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Discounted Stock Options Hit With Section 409A Surtaxes

A recent summary judgment decision, in Sutardja v. United States (Federal Claims No. 11-724T 227-13), makes it clear that discounted stock options face the draconian penalties of IRC Section 409A. The ruling upheld the IRS assessment of a 20% surtax plus interest on income the plaintiff received at option exercise under deferred compensation arrangements found to be noncompliant with 409A. The amounts in dispute total $3,172,832, plus another $304,456 in interest. While in this challenge to the IRS assessment the court still must decide whether discounted stock options were actually granted, it brushed off all the plaintiff's legal arguments claiming that Section 409A does not apply to discounted options.

This case drew attention in a few different law firm blogs. These included Benefits Notes by Leonard Street & Deinard, where attorney bloggers discussed the case on March 7 and again on March 12. As the attorneys warn, the IRS is strictly enforcing the Section 409A rules in examinations of employers. Unless discounted options are structured to be exercised only on a fixed date or upon an allowable 409A event, the law firm urges companies to use one of the safe harbors in the regulations on setting exercise prices. It also warns executives that "they can be the ones who suffer even if they are not the ones who set the discounted price for the options."

In an alert on March 21, the law firm Morgan Lewis examines some implications of the decision. In their view, the case symbolizes the need for careful attention in determining and documenting how the fair market values of options are determined—at the risk of dire tax consequences. The firm also notes that the plaintiff, a co-founder of a now public and successful semiconductor company, "may still prevail" in the trial to determine whether the options were discounted when the company was private, so additional developments in this case "merit watching."

In his Executive Compensation Blog (Mar. 26), comp and benefits attorney Michael Melbinger of Winston & Strawn criticizes the IRS decision to bring the case, given the common stock option grant practices at the time of the disputed activities. He feels "it is extremely disappointing that the IRS would demand penalties under the facts and timeline in this case."

For additional information on discounted stock options, see the related FAQ on See also, our sister website on nonqualified deferred compensation, for details on IRC Section 409A.


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Bruce: Would ESOs or SARs grants whereby the stock was manipulated down by large firms selling client stock to knock it down to accommodate those grants be considered "discounted stock options" and thereby be subject to 409A penalties?

John Olagues

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