On April 10, 2007, the Internal Revenue Service (IRS) issued final regulations under Section 409A of the Internal Revenue Code. Section 409A was added to the Internal Revenue Code in October 2004 by the American Jobs Creation Act.
Under Section 409A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan (as defined in the regulations) currently are includible in gross income unless such amounts are subject to a substantial risk of forfeiture. In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties. Certain states also have adopted similar tax provisions. (For example, California imposes an additional 20 percent state tax, interest, and penalties.)
Implications for discount stock options
Under Section 409A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The tax consequences include taxation at the time of option vesting rather than the date of exercise or sale of the common stock, a 20% additional federal tax on the optionee in addition to regular income and employment taxes, potential state taxes (such as the California 20% tax) and a potential interest charge. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time.
Please also see the post on “How do you set the exercise price of stock options to avoid Section 409A issues?“
Below are links to all of WSGR’s client alerts on 409A.
You can assess the applicability of Section 409A by reviewing WSGR’s client alerts covering various aspects of Section 409A and the final Section 409A regulations in detail, including:
Highlights of the Final Section 409A Regulations (published April 16, 2007)
Stock Rights Under Final Section 409A Regulations (April 19, 2007)
Separation Pay Arrangements under the Final Section 409A Regulations (April 27, 2007)
Action Items for Compliance with Section 409A Final Regulations (June 12, 2007)
Compliance Required with Section 409A before December 31, 2008 (June 12, 2008)