In Announcement 2007-18, the Internal Revenue Service (IRS) introduced a compliance resolution program that will permit employers to pay the additional taxes employees have incurred under section 409A of the Internal Revenue Code (the Code) as a result of exercising discounted stock options and stock appreciation rights during 2006. The Program also provides certain reporting relief for employers, but it does not affect either the employer’s obligation to report on Form W-2 the employee’s compensation income from exercising the stock right or the employee’s obligation to report and pay income tax on that compensation income.
To take advantage of the Program, an employer must submit an initial notice of its intent to participate in the Program to the IRS by February 28, 2007, provide notice to affected employees of its participation, and make an additional filing with the IRS within 15 days of the original IRS filing (i.e., no later than March 15, 2007). In addition, the employer must remit the taxes due and provide further information to the IRS and affected employees within the time frames specified in the Announcement.
Stock options and stock appreciation rights that are issued with an exercise or payout price that is less than the fair market value of the underlying stock on the date of grant are referred to as discounted, or “in the money,” stock rights. Discounted stock rights that either were issued or become earned and vested on or after January 1, 2005 are treated as deferred compensation subject to section 409A. If a discounted stock right does not satisfy the section 409A requirements, once the stock right is no longer subject to a substantial risk of forfeiture, the difference between the exercise price and the fair market value is subject to income inclusion, and two additional taxes apply: (1) an additional 20% income tax on the amount required to be included in income, and (2) a tax based on interest calculated from the time the amount should first have been included in income. In addition, the income inclusion triggers certain reporting requirements for the employer under Notice 2006-100 (see Legal Alert – Withholding Judgment: IRS Issues Guidance for Reporting and Withholding on Nonqualified Deferred Compensation).
discounted stock rights in 2006 before either fix was implemented, however, there was a violation of section 409A for the stock rights that were exercised. The violation also affects any other discounted stock rights or other equity-based compensation for the same individual that are subject to section 409A.
The Program is available only for stock rights exercised in 2006. It is not available for stock rights issued to an employee who was subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934 (an insider) on the date of grant, or on the date the employer provides notice to affected employees that it will make a submission under the Program to the IRS. The Program allows the employer to remit the “applicable taxes” under section 409A to the IRS on behalf of the employee, which include the additional 20% tax and the interest-based tax, but not the ordinary income tax. These applicable taxes must be calculated based on a “reasonable, good faith” interpretation of the section 409A guidance. The Announcement includes guidelines for calculating the additional 20% tax and any interest-based tax. It also provides that any applicable taxes paid by the employer on behalf of the employee will constitute additional compensation income to the employee and will be considered wages for Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and Federal income tax withholding purposes.
Implications of Plan Aggregation Rules for the Program and Future Corrections
Notice 2006-79 provides that discounted stock rights may be corrected to avoid adverse tax consequences under section 409A, either by establishing fixed payment terms that comply with section 409A, or by substituting for them stock rights that have an exercise price equal to the fair market value of the underlying stock at the original date of grant and no other deferral feature (therefore not subject to section 409A). Generally either correction can be made until December 31, 2007; however, the aggregation rules of Notice 2005-1 make it undesirable to use the fixed payment correction method for an employee who exercised any discounted stock rights in 2006.
Specifically, Notice 2005-1 provides that all equity-based, nonqualified deferred compensation arrangements (including discounted stock rights) for an individual are treated as a single plan for purposes of section 409A. A violation of section 409A for even one discounted stock right affects all remaining stock rights and other equity-based arrangements subject to section 409A. Thus, if an employee exercised a discounted stock right in 2006, and the employer later attempted to correct any stock rights still held by the employee by fixing the payment terms for them, all of the discounted stock rights would be subject to section 409A, and all of the stock rights would be in violation of section 409A because some of the stock rights were exercised in 2006 before a correction was made. In contrast, if the employer corrected any outstanding stock rights by substituting fair market value stock rights, those outstanding stock rights would no longer be subject to section 409A, and the section 409A violation would be limited to the discounted stock rights that had been exercised and other equity-based nonqualified deferred compensation, if any.
The Program does not appear to change any of these tax results; however, to participate in the Program, taxpayers may assume that the plan aggregation rules apply only to aggregate all amounts deferred under stock rights subject to section 409A. Accordingly, the employer need not treat all outstanding discounted stock rights as being in violation of, and subject to tax under, section 409A for 2006. The employer may calculate the applicable taxes only with respect to the discounted stock rights that have been exercised.
Terms of Participation
To participate in the Program, the employer must:
- Submit to the IRS a notice of its intent to participate in the Program by February 28, 2007. The Announcement provides language for this notice.
- Within 15 days after notice to the IRS (no later than March 15, 2007), provide notice of the employer’s intent to participate to all employees who may be affected under the Program, explaining the Federal income tax consequences of the employer’s participation in the Program. The notice to employees must reference the Announcement by name and number.
- Within 15 days after the employer submits the notice of intent to participate to the IRS (no later than March 15, 2007), provide notice to the IRS stating the number of employees to whom the employee notice was provided.
- Remit to the IRS an amount equal to the full amount of the additional tax liability under section 409A for the affected employees by June 30, 2007. The payment must be accompanied by a further submission that lists the names of the employees for whom the employer is remitting the section 409A taxes, provide information on the stock right exercise resulting in the section 409A taxes, and explains the manner in which the taxes were calculated. The employer must also represent that it has provided the applicable notice to affected employees, that it has made “reasonable, good faith efforts” to identify all exercises of stock rights by affected employees during 2006 that resulted in income under section 409A, and that it will disclose to affected employees any information needed to report payments made on their behalf.
- Notify affected employees of the further submission by July 15, 2007.
- Report to and on behalf of each employee additional compensation income equal to the applicable section 409A taxes paid, plus any additional amount paid to cover the employee’s share of FICA, FUTA, and Federal income tax withholding.
If an employer complies with these terms of participation, the employer is not required to report the amounts subject to the applicable section 409A taxes in box 12 of the employee’s Form W-2 for 2006. In addition, the employee will not be required to pay the applicable section 409A taxes for the 2006 tax year with respect to those amounts. The Announcement does not provide any relief from Federal income tax or employment tax the employee incurred by exercising the stock rights or any applicable state or local reporting, filing, or tax requirements.
While the notice requirements of the Program appear somewhat cumbersome, the Announcement comes as welcome news to employers concerned about the tax effects on employees of discounted stock rights that were exercised in 2006. Given the Program’s limited window of opportunity, employers who are considering participation in the Program must immediately begin gathering the necessary information and making the section 409A calculations related to the exercise of any discounted stock rights in 2006. Affected employees should also be made aware that while the Program permits employers to pay any section 409A taxes applicable to the 2006 exercise of a discounted stock right, the employee is still obligated to pay the full amount of any individual income tax due as a result of the exercise, including taxes on any realized gain.