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Potential Adverse Tax Consequences for Stock Options
by
G. Pearson Smith, Jr.
Stock options and stock appreciation rights issued after 2004 (and previously issued options or rights that vest after 2004 or are modified after October 3, 2004) may be subject to adverse tax consequences under the American Jobs Creation Act, which added new section 409A to the Internal Revenue Code. Such options and rights are subject to section 409A if they are granted with an exercise price that is less
than 100% of the fair market value of the underlying stock on the grant date. If they are granted with a lesser exercise price, the grantee will be subject to ordinary income tax (plus a 20% penalty, and possibly plus substantial interest charges) in the year when they become vested, whether or not they are exercised. In certain situations, the modification of an option or right may be considered the grant of a new option or right, in which case the fair market value requirement applies as of the modification date, not the original grant date.
The proposed regulations under Code section 409A set forth detailed requirements for establishing fair market value. In the case of financial institutions whose stock is not
widely held, there has been concern that the provisions of Code section 409A might apply even to options and rights that are granted with an exercise price that reasonably is thought to equal or exceed fair market value, but does
not (either because the value was determined by a method other than a method expressly permitted under the proposed regulations or because the value was determined by a method permitted under the proposed regulations, but not permitted under the yet-to-be-issued final regulations.)
In Notice 2006-4, issued December 23, 2005, the IRS provided transitional guidance relating to stock options and stock appreciation rights issued by private companies. The guidance distinguishes between options and rights issued before 2005 and those issued in 2005 and thereafter. Pending issuance of further guidance, options and rights issued before 2004 will be deemed to have been granted with an exercise price not less than fair market value if there was a good faith attempt to set the exercise price at an amount not less than fair market value. Options and rights issued in 2005 and thereafter, and prior to the issuance of further guidance, will be deemed to have been granted with an exercise price not less than fair market value if the taxpayer can establish that this was the intent and that the value was determined using a reasonable valuation method.
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