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05-02-2013 Employees Could Face Surplus Tax on Exercise of Discounted Stock Options

On February 27, 2013, the United States Court of Federal Claims issued a summary judgment opinion in Sutardja vs. United States, dismissing several of the plaintiff's legal arguments. This case involves the application of Internal Revenue Code ("IRC") § 409A to employee stock options that may have been issued at a discount from fair market value. IRC § 409A provides for a twenty-percent surtax on amounts received under a nonqualified deferred compensation plan. § 409A(a)(1)(A-B). The plaintiffs challenged the application of the § 409A surplus tax to the exercise of employee stock options where they were exercised within 2 ½ months of vesting.

The plaintiffs in Sutardja were employees and founders of Marvel Semiconductor, Inc. ("Marvel"). The Marvel Board approved a grant of Marvel stock options to the plaintiffs. Under the terms of the options agreement, as long as plaintiffs remained employees of Marvel, the options were to vest in segments at predetermined dates. If a plaintiff's employee status was terminated for any reason, the plaintiff would be eligible to exercise previously vested, but unexercised, options during a thirty-day period following the termination of employment. At the time of the grant, the options did not have a readily determined market-value, making it unclear whether or not the options were issued at a discount.

The Government conceded that the § 409A surplus tax could only apply to an exercise of stock options if the options were issued at a discount. The plaintiffs argued that § 409A should not apply to the exercise of stock options, regardless of whether they are issued at a discount. Among their arguments, the plaintiff's asserted that a stock option cannot be a "deferral of compensation" because: (1) the grant of an employee stock option is not a taxable event, (2) the Treasury regulations exclude stock options from treatment as "deferred compensation," and (3) there was no legally binding right to the options until they were exercised. In its summary judgment opinion, the Court did not decide the factual issue of whether the particular options were issued at a discount. But, the Court did address the legal issue of whether § 409A applies to options issued at a discount.

Grant of Stock Option Constitutes Compensation:

Section 409A applies to a "deferral of compensation." The plaintiff argued that § 409A could not apply to an employee stock option because the granting of the options is not a taxable event and therefore cannot result in compensation. Shortly after the enactment of § 409A, the IRS issued IRS Notice 2005-1, which advised that if a stock option is granted at a discount, then the option will be treated as a deferral of compensation. The plaintiff challenged this guidance, arguing that it was against Supreme Court precedent. The Supreme Court had established that stock options granted at a price above market value did not result in recognizable compensation until the options were exercised. Commissioner v. Smith, 324 U.S. 177 (1945). However, the Supreme Court had not addressed whether the grant of employee stock options at a discount could result in a deferral of compensation. The Court rejected the plaintiff's argument, finding that the IRS guidance was consistent and therefore entitled to deference. In doing so, the Court found that the guidance did not disrupt the precedent established in Smith because it was limited to options issued at a discount.

Conflicting Treasury Department Regulations:

The plaintiffs argued that, because a Treasury Regulation issued under the Federal Insurance Contributions Act specifically excluded grants of stock options from its definition of "deferral of compensation," stock options also could not meet the definition of "deferred compensation" for purposes of § 409A. The Court rejected this argument because the particular Treasury Regulation contained language limiting its application solely to the Federal Insurance Contributions Act. The Court refused to extend this definition to the use of a similar term in § 409A.

Legally Binding Right:

The plaintiffs argued that because they could be fired prior to the vesting or exercise of their options they did not have a legally binding right to the options, and therefore no compensation was deferred. Because the plaintiffs, in the event of their termination from employment, were guaranteed the right to exercise all vested options at the time of termination, the Court found that the plaintiffs had a legally binding right to the options upon their vesting. The Court did not consider the thirty-day exercise period following the date of termination to be a significant interference with a terminated employee's right to exercise vested options.

In rejecting the plaintiff's arguments, the Court found that the grant of a discounted stock option constitutes compensation at the time of the grant. Accordingly, § 409A may apply to employee stock options issued at a discount. If such options meet the other conditions of § 409A and are classified as nonqualified deferred compensation, the twenty percent surplus tax will be applied when the options are exercised.

Fraser Stryker is a nationally recognized leader in employee benefits and tax law. Attorneys in the Firm's Employee Benefits & ERISA Practice Group advise businesses, governments, and nonprofit/tax-exempt organizations on a wide variety of tax and employee benefits matters, transactions, and litigation. Fraser Stryker helps employers implement and maintain innovative and cost-effective employee benefit plans that attract and retain top talent. For more information, or if you would like to discuss benefits provided by your company, please contact Nicole R. Konen, Kevin Tracy, or  Emily Wischnowski.


This article is provided by Fraser Stryker for general informational purposes and is not intended to be and should not be construed as legal advice on any specific facts or circumstances.

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