Avoiding Unwanted Tax Results When Awarding Stock Options

May 9, 2013 Louis Barnett Barr

In the recent case of Sutardja v. United States, No. 11-724T (Fed. Cl. Feb. 27, 2013)  the United States Court of Federal Claims ruled in favor of the IRS and confirmed that discounted stock options (the exercise price is less than the stock’s fair market value on the grant date) are deferred compensation subject to the requirements of Internal Revenue Code Section 409A.

As a practical matter, classically structured stock options exercisable over a period of multiple years following vesting will generally fail to comply with the requirements of Section 409A and the options will be subject to income tax upon vesting, interest at a premium rate, plus an additional 20 percent penalty tax will be imposed.

In the Sutardja case this could result in a potential tax penalty and interest in excess of $4.5 million if it is factually determined that the stock option was discounted at the time it was granted, which will be addressed in a future opinion.

While it has been generally accepted that discounted options are problematic under 409A, it is particularly instructive that the IRS is aggressively pursuing the issue in this case.  Adding insult to injury, the Plaintiffs, as California residents, have purportedly received a Notice of Proposed Adjustment from the State of California (which has state tax rules similar to 409A) imposing an additional 20 percent penalty tax.

The Sutardja case involved options that were granted prior to the effective date of 409A and the exercise of the option occurred during a transition period between the effective date of 409A and before the adoption of related regulations. Also, the stock option was originally “granted” at fair market value but was “ratified” about three weeks later after the NASDAQ traded stock had appreciated. The grantee made a good faith attempt to correct any issues arising due to the ratification once he was made aware of the issue by paying several million dollars to the company to cover the difference in value between the trading prices on the grant date and ratification date.  Notwithstanding the foregoing facts, the IRS still pursued this action.

Therefore we cannot over emphasize the importance of companies carefully establishing and documenting the fair market value of options on the date of grant and grant award procedures. Moreover, since U.S. citizens are taxed on their global income, any equity compensation plan including U.S. taxpayers needs to recognize the stakes at risk.  Therefore, for example, even if discounted option grants are issued to a trustee under an Israel qualified 102 regime, the U.S. tax consequences must still be considered and addressed by either complying with, or otherwise qualifying for an exemption from, 409A.

Louis is the head of the Tax practice at SWA, with a strong focus on executive compensation and business formation and structuring as well as comprehensive experience in advising on mergers and acquisitions, especially involving start-ups.

Louis Barnett can be reached at 646 328 0783 or lbarr@swalegal.com

This SWA publication is intended for informational purposes and should not be regarded as legal advice. For more information about the issues included in this publication, please contact Louis Barnett Barr. The invitation to contact is not to be construed as a solicitation for legal work. Any new attorney/client relationship will be confirmed in writing.