In today’s tight labor market, companies are constantly searching for creative ways to attract and retain top talent. While innovative start-ups and larger companies have long granted equity as a means of attracting, retaining, and incentivizing skilled and talented workers, more mid-market and small companies in a variety of industries are turning to such strategies to gain a competitive edge over their peers.
One common type of equity incentive granted to service providers are stock options, which are attractive to both the company and service providers for a multitude of reasons. From the company’s perspective, stock options not only incentivize employees to grow the business and align their interests with the owners, but they also require the individual to pay cash to the company in an amount equal to the exercise price of the option, thereby forcing the individual to have more “skin in the game” in comparison to outright grants of stock or restricted stock for no consideration. Additionally, options can act as an alternative for cash compensation so the company can conserve cash. From the perspective of the service provider, stock options are attractive since they provide the individual an opportunity to become an owner of the company and to determine when to exercise the option and, thus, recognize income.
Notwithstanding the ubiquity of stock options and the benefits they provide companies and service providers, many business owners and option recipients are not aware that stock options may be subject to the onerous requirements of Section 409A of the Internal Revenue Code and that failure to comply not only minimizes the benefits and flexibility of stock options (especially for the recipients) but also may lead to significant tax consequences.
Under the Internal Revenue Code, options may be either classified as “incentive stock options” (or statutory options) or “nonqualified stock options” (or non-statutory options). Incentive stock options are exempt from Section 409A if they are issued pursuant to Section 422 of the Code and continue to meet the requirements thereof. Any options that fail to meet the requirements of Section 422 are nonqualified stock options.
Nonqualified stock options are exempt from Section 409A only if:
- the exercise price is never less than the fair market value of the underlying stock on the date the option is granted and the number of shares subject to the option is fixed on the original date of grant of the option;
- the transfer or exercise of the option is subject to taxation under Section 83 of the Code; and
- the option does not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of the (i) exercise or disposition of the option or (ii) the time the stock acquired pursuant to the exercise of the option first becomes substantially vested.
If the option fails to meet any of these requirements, then the option will be deemed to be deferred compensation and, thus, subject to Section 409A. Being subject to Section 409A creates problems for the unknowing company and recipient since Section 409A mandates that deferred compensation be distributed only in connection with the permissible payment events set forth in Section 409A, e.g., death, disability, separation from service or a change of control, to name a few.
Company’s stock option plans generally become inadvertently subject to Section 409A by issuing options with an exercise price below the fair market value of the underlying stock, i.e., “discounted options.” Discounted options may arise in two situations – first, on the date of grant if the exercise price is less than the fair market value of the underlying stock on the grant date, and second, on the date the term of the option is extended if the exercise price is less than the fair market value of the underlying stock on such date.
If the company’s options are intentionally or inadvertently discounted, then the options must be structured in such a way that complies with Section 409A. Specifically, the option plan and agreement must provide that either (i) the options may only be exercised upon the occurrence of one of the permissible payment events set forth in Section 409A, or (ii) the underlying stock may only be delivered upon the occurrence of a permissible payment event even though such options are exercisable at any time after vesting and prior to the termination date. While discounted options with these features would comply with Section 409A, they are not particularly attractive elements for option recipients since they remove the main benefits of options, such as the flexibility in determining when to exercise the options and recognize income or enjoy the benefits of stock ownership upon exercise.
If stock options subject to Section 409A do not comply with its requirements, then severe tax consequences result from such failure, all of which generally fall on the recipient. First, the stock options themselves become immediately taxable to the recipient upon grant, or if such options are unvested, then upon vesting. Second, the recipient, in addition to regular income tax, is subject to a 20% penalty on the amount of deferred compensation inherent in the option, i.e., the spread between the exercise price and the fair market value of the underlying stock on the grant date. Third, interest may apply to the compensation that was deferred and vested from prior years. Finally, the company may be subject to penalties if it failed to report and withhold on amounts that became subject to taxation due to the Section 409A failure.
To avoid these negative tax consequences and maintain the desired flexibility of stock options, it is necessary to draft the option plan and issue options in such a manner that exempts the options from Section 409A. Therefore, it is critical to obtain a Section 409A valuation of the company’s stock prior to granting the options so the exercise price is at least equal to the stock’s fair market value. While such valuations may be time-consuming and expensive, the benefits of being exempt from Section 409A substantially outweigh such costs.
If you have questions about anything discussed in this blog post, or for further counsel, please reach out to Brian Barrett or a member of the Fortis corporate team.
