Printer Friendly

Sec. 409A and stock options: a cause for concern?

As the tax filing deadline approaches, questions always arise about clients who exercised stock options last year and are now in shock over their tax bills. These clients forgot to consider how exercising their options could affect their compensation or capital gain.

Sec. 409A was added to the Code as part of the American Jobs Creation Act of 2004 (AJCA), effective as of Jan. 1, 2005. What is the impact of Sec. 409A on stock options for 2005 and beyond?


Incentive stock options (ISOs) are options granted to individuals for any reason connected with their employment by a corporation to purchase the stock of such corporation. To be treated as an ISO, an option must meet certain requirements under Sec. 422, which include, among others, (1) an option price that is greater than or equal to the fair market value (FMV) of the corporation's stock at the time the option is granted and (2) an individual who, at the time the option is granted, does not own more than 10% of the total combined voting power of all classes of stock.

When a corporation grants an ISO to an employee, there is no tax effect for either the employee or the corporation at the grant date. Once the ISO is exercised, the employee does not recognize any income at the exercise date, according to Sec. 421. Further, the corporation cannot deduct the transfer of its stock to the employee. The employee's basis in the stock received will be equal to the amount paid under the option at the exercise date.

Qualifying Dispositions

When employees sell the stock they acquired through stock options, their goal is a long-term capital gain. A disposal of shares acquired through an ISO must meet employment and holding period requirements to be a qualifying disposition, which would also qualify for capital gain treatment. The holding period requirement defined in Sec. 422(a)(1) states that an employee must hold the stock for at least two years from the ISO's grant date, and; if later, at least one year following the exercise date before disposal. The employment requirement under Sec. 422(a)(2) states that the employee must have been an employee beginning on the date that the option was granted and up to three months prior to exercising the option. If the ISO meets both of the requirements, the disposition will be a qualifying disposition and receive capital gain treatment.

Note: Sec. 56(b)(3) can disallow the benefit of Sec. 421 for alternative minimum tax (AMT) purposes. The spread between the exercise price and the FMV on the exercise date is reported for AMT purposes on exercise. The shares then carry a different basis for that purpose.

Disqualifying Dispositions

A disqualifying disposition occurs when an employee sells ISO shares without satisfying the holding period requirement. As many option holders often exercise an option and sell the stock for cash the same day, disqualifying dispositions are very common. Sec. 421 will not apply to a disqualified disposition--treatment is similar to that of a nonqualified stock option (NQSO).

If a disqualifying disposition occurs, the option holder has to include compensation income in gross income for the year. The compensation income will be equal to the stock's FMV on the exercise date less the option price paid. On the disposition date, the corporation will be allowed a compensation deduction equal to the income recognized by the option holder. Even if the employee triggers ordinary income due to a disqualifying disposition, there is no FICA or Medicare tax due on ISO shares.


NQSOs are treated very differently from ISOs. Like ISOs, there is no income at the grant date. However, the holder (who may or may not be an employee of the issuing company) generally has to include in income the difference between the stock's FMV at the exercise date over the price paid for the stock. This income is ordinary income to the recipient (in accordance with Sec. 83) and, when added to the price paid, becomes the basis of the stock acquired through exercise. The difference between the FMV at the exercise date and the price paid can be deducted by the issuing company as compensation. Consistent with Sec. 83, if the stock received is subject to a substantial risk of forfeiture, taxation may be delayed until such risk lapses.

Effect of Sec. 409A

Sec. 409A restricts the ability of executives to control the deferral compensation and applies rigorous standards to the timing of elections to defer compensation and the form and timing of the eventual receipt of those deferrals. In addition, changes have been made in the funding and security of such plans. Consistent with the new restrictions, Sec. 409A imposes new reporting requirements.

Failure. to satisfy the new standards under Sec. 409A results in current taxation, a 20% penalty tax and a potential interest charge for amounts deferred or vested under a nonqualified deferred compensation (NQDC) plan after Dec. 31, 2004.All U.S. employers have until Dec. 31, 2006 to bring the terms of their NQDC plans in line with these changes. Until then, plans are required to make a "good faith" effort to comply with the rules.

There are certain exceptions to Sec. 409A. Under Notice 2005-1, the grant of an ISO as described in Sec. 422 is not a deferral of compensation; thus, ISOs are excluded from Sec. 409A treatment. This is consistent with Congressional intent.

Further, under Notice 2005-1 and the proposed regulations (REG-158080-04), an NQSO will not be considered deferred compensation for Sec. 409A purposes if the following conditions are met:

* The exercise price is never less than FMV on the grant date;

* The number of shares is fixed at the grant date;

* The option privilege is for stock of the service recipient; and

* The option does not otherwise provide for the deferral of income.

For purposes of determining the stock's FMV at the grant date, any reasonable method may be used. Three techniques presumed reasonable for valuing nontraded shares are provided by Prop. Regs. Sec. 1.409A-1(b)(5) (iv)(B). Further, Notice 2006-4 clarifies the transition guidance.

The FMV grant requirement and the apparent inconsistencies between the rigor of the measurement for Sec. 422 in comparison with new Sec. 409A has become one of the most contentious issues under the new rules. If NQSOs are deemed issued at a price lower than the FMV of the underlying stock on the grant date, Sec. 409A would apply.

When Sec. 409A applies to options, an employer is faced with a choice of two unattractive alternatives. Under the transition guidance, it can re-price options to FMV as of the grant date, by no later than Dec. 31, 2006. When the employer wishes to retain the below-market exercise price, the exercise privilege on the option will need to be revised to comply with Sec. 409A. In other words, the "option" concept of triggering income at the discretion of the employee must be eliminated, and the employee will exercise the option on the passage of a specific period or on attaining an objectively determined event (e.g., separation from service, death, disability or a sale of the company). Note: this approach works only for NQSOs.

New Reporting Requirements

New reporting rules were supposed to be effective for amounts deferred in calendar years beginning after 2004. One of the key requirements of the new rules includes annual reporting on Form W-2 or Form 1099-MISC of all amounts deferred, whether or not includible in income for the year. However, according to Notice 200594, the IRS is now suspending employers' and payors' reporting and wage withholding requirements for calendar-year 2005 for compensation deferrals under Sec. 409A. Further, future published guidance may require an employer/payor to file a corrected information return and to furnish a corrected payee statement for calendar-year 2005, which will report any previously unreported income under Sec. 409A. This relief does not apply to amounts currently includible in income. The service provider/individual must file a return and pay any taxes due for amounts includible in gross income under Sec. 409A for calendar-year 2005. Also, the IRS will not assert additional penalties over the 20% tax due under Sec. 409A for amounts includible in gross income under Sec. 409A, as long as the service provider reports the income and pays taxes in accordance with future published guidance.

How will taxpayers know which amount to include in gross income and the amount on which to pay taxes if they do not receive a statement from their employer or payer? The IRS appears to be aware of this problem but has not provided additional guidance. According to Notice 2005-94, it is currently working on guidance that it expects to issue in the first half of 2006. The guidance should provide a period during which taxpayers can report and pay taxes due on deferred compensation includible in gross income without incurring penalties. The IRS has stated however that interest will apply to any underpayments of tax resulting from a taxpayer's failure to include amounts includible in gross income under Sec. 409A for calendar-year 2005.


Stock options are a popular method of motivating and retaining employees. How much Sec. 409A will affect the number of companies offering these benefits is yet to be seen. Clearly, the new financial reporting standards for equity-compensation awards come at a bad time. They have been blamed for the revision, curtailment and termination of option awards by many companies. This compensation technique is also being highlighted by the Securities & Exchange Commission's current focus on executive compensation. Further, the uncertainty associated with the implications of Sec. 409A for option awards certainly works against the growth of these programs.

Sec. 409A has raised several thought-provoking questions that may not be answered until the IRS publishes further guidance. However, tax professionals need to be aware of the implications of Sec. 409A on stock options. It is wise to start asking questions now, so that clients become aware of the possibilities, and to continue to make any suggestions and/or changes to comply with future published guidance as it is released.

COPYRIGHT 2006 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2006, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
Printer friendly Cite/link Email Feedback
Author:Wood, Susan
Publication:The Tax Adviser
Date:Apr 1, 2006
Previous Article:UNICAP controversy.
Next Article:Energy-efficient commercial building deduction.

Related Articles
Tender offer considered an option under Sec. 382 option attribution rule.
Nonqualified deferred compensation plans: new rules under the AJCA.
The law of unintended consequences: international implications of section 409A.
Current developments (Part I: this two-part article provides an overview of current developments in employee benefits, including executive...
Sec. 409A: where do taxpayers stand?
PSC retirement agreements may be subject to sec. 409A prop. regs.
Funding arrangements under sec. 409A.
Deferred compensation for executives under sec. 409A.
Deferred compensation for executives under sec. 409A.
Current developments.

Terms of use | Copyright © 2017 Farlex, Inc. | Feedback | For webmasters