Section 409A Pitfalls with Stock Options

A federal court ruled several weeks ago that discounted stock options (stock options where the exercise price is less than the fair market value on the grant date) are deferred compensation under Internal Revenue Code Section 409A. Section 409A sets up rules for the awarding of any kind of nonqualified deferred compensation, and further provides that such compensation which does not meet the requirements of the section is subject to being included in gross income in the grant year if immediately vested, or if the options are vesting in the tax year in which such options vest, plus interest and a 20% “penalty” tax.

Much of the controversy in the federal court case surrounding whether the options were discounted stems from the fact that the company which granted the options was a publicly traded company, and as a result the fair market value of its stock varies from day to day. Conversely, startup companies have the benefit that the fair market value of their stock does not vary so wildly. However, Section 409A and the issue of discounted stock options can be something to consider even for startups who utilize stock options, especially if the startup is in the midst of some sort of valuation or liquidity event, such as a Series A round, which can alter the fair market value of its stock.

The federal court ruling stresses the importance for every company, including startups, that grants stock options, to properly document the fair market value of its stock upon the grant of options, lest there be an issue of whether the options were discounted. If the tax liability of the grantee under a Section 409A violation would be a significant amount, without documentation to back up the fair market value, it could catch the attention of the IRS.

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