Ruling in favor of the IRS, the U.S. Court of Federal Claims confirmed in a recent case that discounted stock options are deferred compensation subject to the requirements of Section 409A of the Internal Revenue Code. Under the Section 409A regulations, incentive stock options are exempt from coverage. Nonqualified stock options are also exempt from Section 409A, if, among other requirements, the options are granted with an exercise price that may never be less than the fair market value of the underlying stock on the date of grant. If the options are discounted, the Section 409A regulations provide that the options are treated as deferred compensation. If the terms of the discounted options fail to comply with the requirements of Section 409A, the options are subject to taxation upon vesting, interest at a premium rate, and a 20 percent additional tax. As a practical matter, because stock options are typically structured to be exercisable over a period of multiple years following vesting, options that are not exempt from Section 409A are unlikely to be compliant with Section 409A.

The case at hand arises from a determination by the IRS that stock options granted to a CEO of a company were issued with a discounted exercise price, resulting in a violation of Section 409A. On December 26, 2003, the company’s executive compensation committee approved a grant of nonqualified stock options to its CEO. The options had an exercise price equal to the trading price of the company stock on that date. The grant was not ratified, however, until January 16, 2004, at which time the stock had risen in value. Following the executive’s exercise of a portion of his options in 2006, the company’s board of directors conducted an internal review of its option granting practices. The reviewing committee found that the appropriate measurement date for the grant of the CEO’s options was not December 26, 2003, but January 16, 2004, the date on which the compensation committee ratified the grant. The company and the CEO entered into a reformation of the stock option agreement, and the CEO paid an additional $5.3 million to the company, representing the difference between the amended and the original exercise prices. In 2010, the IRS issued a Notice of Deficiency to the CEO and his wife for the 2006 tax year due to a violation of Section 409A, assessing additional taxes and interest of over $3.4 million. An additional $704,883 of interest was assessed in 2011. The couple paid the assessed amounts and filed suit for a refund. Both sides filed for partial summary judgment.

The CEO and his wife claimed that Section 409A did not apply to the stock options, advancing several legal arguments for their exemption: that options are not taxable until exercise; that options are not deferred compensation under the Code Section 3121(v) regulations; that the option income should be exempt under the short-term deferral exception; and that there was no deferral to a later year, because there was no legally binding right to option compensation until actual exercise of the options. The court rejected each argument, holding that discounted options are deferred compensation subject to Section 409A and granting partial summary judgment to the IRS. The case was set for trial on the factual issue of whether the options were issued at a discounted price on the grant date.

This case underscores the importance of establishing a methodology for determining the fair market value of stock options (and stock appreciation rights) that will satisfy Section 409A and stand up to IRS scrutiny on audit. Companies should establish and consistently follow a 409A-compliant process for determining the exercise price and be prepared to support their determinations through careful documentation. Sutardja v. United States (Fed. Cl. 2013)