Yesterday we reviewed the IRS’s determination that a nonstatutory stock option (NSO) violated Section 409A. Today we will review the income tax consequences of such failure.

Taxes

Income Inclusion under Section 409A

Section 409A provides that, if at any time during a taxable year a nonqualified deferred compensation plan fails to meet certain distribution-timing requirements, or is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income for that taxable year to the extent it was not subject to a substantial risk of forfeiture (i.e., it was vested) and was not previously included in gross income.

If the NSO that fails under Section 409A remains unexercised and outstanding on the last day of the employee’s taxable year, the total amount deferred under the NSO for the taxable year is the excess of the FMV of the underlying stock on the last day of the taxable year over the sum of the NSO’s exercise price plus any amount paid for the option.

Any amount deferred that remains unvested as of the end of the taxable year of the section 409A failure is not subject to income inclusion under section 409A for the taxable year.

As we reviewed yesterday, an amount that is vested is includible in income under section 409A for a taxable year only if the plan fails to meet the requirements of section 409A during the taxable year. Whether a plan fails to meet the requirements of section 409A during a taxable year is determined independently of whether the plan fails to meet the requirements during a previous or subsequent taxable year. Accordingly, the consequences of a section 409A failure are determined independently for any particular taxable year during which the failure occurs or continues to occur, without regard to such consequences affecting any other taxable year.

The IRS Advisory’s Application of 409A

Returning to yesterday’s discussion, because Option failed to meet the requirements of section 409A, the total amount deferred under Option at the end of the taxable year of the Section 409A failure was includible in Employee’s income under section 409A to the extent it was not subject to a substantial risk of forfeiture (i.e., it was vested) as of the end of the taxable year and it was not included in income for a prior taxable year.

Here, the taxable year of the section 409A failure was Year 3, the year under exam. Although Option failed to meet the requirements of section 409A from the grant date, the statute of limitations on assessment had expired for Years 1 and 2. The consequences of the section 409A failure were determined independently for Year 3 without regard to the consequences affecting any other taxable year (except that Employee would receive credit for any amounts included in income under section 409A for a prior taxable year – none in this case).

By the end of Year 2, some of the Option Shares had vested and Taxpayer had partially exercised Option to purchase shares. Other Option Shares had vested and were purchased during Year 3.

The Option Shares that remained unvested at the end of Year 3 were subject to a substantial risk of forfeiture for purposes of section 409A as of the end of Year 3 and, therefore, were not subject to income inclusion under section 409A for Year 3.

However, because the section 409A failure would continue to occur until the end of the taxable year during which these Option were fully exercised or expired, the deferred amounts applicable to such Options Shares would be subject to section 409A inclusion beginning with the subsequent taxable year during which they vested.

Compensation related to Employee’s purchase of Year 2 exercised Option Shares was not subject to section 409A for Year 3 because it did not constitute an amount deferred (or a payment) under Option during Year 3. However, compensation related to Employee’s purchase of Year 3 exercised Option Shares was subject to section 409A for Year 3 because it constituted a payment of amounts deferred during Year 3.

Accordingly, the total amount deferred under Option for Year 3 that was subject to income inclusion under section 409A for Year 3 was comprised of two components: (1) the portion that was vested and deferred (that is, unexercised and outstanding, including any shares that had vested in Year 2 but were not exercised) at the end of Year 3, and (2) the portion related to payments of amounts deferred under the Option as the result of its exercise during Year 3.

For purposes of determining the amount includible in income under section 409A related to the portion that was vested and deferred (but not exercised) at the end of Year 3, calculate the excess of the FMV of Employer’s stock on the last day of Year 3  over the Exercise Price for the Option.

For purposes of determining the amount includible in income under section 409A related to payments of amounts deferred under the Option (that is, as the result of exercise) during Year 3, calculate the excess of the FMV of the Year 3 exercised shares on the date of exercise over the sum of the Exercise Price for the Option.

The Importance of Determining FMV

Pretty straightforward, right? (Take a deep breath, clear your head.)

Now, imagine the shock of a key employee upon learning that the vested NSO that he or she was granted is not compliant with Section 409A because its strike price is less than the FMV of the underlying share of stock at the time of its grant.

What was intended to be a benefit and incentive to the employee, for the purpose of aligning his or her interests with those of the business owners, turns out to be an expensive proposition. The option spread will be included in the employee’s income in the year the option vests (as will any “appreciation” in the spread in later years), thereby generating a tax liability. He or she must find the liquidity with which to pay the tax (plus an additional 20% penalty tax). If the option is exercised, will the employee be able to put the shares to the business in order to raise some cash? Ultimately, it is likely that the employer will have to bear this cost.

In light of the foregoing, it is imperative that the valuation of the option shares be taken seriously. According to IRS regulations, a private company may use a “reasonable application of a reasonable valuation method” in determining the fair market value of its stock for purposes of Section 409A.

Whether a valuation method is deemed reasonable by the IRS will depend on the facts and circumstances, but, in order to be considered reasonable, the method employed must take into consideration all material information available at the time of the determination.  A number of factors may be considered in this analysis. It would certainly behoove an employer to secure the assistance of a qualified appraiser (and tax adviser) to provide some certainty with respect to Section 409A compliance, and to avoid the tax consequences in the advisory described above.