Court Rules Discounted Stock Options Are Nonqualified Deferred Compensation

The U.S. Court of Federal Claims has ruled in Sutardja v. United States (Fed. Cl., No. 11-724T) that stock options granted to an employee were deferred compensation subject to Section 409A, pending a ruling on the fair market value of the underlying stock on the grant date. The court did not come to a complete resolution regarding whether the stock options were subject to Section 409A, because a determination had not yet been made regarding whether the stock options were discounted (i.e., issued with an exercise price less than the fair market value of the underlying stock on the grant date).

The grant of nonqualified stock options that was the center of the case was approved by the compensation committee of Marvell Technology Group Limited on Dec. 26, 2003. But the grant wasn't ratified until Jan. 16, 2004. The exercise price of the options was set at the trading price of Marvell's stock on Dec. 26, 2003. In January 2006, Sutardja exercised a portion of the stock options and recognized compensation income equal to the spread of the option. After the exercise of the options, an internal committee of Marvell determined that the grant date of the options was Jan. 16, 2004, at which time the trading price of the company's stock had increased from the price on Dec. 26, 2003.

Section 409A places strict requirements on nonqualified deferred compensation, which generally includes discounted stock options. If these requirements are not met, the intrinsic value of the discounted stock options can be included in the employee's income at the time of vesting, even if the options are not exercised, and the income is subject to an additional 20% income tax.

Sutardja argued that if the stock options were in fact discounted, they were not subject to Section 409A for various reasons. First, based on Supreme Court rulings in Comm'r v. LoBue, (351 U.S. 243, 247) and Comm'r v. Smith (324 U.S. 177, 181), stock options are not taxable until they are exercised. Thus, Sutardja argued that Section 409A could not require him to recognize income prior to the exercise of the options, and, therefore, there was no deferred compensation. The court rejected this argument because the Supreme Court's rulings were based on options that were not discounted.

Second, Sutardja argued that because these options were granted and exercised before the final Section 409A regulations became effective, the definition of deferred compensation should be determined under Treas. Reg. Sec....