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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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