Section 409A of the Internal Revenue Code of 1986, as amended ("409A"), contains strict rules applicable to most forms of deferred compensation. 409A provides severe penalties in the event of a failure to comply with these rules, including a 20% excise tax, interest, and the acceleration of taxable income. The Treasury Regulations under 409A provide that 409A applies to stock options that are issued with an exercise price that is less than the fair market value of the shares as of the date the options are granted (i.e., discounted stock options). The IRS has now begun to actively enforce the applicability of 409A to discounted stock options.

In a recent United States Court of Federal Claims case, Sutardja v. United States (No. 11-724T, February 27, 2013), the plaintiffs filed a refund action challenging the IRS's assessment of the 20% 409A excise tax and interest on stock options that the IRS alleged were issued at a discount. The plaintiffs challenged the application of 409A to stock options (whether or not discounted), claiming that the grant of stock options does not constitute a taxable event. In its decision, the Court gave deference to the IRS's position that discounted stock options result in a deferral of compensation and are thus subject to 409A (as provided in applicable Treasury Regulations and other guidance).

The Treasury Regulations under 409A contain detailed rules for determining whether a stock option has been issued at fair market value. If options are issued at a discount, in order to comply with 409A, the options can only be exercisable upon 409A permissible payment events, such as a predetermined date or the death or disability of the grantee. Failure to comply with these requirements will result in penalties under 409A. Under current IRS guidance, the same rules under 409A that are applicable to stock options also apply to options to purchase an interest in a partnership (including in an LLC that has not elected to be taxed as a corporation) in connection with the performance of services to the partnership.

A copy of the Sutardja v. United States decision can be obtained here.