Source: https://www.teknosassociates.com/think-that-the-irs-doesnt-care-about-irc-%C2%A7409a-think-again/
Timestamp: 2017-12-12 16:09:24
Document Index: 305847958

Matched Legal Cases: ['§409', '§409', '§409', '§409', '§409', '§409', '§409', '§409', '§409', '§409', '§409', '§409', '§409', '§409']

Think That the IRS Doesn’t Care About IRC §409A? Think Again. - Teknos Associates
Think That the IRS Doesn’t Care About IRC §409A? Think Again.
The US Court of Federal Claims ruled that §409A of the Internal Revenue Code applies to stock options which were issued at a discount, upholding a decision by the IRS to impose more than $5.3 million in penalties and interest on the option recipient and his wife.
The parts of §409A which apply to stock options went into effect on January 1, 2009, but for the next four years there were few indications of IRS enforcement activity.* In fact, things were so quiet for so long that we heard some entrepreneurs and investors say that the IRS did not care about underpriced stock options.
Sehat Sutardja, the president, CEO, and chairman of Marvell, was granted a stock option by the compensation committee in December 2003 (before Congress even passed the law creating §409A). The option was ratified in January 2004 by the board of directors, after the stock price had increased. Sutardja voluntarily paid an additional amount to make up for the stock price increase when he exercised the option in January 2006 (after §409A was created, but during the transition period before it went into full effect in 2009).
The IRS contended that the stock option was discounted at the date of grant and assessed a penalty of 20% of the option gain (approximately $5.3 million), plus interest at the federal penalty rate. Sutardja paid the assessment, but filed a tax refund suit and moved for partial summary judgment using four legal theories about why §409A did not apply to his case.
The US Court of Federal Claims denied the motion for partial summary judgment on the four legal theories and ordered a trial on the factual issue of whether the option was discounted at the time of grant.
Valuation Implications of the Decision
On the face of it, some of the facts of this case do not resemble the circumstances of typical private companies issuing stock options. Marvell was publicly traded at the time of the option grant, so there was no argument about whether a valuation report was understating value. And the option grant occurred before §409A was in full effect, so there was an argument about whether §409A even applied.
But Sutardja v. United States clearly indicates several things that are relevant to private companies issuing stock options. Without any doubt, the IRS is willing to pursue cases where it believes that an option has been issued below the fair market value of the underlying stock. The IRS is willing to impose the penalty surtax of 20% of the option gain plus interest, on top of the ordinary income tax.** And the IRS is willing to do so even during the transition period, a time during which some tax professionals believed that the IRS would be lenient if there was evidence of a good faith effort to comply (such as Sutardja voluntarily paying the higher option strike price).
It now is plain the IRS is very serious about enforcing §409A as it applies to stock options. Because these cases take a long time to develop inside the IRS, there likely will be additional guidance about §409A emerging over the next few years.
Companies issuing stock options should be careful to follow good practices to ensure that these options are in compliance with §409A. As we have written previously, companies should follow IRS guidance in §409A and obtain an independent appraisal of the value of their common stock before issuing stock options. Following a compliant process and documenting it thoroughly are the keys to being able to survive an IRS audit at some point in the future.
* The only signs of IRS interest in the interim were speeches by IRS officials at valuation and accounting conferences and delivery of Information Document Requests (IDRs) to companies undergoing audits of pay practices that could be subject to IRC §409A.
** It remains to be seen whether the California Franchise Tax Board will move to impose an additional 5% surtax on Sutardja and Dai.