Discount Stock Options As Deferred Compensation

Recent legislation has heralded a dramatic shift in the United States federal income tax treatment of nonqualified deferred compensation arrangements. One of the potentially more far-reaching aspects of the legislation is its effect on individuals who receive certain non-statutory stock options for their services. This article focuses on the circumstances under which the Act treats compensatory stock op-tions as nonqualified deferred compensation for federal income tax purposes, the consequences of such treatment, and the resulting practical considerations in dealing with the treatment of certain stock options as nonqualified deferred compensation.

Background

In October 2004, President Bush signed into law the American Jobs Creation Act (the Act). The Act added new Section 409A to the Internal Revenue Code of 1986 (the Code) generally effective for amounts deferred after Dec. 31, 2004. Concerned about “the popular use of deferred compensation arrangements by executives to defer current taxation of substantial amounts of income,” Congress enacted Code Section 409A to narrow the circumstances under which executives could effectively defer the recognition of taxable compensation. In doing so, however, Congress cast an extremely wide net. Section 409A draws no distinction between executives and lower echelon employees and it defines the targeted class of “nonqualified deferred compensation plans” in the broadest possible terms subject to a very limited list of exceptions. As a result, certain compensatory non-statutory stock option arrangements are now subject to the Code Section 409A regime, with possibly disastrous tax results to the option holders.

Operation of Code Section 409A in General

New Code Section 409A adversely affects the federal income tax treatment of so-called “nonqualified deferred compensation plans” in three ways. First, it effectively taxes an individual on all deferred compensation to which he is entitled under a nonqualified deferred compensation plan once he vests in the right to receive such future compensation unless the plan meets certain conditions. Those conditions are more stringent than the requirements for effective deferral under prior tax law. Second, Section 409A imposes a penalty tax of 20% on a participant in a nonqualified deferred compensation plan that fails to comply with the enumerated conditions. Third, it adds an interest charge on the tax attributable to ineffective deferrals under non-conforming plans.

One of the many conditions that Code Section 409A imposes on non-qualified deferred compensation plans for avoidance of the adverse tax consequences described above is a requirement that the employee not have control over the timing of future compensation payments once his right to that compensation has become non-forfeitable (ie, vested). In contrast, compensatory stock options usually give the option holder wide discretion as to the timing of option exercise once the option vests and, therefore, the potential ability to defer taxation of option-related compensation into subsequent tax years by simply postponing the date of option exercise. The discretion to control the timing of the taxable event associated with option exercise is fundamentally at odds with, and will rarely satisfy, the “compensation timing” conditions imposed by Code Section 409A.

Therefore, in cases in which a compensatory stock option is a nonqualified deferred compensation plan subject to Code Section 409A, the option holder normally will incur taxable compensation income under Section 409A of the Code at the time the option vests. The amount of that taxable income appears to equal the excess on the vesting date of the fair market value of the underlying option shares over the option exercise price, although IRS has provided no clear guidance on this point yet. Taxes would be due from the option holder (with an associated withholding obligation on the option issuer if the option holder is an employee) whether the option was ultimately exercised or not, and the 20% penalty tax would also apply.

In light of such dire tax consequences, it is critical that employers issuing compensatory stock options, and the employees, directors and other service providers to whom such options are issued, understand whether Code Section 409A will apply to their stock options and if necessary act to avoid the resulting adverse tax consequences.

What Types of Stock Options Are Subject to Code Section 409A?

General

Prior to the Act, compensatory stock options generally were not viewed as nonqualified deferred compensation plans for income tax purposes. As described below, the Act effectively changes that view as to certain “discounted options.” Discounted options are compensatory stock options that permit the option holder to purchase the underlying option shares at an exercise price which is less than the fair market value of those shares on the date of option grant.

Code Section 409A(d)(1) broadly defines the term nonqualified deferred compensation plan to include “any plan that provides for the deferral of compensation” other than certain enumerated types of tax-qualified retirement plans, bona fide employee leave arrangements, compensatory time plans, disability pay and death benefits. This broad statutory definition clearly encompasses the typical compensatory stock option that allows the option holder to defer recognition of taxable income until the year of option exercise or later. Thus, absent regulatory relief, all compensatory stock options would fall within the definition of nonqualified deferred compensation plans subject to Section 409A.

The ISO, ESPP and Non-Discount Option Exceptions

Fortunately, Congress indicated in the applicable legislative history that two categories of compensatory stock options are excused from the new nonqualified deferred compensation tax regime. The first category of excluded options is statutory stock options. Statutory stock options are incentive stock options qualifying under Section 422 of the Code (ISOs) and options issued under a Code Section 423 compliant employee stock purchase plan (ESPP Options). By definition, ISOs are options granted with an exercise price at least equal to 100% of the underlying fair market value of the option shares on the date of option grant. ESPP Options can be permit purchase of employer shares with up to a 15% discount. The second category of exempt options mentioned in the legislative history is non-statutory options issued with an exercise price of not less than 100% of the fair market value of the underlying option shares on the date of option grant. Congress granted IRS regulatory authority to deal with the treatment of options under Code Section 409A.

In IRS Notice 2005-1 (Dec. 20, 2004), the IRS announced that ISOs and ESPP Options would not be treated as nonqualified deferred compensation plans under Section 409A of the Code. The IRS also announced in Notice 2005-1 that a non-statutory stock option granted to an employee or other service provider would not be a nonqualified deferred compensation plan subject to Code Section 409A if certain conditions are met. First, the amount required to purchase stock under the option (the exercise price) may never be less than the fair market value of the underlying stock on the date of grant. Second, the receipt, transfer or exercise of the option must be subject to taxation under Code Section 83, which it normally would be. Third, the option may not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of exercise or disposition of the option. Accordingly, ISOs, ESPPs and most other non-discounted compensatory stock options (ie, those that offer no further deferral opportunity post exercise) will escape the provisions of Code Section 409A

Discounted Non-Statutory Options

Discounted non-statutory options are an entirely different matter. The legislative history of Code Section 409A makes no specific mention of the status of discounted non-statutory options under Section 409A, but the logical inference to be drawn from that silence is that discounted non-statutory options are subject to Section 409A.

IRS Notice 2005-1 is consistent with that conclusion. It states in pertinent part that except for statutory options and non-discounted, non-statutory options meeting the conditions described above, the grant of a compensatory stock option provides for a deferral of compensation subject to Code Section 409A. The Notice then further states with respect to non-statutory options that:

“[If] under the terms of the option, the amount required to purchase … the stock is or could become less than the fair market value of the … stock on the date of grant, the grant of the stock option may provide … for the deferral of compensation within the meaning of [Section 409A].” (Emphasis added).

It is unclear why the IRS elected in Notice 2005-1 to use the equivocal word “may” rather than the more absolute word “will” in describing whether discounted, non-statutory options are subject to the new Section 409A regime. Perhaps the IRS intends to allow taxpayers the latitude to argue that a minor or unintentional discount exercise price does not render the stock option subject to Section 409A. Prior to the Act, IRS representatives had informally taken the position that compensatory stock options that were “too-deeply-discounted” might be currently taxable to the option recipient. But that position lacked a clear statutory foundation and the issue of how much discount was “too much” was unclear. Now that Congress has given the IRS the ability to deal with the discount option issue under Section 409A it seems curious that the IRS would want to leave room for discounted non-statutory options to escape the grasp of Section 409A on the basis that the exercise price discount is slight or inadvertent. Absent further IRS guidance, it seems dangerous to rely on Notice 2005-1's use of the term “may” as a basis for excluding discounted non-statutory options from Section 409A.

Note that it may still be possible for a discounted, non-statutory option to fall outside the reach of Code Section 409A if the option terms limit the deferral opportunity, but such instances will be rare. For example, an option that vests and is exercisable only at the time of a specified future event which is both outside the option holder's control and uncertain to occur (eg, a sale of the business) appears to fall outside the definition of deferred compensation because there is no deferral between the time of vesting and the taxable event of exercise. Similarly, under IRS Notice 2005-1, a discounted, non-statutory stock option that could only be exercised within the taxable year in which it vests appears to be outside the IRS's announced definition of nonqualified deferred compensation. Such “short-lived” options, however, would rarely be practical compensation vehicles.

Therefore, as a general rule, discounted, non-statutory stock options should be viewed as subject to Code Section 409A and avoided.

Determining Discounted Option Status

Given the problematic tax status of discounted, non-statutory stock options, the question arises as to how employers issuing non-statutory stock options are to determine whether the options are being issued at a discounted exercise price. The IRS indicated in Notice 2005-1 that any reasonable valuation method may be used for determining the fair market value of the underlying option shares on the grant date. Such methods include, for example, the valuation methods described in the IRS' Estate Tax Regulations. The IRS, however, has not yet completely adopted under Code Section 409A the analogous ISO pricing rules found in Treasury Regulation Section 1.422-2(e). Most notably, in determining whether an option satisfies the Code Section 422 ISO requirement that the option exercise price be at least 100% of fair market value, Treasury Regulation Section 1.422-2(e)(2) provides that the issuer's good faith determination of fair market will be respected. Unfortunately, that “good faith” ISO valuation safe harbor has not yet been grafted into rules under Code Section 409A. This lack of symmetry in the valuation rules poses no problem so long as the option in question is issued as an ISO because ISOs are exempt from Code Section 409A. But if the option is not intended to qualify or does not qualify as an ISO, the “good faith” valuations may not help under Code Section 409A.

For publicly traded companies with regularly quoted stock prices, the task of determining whether non-statutory options are being issued with a discounted exercise price should be relatively easy. Use of the closing day price on the option grant date or on last preceding trading date, the average price on the grant date or preceding trading date, or the average price over some narrow range of trading days immediately prior to the grant date should suffice.

For non-publicly traded employers, however, the pricing issue is much more difficult. Absent appraisals or contemporaneous third-party sales of shares of the same class covered by the options in question, it may be difficult to know whether or not the non-statutory options are being issued at a discount. The burden of proving lack of a discount will be on the employer and employee should the IRS assert that there was a discount.

This valuation uncertainty effectively leaves many small, non-publicly traded businesses at a disadvantage vis-'-vis publicly traded employers with respect to the ability to compensate employees through non-statutory stock options. Because of the exemption of ISOs from 409A and the good faith valuation standard that applies in setting the ISO exercise price, all employers (and particularly small non-publicly traded employers) should have an increased preference going forward for ISOs rather than non-statutory options.

It is also worth noting that securities law disclosures to option recipients should be expanded to address the risk that options will be taxed as nonqualified deferred compensation to recipients. Employers must decide what to advise employees regarding the option valuation issue, and whether to continue offering non-statutory stock options if there is a risk that employees are taxable on the option at the time of vesting.

Transition Relief for Discounted Stock Options Vesting After 2004

Under IRS Notice 2005-1, discounted non-statutory options issued prior to the Act that do not vest until after 2004 are subject to new Section 409A and the attendant adverse tax consequences once they vest. To provide transition relief in such situations, IRS Notice 2005-1 permits an effective repricing of the options to eliminate the discount through the issuance of replacement options. Option modification under the transition rule must occur by Dec. 31, 2005. Employers with non-statutory discount stock options issued before the Act, but first vesting after 2004, should now consider modifying their options to obtain the transition relief. The transition relief only applies if: 1)the number of shares under the new stock option corresponds directly to the number of shares under the original stock option; and 2) the new stock option does not provide any additional benefit to the holder (other than the benefit directly due to a change in form of the award to a form not treated as a deferral of compensation).

Conclusion

It is clear that much remains to be settled regarding the treatment of discounted non-statutory stock options as deferred compensation. In the meantime, employers, particularly non-publicly traded employers, issuing non-statutory stock options will need to adjust their view of this important financial and motivational tool to take into account the possible effect of Code Section 409A.

Recent legislation has heralded a dramatic shift in the United States federal income tax treatment of nonqualified deferred compensation arrangements. One of the potentially more far-reaching aspects of the legislation is its effect on individuals who receive certain non-statutory stock options for their services. This article focuses on the circumstances under which the Act treats compensatory stock op-tions as nonqualified deferred compensation for federal income tax purposes, the consequences of such treatment, and the resulting practical considerations in dealing with the treatment of certain stock options as nonqualified deferred compensation.

Background

In October 2004, President Bush signed into law the American Jobs Creation Act (the Act). The Act added new Section 409A to the Internal Revenue Code of 1986 (the Code) generally effective for amounts deferred after Dec. 31, 2004. Concerned about “the popular use of deferred compensation arrangements by executives to defer current taxation of substantial amounts of income,” Congress enacted Code Section 409A to narrow the circumstances under which executives could effectively defer the recognition of taxable compensation. In doing so, however, Congress cast an extremely wide net. Section 409A draws no distinction between executives and lower echelon employees and it defines the targeted class of “nonqualified deferred compensation plans” in the broadest possible terms subject to a very limited list of exceptions. As a result, certain compensatory non-statutory stock option arrangements are now subject to the Code Section 409A regime, with possibly disastrous tax results to the option holders.

Operation of Code Section 409A in General

New Code Section 409A adversely affects the federal income tax treatment of so-called “nonqualified deferred compensation plans” in three ways. First, it effectively taxes an individual on all deferred compensation to which he is entitled under a nonqualified deferred compensation plan once he vests in the right to receive such future compensation unless the plan meets certain conditions. Those conditions are more stringent than the requirements for effective deferral under prior tax law. Second, Section 409A imposes a penalty tax of 20% on a participant in a nonqualified deferred compensation plan that fails to comply with the enumerated conditions. Third, it adds an interest charge on the tax attributable to ineffective deferrals under non-conforming plans.

One of the many conditions that Code Section 409A imposes on non-qualified deferred compensation plans for avoidance of the adverse tax consequences described above is a requirement that the employee not have control over the timing of future compensation payments once his right to that compensation has become non-forfeitable (ie, vested). In contrast, compensatory stock options usually give the option holder wide discretion as to the timing of option exercise once the option vests and, therefore, the potential ability to defer taxation of option-related compensation into subsequent tax years by simply postponing the date of option exercise. The discretion to control the timing of the taxable event associated with option exercise is fundamentally at odds with, and will rarely satisfy, the “compensation timing” conditions imposed by Code Section 409A.

Therefore, in cases in which a compensatory stock option is a nonqualified deferred compensation plan subject to Code Section 409A, the option holder normally will incur taxable compensation income under Section 409A of the Code at the time the option vests. The amount of that taxable income appears to equal the excess on the vesting date of the fair market value of the underlying option shares over the option exercise price, although IRS has provided no clear guidance on this point yet. Taxes would be due from the option holder (with an associated withholding obligation on the option issuer if the option holder is an employee) whether the option was ultimately exercised or not, and the 20% penalty tax would also apply.

In light of such dire tax consequences, it is critical that employers issuing compensatory stock options, and the employees, directors and other service providers to whom such options are issued, understand whether Code Section 409A will apply to their stock options and if necessary act to avoid the resulting adverse tax consequences.

What Types of Stock Options Are Subject to Code Section 409A?

General

Prior to the Act, compensatory stock options generally were not viewed as nonqualified deferred compensation plans for income tax purposes. As described below, the Act effectively changes that view as to certain “discounted options.” Discounted options are compensatory stock options that permit the option holder to purchase the underlying option shares at an exercise price which is less than the fair market value of those shares on the date of option grant.

Code Section 409A(d)(1) broadly defines the term nonqualified deferred compensation plan to include “any plan that provides for the deferral of compensation” other than certain enumerated types of tax-qualified retirement plans, bona fide employee leave arrangements, compensatory time plans, disability pay and death benefits. This broad statutory definition clearly encompasses the typical compensatory stock option that allows the option holder to defer recognition of taxable income until the year of option exercise or later. Thus, absent regulatory relief, all compensatory stock options would fall within the definition of nonqualified deferred compensation plans subject to Section 409A.

The ISO, ESPP and Non-Discount Option Exceptions

Fortunately, Congress indicated in the applicable legislative history that two categories of compensatory stock options are excused from the new nonqualified deferred compensation tax regime. The first category of excluded options is statutory stock options. Statutory stock options are incentive stock options qualifying under Section 422 of the Code (ISOs) and options issued under a Code Section 423 compliant employee stock purchase plan (ESPP Options). By definition, ISOs are options granted with an exercise price at least equal to 100% of the underlying fair market value of the option shares on the date of option grant. ESPP Options can be permit purchase of employer shares with up to a 15% discount. The second category of exempt options mentioned in the legislative history is non-statutory options issued with an exercise price of not less than 100% of the fair market value of the underlying option shares on the date of option grant. Congress granted IRS regulatory authority to deal with the treatment of options under Code Section 409A.

In IRS Notice 2005-1 (Dec. 20, 2004), the IRS announced that ISOs and ESPP Options would not be treated as nonqualified deferred compensation plans under Section 409A of the Code. The IRS also announced in Notice 2005-1 that a non-statutory stock option granted to an employee or other service provider would not be a nonqualified deferred compensation plan subject to Code Section 409A if certain conditions are met. First, the amount required to purchase stock under the option (the exercise price) may never be less than the fair market value of the underlying stock on the date of grant. Second, the receipt, transfer or exercise of the option must be subject to taxation under Code Section 83, which it normally would be. Third, the option may not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of exercise or disposition of the option. Accordingly, ISOs, ESPPs and most other non-discounted compensatory stock options (ie, those that offer no further deferral opportunity post exercise) will escape the provisions of Code Section 409A

Discounted Non-Statutory Options

Discounted non-statutory options are an entirely different matter. The legislative history of Code Section 409A makes no specific mention of the status of discounted non-statutory options under Section 409A, but the logical inference to be drawn from that silence is that discounted non-statutory options are subject to Section 409A.

IRS Notice 2005-1 is consistent with that conclusion. It states in pertinent part that except for statutory options and non-discounted, non-statutory options meeting the conditions described above, the grant of a compensatory stock option provides for a deferral of compensation subject to Code Section 409A. The Notice then further states with respect to non-statutory options that:

“[If] under the terms of the option, the amount required to purchase … the stock is or could become less than the fair market value of the … stock on the date of grant, the grant of the stock option may provide … for the deferral of compensation within the meaning of [Section 409A].” (Emphasis added).

It is unclear why the IRS elected in Notice 2005-1 to use the equivocal word “may” rather than the more absolute word “will” in describing whether discounted, non-statutory options are subject to the new Section 409A regime. Perhaps the IRS intends to allow taxpayers the latitude to argue that a minor or unintentional discount exercise price does not render the stock option subject to Section 409A. Prior to the Act, IRS representatives had informally taken the position that compensatory stock options that were “too-deeply-discounted” might be currently taxable to the option recipient. But that position lacked a clear statutory foundation and the issue of how much discount was “too much” was unclear. Now that Congress has given the IRS the ability to deal with the discount option issue under Section 409A it seems curious that the IRS would want to leave room for discounted non-statutory options to escape the grasp of Section 409A on the basis that the exercise price discount is slight or inadvertent. Absent further IRS guidance, it seems dangerous to rely on Notice 2005-1's use of the term “may” as a basis for excluding discounted non-statutory options from Section 409A.

Note that it may still be possible for a discounted, non-statutory option to fall outside the reach of Code Section 409A if the option terms limit the deferral opportunity, but such instances will be rare. For example, an option that vests and is exercisable only at the time of a specified future event which is both outside the option holder's control and uncertain to occur (eg, a sale of the business) appears to fall outside the definition of deferred compensation because there is no deferral between the time of vesting and the taxable event of exercise. Similarly, under IRS Notice 2005-1, a discounted, non-statutory stock option that could only be exercised within the taxable year in which it vests appears to be outside the IRS's announced definition of nonqualified deferred compensation. Such “short-lived” options, however, would rarely be practical compensation vehicles.

Therefore, as a general rule, discounted, non-statutory stock options should be viewed as subject to Code Section 409A and avoided.

Determining Discounted Option Status

Given the problematic tax status of discounted, non-statutory stock options, the question arises as to how employers issuing non-statutory stock options are to determine whether the options are being issued at a discounted exercise price. The IRS indicated in Notice 2005-1 that any reasonable valuation method may be used for determining the fair market value of the underlying option shares on the grant date. Such methods include, for example, the valuation methods described in the IRS' Estate Tax Regulations. The IRS, however, has not yet completely adopted under Code Section 409A the analogous ISO pricing rules found in Treasury Regulation Section 1.422-2(e). Most notably, in determining whether an option satisfies the Code Section 422 ISO requirement that the option exercise price be at least 100% of fair market value, Treasury Regulation Section 1.422-2(e)(2) provides that the issuer's good faith determination of fair market will be respected. Unfortunately, that “good faith” ISO valuation safe harbor has not yet been grafted into rules under Code Section 409A. This lack of symmetry in the valuation rules poses no problem so long as the option in question is issued as an ISO because ISOs are exempt from Code Section 409A. But if the option is not intended to qualify or does not qualify as an ISO, the “good faith” valuations may not help under Code Section 409A.

For publicly traded companies with regularly quoted stock prices, the task of determining whether non-statutory options are being issued with a discounted exercise price should be relatively easy. Use of the closing day price on the option grant date or on last preceding trading date, the average price on the grant date or preceding trading date, or the average price over some narrow range of trading days immediately prior to the grant date should suffice.

For non-publicly traded employers, however, the pricing issue is much more difficult. Absent appraisals or contemporaneous third-party sales of shares of the same class covered by the options in question, it may be difficult to know whether or not the non-statutory options are being issued at a discount. The burden of proving lack of a discount will be on the employer and employee should the IRS assert that there was a discount.

This valuation uncertainty effectively leaves many small, non-publicly traded businesses at a disadvantage vis-'-vis publicly traded employers with respect to the ability to compensate employees through non-statutory stock options. Because of the exemption of ISOs from 409A and the good faith valuation standard that applies in setting the ISO exercise price, all employers (and particularly small non-publicly traded employers) should have an increased preference going forward for ISOs rather than non-statutory options.

It is also worth noting that securities law disclosures to option recipients should be expanded to address the risk that options will be taxed as nonqualified deferred compensation to recipients. Employers must decide what to advise employees regarding the option valuation issue, and whether to continue offering non-statutory stock options if there is a risk that employees are taxable on the option at the time of vesting.

Transition Relief for Discounted Stock Options Vesting After 2004

Under IRS Notice 2005-1, discounted non-statutory options issued prior to the Act that do not vest until after 2004 are subject to new Section 409A and the attendant adverse tax consequences once they vest. To provide transition relief in such situations, IRS Notice 2005-1 permits an effective repricing of the options to eliminate the discount through the issuance of replacement options. Option modification under the transition rule must occur by Dec. 31, 2005. Employers with non-statutory discount stock options issued before the Act, but first vesting after 2004, should now consider modifying their options to obtain the transition relief. The transition relief only applies if: 1)the number of shares under the new stock option corresponds directly to the number of shares under the original stock option; and 2) the new stock option does not provide any additional benefit to the holder (other than the benefit directly due to a change in form of the award to a form not treated as a deferral of compensation).

Conclusion

It is clear that much remains to be settled regarding the treatment of discounted non-statutory stock options as deferred compensation. In the meantime, employers, particularly non-publicly traded employers, issuing non-statutory stock options will need to adjust their view of this important financial and motivational tool to take into account the possible effect of Code Section 409A.