Court Affirms Discounted Stock Options Are Deferred Compensation Subject To Section 409A

Court of Federal Claims agrees with the IRS position that section 409A applies to discounted stock options; holding is important for compensatory stock option grants.

On February 27, the U.S. Court of Federal Claims ruled in Sutardja v. United States,1 finding that section 409A of the Internal Revenue Code applies to discounted stock options, with the potential adverse tax consequences that the entire appreciation in the option position is subject to the 20% penalty tax under section 409A in addition to ordinary income tax and that this tax would be payable on option vesting rather than on exercise.

Background

Section 409A of the Internal Revenue Code provides a comprehensive set of rules regulating the taxation of nonqualified deferred compensation. Section 409A does not explicitly define "deferral of compensation," but, throughout Internal Revenue Service (IRS) notices, proposed regulations, and the final Treasury Regulations, the IRS has been consistent in its position that discounted stock options are deferred compensation subject to section 409A. Most notably, IRS Notice 2005-1 states that, if a stock option is granted with a per share exercise price that is less than the fair market value of the underlying stock on the date of the grant, the option will be treated as a deferral of compensation and will fall under the parameters of section 409A.2

Sutardja Decision

In Sutardja, the Court of Federal Claims affirmed the IRS's position that Section 409A applies to discounted stock options. The case arose after the IRS determined that the plaintiff's exercise of stock options was subject to an additional 20% tax under section 409A. The plaintiff was the president, chief executive officer, and chairman of the board of directors of a technology company whose stock is traded on the NASDAQ stock exchange. The plaintiff exercised his stock options in 2006, during a transition period between the effective date of section 409A and the effective date of the applicable regulations.

The plaintiff argued that the definition of "deferrals of compensation" under Notice 2005-1 was contrary to U.S. Supreme Court jurisprudence. Specifically, in the seminal case of Commissioner v. Smith,3 the Supreme Court established the principle that the mere grant of employee stock options is not a taxable event. In that case, the Supreme Court analyzed an option to purchase stock "at a price not less than the then value of the stock"4 (i.e., a nondiscounted option) and...