The recent US court case of Sutardja v. United States has reinforced the advisability of issuing stock options with an exercise price at or above the fair market value of the underlying stock on the date of grant to US taxpayers. The decision is an important reminder that discounted stock options are a form of deferred compensation that is subject to the complex rules of Internal Revenue Code (“IRC”) Section 409A, which can lead to substantial tax penalties for the optionee if the stock option plan is not drafted in compliance with IRC Section 409A’s deferral and payment provisions.
The optionee taxpayer received a Notice of Deficiency from the IRS for roughly $4 million, representing a 20% excise tax, plus interest, for IRC Section 409A violations on the grounds that the stock options constituted deferred compensation because they had been granted at a discount. Not surprisingly, the taxpayer disputed the claim.
The plaintiff relied on the 1945 Supreme Court case of Commissioner v. Smith to protect him from the Section 409A penalties because that case had held that an option to purchase stock is only taxable when the option is exercised. However, the Sutardja court held that Smith did not apply, because the options in Smith had been granted with an exercise price that was not less than fair market value. The Sutardja court’s ruling left one key question unanswered: were the stock options in fact issued at an exercise price below the fair market value of the underlying stock? The court deferred a decision on this point.
In light of the court’s conclusion, issuing stock options with an exercise price below the fair market value of the underlying stock on the date of grant should be approached with caution. If you have issued discounted stock options during 2013, now would be a good time to consider a correction under Section IV.D. of IRS Notice 2008-113 which allows the exercise price to be adjusted to fair market value.