April, 2007 | Issue 17
IRS Code § 409A imposes a tax penalty on holders of certain stock options if the exercise price of the option is less than the fair market value of the stock on the date the option was granted. Such options are referred to as “discounted stock options.” Added to the tax code as part of the American Jobs Creation Act of 2004, § 409A generally requires that amounts deferred under a nonqualified deferred compensation plan are includable in gross income. The IRS believes that stock options that are “in the money” on the date of grant are a form of deferred compensation and thus are subject to taxation and a tax penalty.
Avoiding the Tax Penalty
In order to avoid having options subject to § 409A, employers need to demonstrate that the options were issued with an exercise price not less than the fair market value of the underlying shares on the date of the grant. A discounted option may be brought into compliance by replacing it with one that has a revised exercise price that doesn’t give rise to deferred compensation. Originally, the deadline for such compliance was set for January 1, 2007. This was extended in Notice 2006-79 to January 1, 2008. A replacement option, if issued before this date, will be treated for § 409A purposes as if it were granted on the grant date of the original option.
It should be noted that this transition relief has not been extended to public companies having “backdated option” financial reporting problems.
For all companies, it important to examine outstanding stock options to see if any are at risk of being deemed discount options. Hempstead & Co. would be happy to provide you with valuation assistance in this process.