SEC is Tightening the Screws on Pre-IPO Stock Awards

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JavaScript is turned off in your web browser. Turn it on to take full advantage of this site, then refresh the page. Court of Federal Claims agrees with the IRS position that section A applies to discounted stock options; holding is important for compensatory stock option grants.

On February 27, the U. Court of Federal Claims ruled in Sutardja v. Section A of the Internal Revenue Code provides a comprehensive set of rules regulating the taxation of nonqualified deferred compensation.

Section A 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 A.

Most notably, IRS Notice 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 A. 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 induring a transition period between the effective date of section A and the effective date of the applicable regulations. The plaintiff argued that the definition of "deferrals of compensation" under Notice was contrary to U.

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. Since Notice preserves the same treatment for nondiscounted options by excluding them from the definition of "deferred compensation," the Court of Federal Claims found that the Notice was, in fact, consistent with Supreme Court jurisprudence.

The plaintiff also argued that, in determining what constitutes a "deferral of compensation," the court should look to the definition contained in the Federal Insurance Contributions Act FICA regulations, [5] which includes a definition substantially similar to the definition in Notice The FICA regulations, however, specifically exclude the grant of a stock option from the definition "for purposes of Section v 2.

Finally, the plaintiff argued that, even if the option was granted at a discount and subject to section A, any deferral of income would fall within the short-term deferral exception because he exercised the fully vested portions of the option in January and therefore did not defer his compensation for a period greater than two and a half months after the year in which the portions of the option vested. The court disagreed, stating that the stock option plan under which the plaintiff's option was granted allowed for a vested option to be exercised within 10 years from the grant date, thus exceeding the two-and-a-half-month short-term deferral period.

This conclusion conforms to the IRS's position as stated in Chief Counsel Advice[6] which had been somewhat controversial because a number of taxpayers believed that this conclusion was not clearly required by Notice The court also held that section A enacted a statutory change that results in the treatment of discounted stock options as deferred compensation for purposes of section A.

However, the plaintiff has not yet lost his case because the court concluded that a genuine issue of material fact existed as to whether the stock option was discounted at the time it was granted. The matter will be set for trial, and, given the facts and circumstances of the stock option grant, there still remains the possibility the plaintiff will prevail.

This decision underscores the importance of careful attention by issuers of stock options to determining and documenting the fair market value strike price of options so as to withstand review on audit. The regulations under section A provide procedures for determining fair market value for these purposes, and there are advantages and disadvantages to the alternatives provided. In the event that the issuer wants to issue a stock right to a service provider with a built-in discount, a number of methods of accomplishing this goal are available.

However, this decision serves as a good reminder that discounted stock options or discounted stock appreciation rights must be treated as deferred compensation subject to section A payment timing restrictions and must be properly documented to be compliant with section A from the date of the grant, or profoundly negative section A tax consequences will apply. Further, future developments in this case addressing the factual and legal issues relating to the determination of the grant date also merit watching, because the Court of Federal Claims is expected to address in its next decision issues relating to i the compensation committee's authority to make grants; ii the effect of ratification of prior grants; and iii the special "good faith" exception, which protects taxpayers from the assessment of any taxes under section A if any option granted before had been granted in compliance with the incentive stock option regulations and the parties to the option agreement believed in good faith that the option was not discounted.

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis attorneys: New York Craig A. James DiBernardo Zaitun Poonja. Handy Hevener Gregory L. United StatesNo. View Notice here. SmithU. View Chief Counsel Advice here. Background Section A of the Internal Revenue Code provides a comprehensive set of rules regulating the taxation of nonqualified deferred compensation.

Implications This decision underscores the importance of careful attention by issuers of stock options to determining and documenting the fair market value strike price of options so as to withstand review on audit. Stapel New York Craig A. Rothstein Palo Alto S.

Zelikoff Pittsburgh Lisa H. Randall Tracht Washington, D. See NoticeI.

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Many small, closely held companies, especially start-up companies, like to issue stock options to key executives and employees as both an incentive to help grow the company and as a substitute for cash compensation when they need the cash to invest in the business. In both instances, the tax consequences for executives and employees can be disastrous. IRC section A provides comprehensive rules regulating the taxation of nonqualified deferred compensation.

While section A does not explicitly define a "deferral of compensation," the IRS has been consistent in its position that discounted stock options are deferred compensation subject to section A throughout its notices, proposed regulations, and the final regulations. Specifically, IRS Notice states that if a stock option is granted with an 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 be subject to the requirements of section A.

The attraction of stock options to executives and employees is that they themselves control the timing of income recognition by timing the exercise of the option.

If section A applies to the option, this flexibility is lost, substantially eliminating the value of the stock option. To avoid taxation under section A, the option must either be specifically exempted from section A or meet certain requirements as outlined below.

Incentive stock options issued pursuant to IRC section and stock options issued under an employee stock purchase plan pursuant to IRC section are specifically exempted under the regulations from section A provided that they continue to meet the applicable qualification requirements of those sections of the IRC.

If any of the requirements of section A outlined above are violated, the nonqualified stock options or SARs are immediately taxable or, if later, upon vesting when the stock option is no longer subject to a substantial risk of forfeiture.

The amount recognized as ordinary income by the grantee is the excess of the fair market value of the stock at December 31 less the exercise price and any amount paid for the option at grant. Further, any appreciation in the value of the option in subsequent years is also taxed under section A including the year the option is exercised [Treas.

In conducting field audits, the IRS is clearly looking at stock option grants with respect to whether the option was granted at fair market value. The case, Sutardja v. United States, is not yet settled; however, in an initial ruling the Court of Federal Claims confirmed that section A applies to stock options. Still to be decided in the case is whether, based on the facts, the options granted were in fact granted at a discount to fair market value. With confirmation that section A applies to stock options, the IRS will continue to scrutinize option grants.

All businesses need to be aware of the rules applicable to the granting of stock options and SARs to their employees. Closely held businesses need to be acutely aware of the valuation requirements related to stock and appreciation right grants under section A to avoid the extremely harsh tax consequences imposed on the employee for failure to comply with these rules.

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