On June 10, 2014, the Internal Revenue Service issued a ruling holding that nonstatutory stock options (also known as nonqualified stock options) and stock-settled stock appreciation rights (“SARs”) are not subject to section 457A of the Code. Generally, section 457A of the Code includes deferred compensation issued under a nonqualified entity’s deferred compensation plan in the recipient’s gross income when the compensation is no longer subject to a substantial risk of forfeiture.
In Rev. Rul. 2014-18, a foreign corporation which constituted a “nonqualified entity” under section 457A of the Code received services from a U.S. limited liability company taxed as a partnership for U.S. tax purposes. In exchange for these services, the foreign corporation granted a nonstatutory stock option and a SAR, each with respect to a fixed number of its common shares, to the limited liability company as incentive compensation. Each stock right had an exercise price per share not less than the fair market value of the associated common share of the foreign corporation on the date of grant and did not include any feature constituting the deferral of compensation under the section 409A Treasury Regulations. Importantly, the terms of the SAR at all times provided (i) that the stock right must be settled in stock of the foreign corporation and (i) the SAR actually is settled in foreign corporation stock. Finally, the limited liability company service provider had the same redemption rights with respect to the common shares upon the exercise of the stock rights as other shareholders had with respect to their common shares of the foreign corporation.
After analyzing sections 457A and 409A of the Code and the relevant legislative history, the Internal Revenue Service concluded that a nonstatutory stock option exempt from taxation under section 409A is also exempt from taxation under section 457A of the Code. Furthermore, the Internal Revenue Service found that a SAR exempt from taxation under section 409A that at all times must be settled, and is settled, in stock of the service recipient (in this case, the foreign corporation) also is exempt from taxation under section 457A. Under these circumstances, the SAR is functionally identical in all material respects to a nonstatutory stock option to purchase stock of the service recipient with a net exercise feature and instead is taxable under section 83 of the Code. However, the Internal Revenue Service held that a SAR which may be or actually is settled in stock of an entity other than the service recipient is not exempt under section 457A, regardless of whether the SAR constitutes a nonqualified deferred compensation plan for purposes of section 409A of the Code.