IRC Section 409A applies to discounted stock options, court affirms

In terms of taxpayer liability under Section 409A of the Internal Revenue Code, does it really matter whether a stock option is discounted?

This issue was at the center of a recent pretrial ruling from the U.S. Court of Federal Claims that has sparked interest from LinkedIn’s BV Professionals Group (registration required). Under the statute and accompanying regulation (Notice 2005-1), nonstatutory stock options may qualify as deferred compensation and, as such, must be included in gross income. If the option is granted “at the money,” that is, the strike price is equal to the fair market value of the underlying shares at the grant date, Section 409A does not apply. Any amount includible in gross income is also subject to interest on prior underpayments, and an additional income tax equal to 20% of the compensation is required to be included.

The taxpayers (a husband and wife) worked for a prominent semiconductor firm. As a senior executive officer, the husband received an option to a fixed number of shares that did not have a readily ascertainable fair market value at the time of grant. He exercised three fully vested portions of the option in 2006 during a transition period between the effective date of the statute and the effective date of the applicable regulations. The amount in dispute in his refund suit was $5,282,125, plus interest.

The IRS conceded that if the option price aligned with the fair market value, there was no Section 409A taxation. But the taxpayer rejected this premise. Discounted or not, there was no taxable event until he exercised the option and sold the stock, he said. For a number of reasons, the issue of discount was not relevant to resolving the case in his favor.

For one, under California law, which governed his option agreement, he did not have a “legally binding right” to compensation until exercise. The government countered that the option itself was compensation and created a right to compensation upon vesting. If granted at a discount, there was deferred compensation from the date of vesting. “[T]he vested options give the optionee the legally binding right to purchase shares at a designated price,” the court found.

The right to purchase shares is not a right to compensation, the plaintiff countered. That argument also had no traction. Even if the option did not have a readily ascertainable market value at the time of grant, “[t]he grant itself, however, constituted compensation,” the court said. Once the option vested, he had a right to buy shares at a designated price.

The court also dismissed the taxpayers’ other arguments. The case is now headed to trial and will turn on the factual (valuation) issue of whether the taxpayer was granted an option at a discounted price. Stay tuned. Find a complete discussion of Sutardja v. United States, 2012 U.S. Claims LEXIS 126 (Feb. 27, 2013) in the June Business Valuation Update; the court’s opinion will be posted soon at BVLaw.