A court (Sutardja v. United States) recently confirmed that discounted stock options are subject to Section 409A. You probably didn’t even know that there was any question about this. But I guess when someone is slapped with the penalty tax under 409A, they are willing to try just about any argument. It certainly would have been big news if the plaintiff had prevailed.

As it stands, you probably think it’s hardly news worth blogging about. That’s because you don’t write a blog. If you had to come up with something pithy and timely to say every week, you’d know that anything is on the table. Which brings us to today’s blog entry…

Don’t Do That!

First, there are a couple of important lessons here:

Lesson 1) If you are thinking of taking the IRS on with regards to whether stock options are subject to 409A, the fact that a court has now backed the IRS on this matter makes it a lot less likely that you’ll succeed. It might be better to just cut your losses and deal with those discounted stock options that you granted accidentally.

Lesson 2) This issue arose out of a backdating investigation. The option in question was approved by the company’s compensation committee at one meeting and then later, at a subsequent meeting, the compensation committee ratified their earlier decision. When the company later conducted an investigation of its grant procedures, it decided that the grant date was when the decision was ratified at the second meeting. The FMV of the stock was higher on this date than at the earlier meeting, but the option price had been set based on the earlier FMV. As a result, the investigation deemed the option to have been discounted.

I’m not sure why the comp committee would approve the grant at one meeting and then ratify the decision at a second meeting (perhaps there was something wrong with the initial approval). Don’t do that! Approve options just once.

What About the Corrections Program?

Another interesting point in this case is that when the company’s internal investigation concluded that the options were discounted, they required the executive to pay the amount of the discount back to the company. If you’re keeping score, that means this guy has been dinged twice. He’s paid the higher (non-discounted) exercise price for the stock yet has also paid the 409A 20% penalty tax plus interest.

But wait–isn’t there some sort of corrections program for discounted stock options? If the exec has made up the difference in the exercise price, why wouldn’t the option be exempt under the corrections program? Why yes, Virginia, there is a 409A corrections program for discounted stock options–I even blogged about it back in 2009 (“Recent 409A Developments,” Jan. 13, 2009). I think there are several reasons why this option doesn’t qualify for the corrections program, however:

1. The events in this drama unfolded from 2003 to 2006, long before the corrections program–announced in late 2008–existed.
2. To be eligible for correction, the option can’t have been exercised yet.  The executive in this case didn’t pay the additional cost to make up for the discounted option price until after he had already exercised the option.
3. Options granted to Section 16 insiders have to be corrected by the end of the calendar year in which they are granted. The options in this case were granted in 2003 but not corrected until 2006.
4. The grant documentation has to indicate that the option was intended to have price equal to FMV. I have no idea if this is an issue in this case, but it’s a good thing to make sure is specified in your own grant documentation. If you are ever in a situation where you need to rely on the 409A corrections program, you’ll be glad you did.

At this point, the case is not yet resolved. While the judge did agree that discounted stock options are subject to 409A, this decision was a partial summary judgment (meaning the judge thought that the IRS’s case was so obviously right that it wasn’t necessary to go to trial over this issue–something else to keep in mind if you were thinking of taking the IRS on). But the remaining question, which is whether or not the option was actually discounted, remains to be decided.

Is This Up to a Jury?

Coincidentally, I just got a jury duty summons, which got me thinking: are these sorts of tax law questions decided by a jury of my peers?  Nothing against my peers, but most of ’em (except, of course, for my colleagues in stock compensation) don’t know beans about stock compensation or tax law. So if that’s the case, that’s a little scary.  Also, how come when I’m called for jury duty, it’s never for cases that involve stock compensation?  I think I’d have a lot to add as a juror for a case like this. Heck, I could probably even count it as “work.” You know, research for the blog…