reformation of Stock Option Agreement and paid an additional $5,355,001, representing the excess of the amended exercise price over the original exercise price.
  • November 10, 2010: The IRS issues a Notice of Deficiency for the 2006 tax year. The IRS claimed that Dr. Sutardja’s 2006 exercise involved a nonqualified deferred compensation plan, which resulted in an additional 20% tax under Code § 409A, an excise tax and late payment penalty. Mr. Sutardja paid the amount and requested a refund.
  • April 2011: Dr. Sutardja received a notice from the IRS demanding an additional interest payment, which he paid.

The Court summarily rejected Dr. Sutardja’s arguments that the stock option should not be considered deferred compensation and that, even if found to be deferred compensation, it was exempt under the short-term deferral rule under Code § 409A. The Court held that if the option is found to be discounted, which it will address in a subsequent opinion, it will fall under the purview of Code § 409A.

Action Items; Contact

In light of Sutardja v. United States, companies should:

  • Be aware that the IRS is willing to litigate Code § 409A in the context of equity compensation. Several years ago, the IRS announced it had started an executive compensation audit program; however, many companies have not taken serious heed to this notice. Sutardja v. United States serves as a wake up call. This case marks one of the first times the IRS has litigated Code § 409A in the context of equity compensation.
  • Expect the IRS to be aggressive in litigating Code § 409A. The stock option grant at issue in Sutardja v. United States occurred prior to the enactment of Code § 409A and exercise of the option occurred before the adoption of related regulations. Further, the stock option was intended to be granted at fair market value and Dr. Sutardja made a good faith attempt to correct any issues arising due to the ratification once he was made aware of the issue. Notwithstanding these facts, the IRS litigated the perceived Code § 409A violation.
  • Attempt to protect optionees from penalties and/or legal action by following well documented and defined grant procedures. Companies should take a fresh look at their compensation plans and grant procedures in consultation with their attorneys, tax advisors and compensation advisors. While the Court is still assessing issues regarding the grant date of the stock option for Code § 409A purposes and the role of ratification, the need for well defined and documented grant procedures is clear.
  • Stay alert of future developments in this case. The United States Court of Federal Claims is expected to issue an additional opinion to address whether the fact pattern involved discounted options subject to Code § 409A penalties. This opinion may offer additional guidance concerning the effect of ratification of prior grants and the application of the “good faith” exception to Code § 409A, which excludes incentive stock options granted prior to 2005 when such grants were made in compliance with relevant regulations and the parties believed in good faith that the options were not discounted.