Trends & Developments - October 2015 - Be Aware (Beware) – Discounted Stock Options are Subject to 409A

Many small, closely held companies, especially start-up companies, like to issue stock options to key executives and employees as both an incentive to help grow the company and as a substitute for cash compensation when they need the cash to invest in the business.  At times, the owners are unaware of the requirements under Internal Revenue Code (“IRC”) section 409A as it applies to stock options and stock appreciation rights (collectively “options” or “stock options”) and fail to appropriately determine the exercise price.  At other times, they simply don’t want to pay for a valuation of the business to establish the exercise price.  In both instances, the tax consequences for executives and employees can be disastrous.

Background

IRC section 409A provides comprehensive rules regulating the taxation of nonqualified deferred compensation.  While section 409A does not explicitly define a "deferral of compensation," the IRS has been consistent in its position that discounted stock options are deferred compensation subject to section 409A throughout its notices, proposed regulations, and the final regulations.   Specifically, IRS Notice 2005-1 states that if a stock option is granted with an exercise price that is less than the fair market value of the underlying stock on the date of the grant, the option will be treated as a deferral of compensation and will be subject to the requirements of section 409A.

Application of Section 409A to Stock Options and Stock Appreciation Rights

The attraction of stock options to executives and employees is that they themselves control the timing of income recognition by timing the exercise of the option.  If section 409A applies to the option, this flexibility is lost, substantially eliminating the value of the stock option.  To avoid taxation under section 409A, the option must either be specifically exempted from section 409A or meet certain requirements as outlined below.

Incentive stock options issued pursuant to IRC section 422 and stock options issued under an employee stock purchase plan pursuant to IRC section 423 are specifically exempted under the regulations from section 409A provided that they continue to meet the applicable qualification requirements of those sections of the IRC.

For stock options not issued pursuant to section 422 (“nonqualified options”), there are four basic requirements that must be met to be exempt under section 409A, as follows:

1. For nonqualified stock options, the exercise price must be at least equal to the fair market value of the underlying shares as of the grant date.  For this purpose, if the grantee is entitled to dividend equivalents at exercise, they will be treated as a reduction to the exercise price; i.e., the grant will be considered as issued at an exercise price below fair market value at the date of grant and subject to section 409A.   The following specific valuation requirements apply to the determination of “fair market value” of the common stock at the date of grant: 
1. A public company must base fair market value on a reasonable method using actual sales of its common stock such as the last sale, closing price or average price on the day before or the day of the option grant.  Further, a company may use an average over a specified period in certain circumstances (typically related to grants to employees in foreign jurisdictions in order to comply with local tax law).  However, the terms of the grant and the averaging period must be specified in advance of the grant date of the option. 
2. A private company must base fair market value on a reasonable application of reasonable valuation methods based on all relevant facts and circumstances and factors such as the value of tangible and intangible assets, the present value of anticipated cash flows, stock value of comparable entities, recent arm’s length sales, and valuation methods used for other non-compensatory purposes.  Under the section 409A regulations, three safe harbor valuation methods are presumed to be a reasonable valuation (shifting the burden of proving unreasonableness to the IRS) for this purpose, as follows: (i) an independent appraisal within the prior 12 months that meets the requirements for valuing stock held by an employee stock ownership plan, (ii) a formula-based valuation that would be considered a nonlapse restriction under section 83 and will by its terms be used as long as the stock is not publicly traded, provided that it is used for both compensatory (options, stock appreciation rights, etc.) and noncompensatory transactions (not required for a sale of all or substantially all of the company’s stock), or (iii) in the case of an illiquid start-up company (generally in business less than 10 years with no publicly traded class of securities and not anticipating a change of control within 90 days or a public offering within 180 days), the regulations require a valuation by a “qualified,” but not necessarily independent, individual (5 years of experience in business valuation, appraisal, finance, investment banking, secured lending, etc.). 
2. The stock subject to the nonqualified option grant must be solely stock of the entity receiving the services of the service provider or any corporation that owns a controlling interest in the service recipient or that is included in a chain of companies each of which is controlled by another company ending with the ultimate parent company.  For purposes of determining a controlling interest, the controlled group rules under IRC section 414 for qualified retirement plans are applied by substituting at least 50% ownership for the at least 80% ownership requirement under those regulations.  The 50% ownership requirement is reduced to 20% where there are legitimate business criteria for the granting of the option due to the relationship between the service provider and the optioned entity. 
3. Only stock that qualifies as eligible common stock may be subject to a stock option granted to the service provider.  For this purpose, section 409A allows the use of any class of common stock as defined under IRC section 305 of any eligible service recipient (as discussed in 2 above).  The stock may be subject to restrictions, but may not have any dividend preferences of any kind.  Liquidation preferences are permitted, but the stock may not be subject to a non-lapse mandatory repurchase obligation or put or call right at a price other than fair market value. 
4. The stock option may not provide for a deferral feature (i.e., cannot provide for the deferral of the delivery of the shares upon exercise) or be exchanged for other deferred compensation.  Material modifications to an existing grant are treated as a new grant subject to the requirements of section 409A and will likely require re-pricing.  Extensions of the right to exercise are permitted up to the lesser of the original exercise period as specified under the option grant or 10 years. Underwater options may be extended without restrictions.  For this purpose, they are treated as a new grant with an exercise price that exceeds the current fair market value of the stock.

Tax Consequences of Failure to Comply

If any of the requirements of section 409A outlined above are violated, the nonqualified stock options or SARs are immediately taxable or, if later, upon vesting (when the stock option is no longer subject to a substantial risk of forfeiture).  The amount recognized as ordinary income by the grantee is the excess of the fair market value of the stock at December 31 less the exercise price and any amount paid for the option at grant.  In addition, section 409A imposes a 20% penalty tax on the compensation recognized and interest (if applicable) at the IRS underpayment rate, plus 1%.  Further, any appreciation in the value of the option in subsequent years is also taxed under section 409A including the year the option is exercised [Treas. Reg. 1.409A-4(b)(6)].

IRS Audit Activity and Federal Claims Court Ruling

In conducting field audits, the IRS is clearly looking at stock option grants with respect to whether the option was granted at fair market value.  The IRS may consider this an easy way to generate additional revenue for the federal government as indicated by their assessment of additional taxes of $3.5 million against the CEO of Marvel Technology Group Limited for having received discounted stock options.  The case, Sutardja v. United States, is not yet settled; however, in an initial ruling the Court of Federal Claims confirmed that section 409A applies to stock options.  Still to be decided in the case is whether, based on the facts, the options granted were in fact granted at a discount to fair market value.  With confirmation that section 409A applies to stock options, the IRS will continue to scrutinize option grants.

Conclusion

All businesses need to be aware of the rules applicable to the granting of stock options and SARs to their employees.  Closely held businesses need to be acutely aware of the valuation requirements related to stock and appreciation right grants under section 409A to avoid the extremely harsh tax consequences imposed on the employee for failure to comply with these rules.

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