Gone are the days when companies could choose the exercise price and option terms for stock options without thinking about IRS Code Section 409A consequences.  Employees and executives, as well as independent contractors and advisors, could face significant taxes and penalties if their stock options are subject to, but not compliant with, IRS Code Section 409A.

What is Code §409A? Code §409A places restrictions on “nonqualified deferred compensation”, which is compensation that is earned in one year, but is paid (or is payable) in a future year.  Stock options having an exercise price less than the stock’s fair market value on the grant date are deemed to be deferred compensation subject to Code §409A.

If Code §409A applies, then stock options generally may be exercisable only upon certain events, including: (i) a separation from service; (ii) disability; (iii) death; (iv) a specified time or fixed schedule; (v) a change in control event; or (vi) an unforeseeable emergency.  Thus, the normal ability to exercise a stock option at any time during the option term, where the term extends over multiple years, would violate the requirements of Code §409A.

What happens of Code §409A is violated? If Code §409A is violated, the optionee could be subject to an acceleration of the taxable income, additional 20% income tax, and interest on the unpaid taxes.  A recent case – Sutardja v United States, 11 Fed.C1.No.724T (February 27, 2013)—illustrates that the Internal Revenue Service (“IRS”) is willing to litigate Code §409A in the context of stock options.  In such case, the IRS is attempting to assess taxes and penalties in excess of $5 million due to an alleged failure of stock options to comply with Code §409A.


            Companies should review their stock option plans and granting practices to ensure compliance with Code §409A.  Otherwise, as Sutardja illustrates, optionees (whether employees, directors, independent contractors or advisors) may be faced with draconian and significant taxes and penalties.


This document is intended to provide information of general interest and is not intended to offer any legal advice about specific situations or problems.  Neither the author nor Metz Lewis Brodman Must O’Keefe LLC intend to create an attorney-client relationship by offering this information, and anyone’s review of the information shall not be deemed to create such a relationship.  You should consult a lawyer if you have a legal matter requiring attention.

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