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Discounted Stock Options are Deferred Compensation, Says Court

April 2013 | Issue 65

Introduction

A discounted stock option is one whose exercise price, at time of grant, is lower than the then fair market value of the underlying stock.  The IRS has maintained that discounted stock options will be treated as deferred compensation, pursuant to Section 409A of the Internal Revenue Code.  Such treatment subjects the entire appreciation in the option position to the 20% penalty tax under 409A.

This position was challenged by Dr. Sehat Sutardja in Sutardja v. United States, No. 11-724T (Fed. Cl. Feb. 27, 2013).  Dr. Sutardja was President and co-founder of Marvell Technology Group Limited, a NASDAQ National Market System company.  He had exercised Marvell stock options in 2006.  In November, 2010, Dr. Sutardja received a Notice of Deficiency concerning his 2006 tax return for Section 409A surtaxes of $3,600,000.  The IRS had determined that the exercise of options in 2006 was from a nonqualified deferred compensation plan as defined under Section 409A, and that therefore the surtax was due.  Dr. Sutardja paid the tax, filed for a refund, and filed a complaint in the U. S. Court of Federal Claims.

The Arguments

The Plaintiff, Dr. Sutardja, advanced a number of arguments.  One argument was that the Supreme Court had ruled more than 50 years ago in Commissioner v. Smith that the mere granting of an option was not a taxable event.  Another argument was that the Treasury excludes stock option grants in its definition of deferred compensation for FICA purposes, and that the IRS should do likewise.

The Court was unmoved by any of the Plaintiffs’ arguments and denied its motion for partial summary judgment.  It granted the Government’s motion for partial summary judgment.

The Next Step

All parties had agreed that the summary judgment proceeding would be moot if the options in question turned out not to be “discount options.”  As said by the Court, “the outcome of this case turns on the factual issue of whether Marvell granted Dr. Sutardja’s stock option at a discounted price below fair market value.”  Determining that fair market value will be the subject of a future trial.

The Takeaway

Issuers of stock options should pay careful attention to determining and documenting the relationship between the strike price of an option and the fair market value of its underlying stock.  This is especially important in the case of untraded stocks, where values are not easily determined.  The services of a business appraiser can be helpful in determining the fair market of the underlying stock.  The issuer can most credibly document the value by having the appraisal performed contemporaneously with the granting of the options.

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) addressed herein.