Important Q&A on the Effect of New Section 409A of the Internal Revenue Code on Stock Options and Other Types of Equity Grants

As you may be aware, Congress enacted Section 409A of the Internal Revenue Code in October 2004 as part of the American Jobs Creation Act. Among other things, the Act broadly regulates “deferred compensation,” which is defined to include stock options. But the Act’s legislative history contemplates an exemption for certain non-discounted options. Congress directed the Internal Revenue Service (IRS) and the Treasury Department to draft regulations providing much of the detail. In December 2004, the IRS released Notice 2005-1 to provide initial guidance and on September 29, 2005, the IRS issued proposed regulations under Section 409A. Companies may rely on this guidance until final rules are enacted. Comments on these proposed rules may be submitted to the IRS and a public hearing is scheduled for January 25, 2006. The purpose of this alert is to provide you with the basic answers to common questions on Section 409A as it relates to stock options based on the statute and current guidance.

Why do I care if a stock option is subject to Section 409A?

If an option, as initially granted or as subsequently modified, is deemed under Section 409A to be deferred compensation and the option does NOT meet the strict requirements of Section 409A, the optionee will be subject to income tax commencing at the time of vesting rather than the date of exercise (or later). The tax will be based on the spread between the exercise price of the option and the fair market value of the underlying stock on the vesting date, plus an additional excise tax of 20% as a penalty for non-compliance with Section 409A and, potentially, interest from the date compensation is deemed to have been deferred. The IRS has not yet released any guidance regarding the details of when and how taxes will be required to be paid but some or all of these taxes are expected to be required to be withheld by the employer and paid to the IRS in connection with regular withholding payments. (On December 8, 2005, the IRS released Notice 2005-94 which suspends for calendar year 2005 (until further notice) the Form W-2 and Form 1099-MISC reporting and wage withholding requirements of Section 409A.) If the payments to the IRS are not made in a timely fashion, the company issuing the option could be subject to penalties for late withholding. In addition, there seems to be a trend developing to include representations and warranties in venture financings requiring the company to represent that it is in compliance with Section 409A.

What option grants are potentially subject to Section 409A?

The following option grants must be analyzed to determine whether they are subject to Section 409A:

• option grants made after October 3, 2004; and
• options issued on or before October 3, 2004 that are either (a) amended after October 3, 2004, or (b) not fully vested as of December 31, 2004.

When will I be required to begin paying taxes under Section 409A?

Commencing on January 1, 2007, outstanding options deemed subject to Section 409A and not then in compliance will be subject to the 20% penalty tax and, potentially, further interest and penalty payments if the IRS deems taxes to have been due for such options under Section 409A for years 2005 and 2006. Options exercised in 2006 that are not in compliance with Section 409A prior to exercise will be subject in 2006 to the 20% penalty tax and other taxes required to be paid under Section 409A with respect to such noncompliant options.

Are all stock options subject to Section 409A?

No. Only the following are subject to Section 409A:

• Option grants below fair market value to employees, directors and certain consultants. (A consultant who provides services to two or more unrelated entities and does not provide management services is not subject to Section 409A and can continue to receive nonqualified stock options at below fair market value.)
• Option grants with respect to classes of stock other than common stock such as preferred stock or any other class of stock that provides a preference as to dividends or liquidation rights.
• Option grants on stock of non-controlled group companies.
• Option grants at fair market value that are later amended at a time when the fair market value of the underlying stock is above the exercise price of the option (assuming such amendment is a "modification" for purposes of Section 409A).
• Option grants that are amended to extend the exercise period (unless such extension is within the period allowed under Section 409A).
• Option grants that do not “fix” the number of shares subject to the option as of the date of grant. Certain types of performance based options may be affected by this requirement. We expect this issue to be clarified in the final regulations.

Are Incentive Stock Options subject to Section 409A?

Incentive stock options are exempt from the requirements of Section 409A. However, if an ISO is modified, extended or renewed and thereby deemed under the ISO rules to no longer qualify as an ISO, then the option may be subject to Section 409A from as early as the original date of grant of the ISO.

Can I ever grant a below fair market value stock option to an employee or director again?

A below fair market value stock option may be structured to comply with Section 409A, which requires strict rules regarding the timing of exercise. The option cannot be exercisable at any time by the optionee but may only be exercised upon the occurrence of one of the specific events set forth in Section 409A—a fixed time period, termination of service, death, disability, unforeseeable emergency, or change of control (as defined in Section 409A). Consistent with current practice, we don’t expect to see public companies granting stock options at below fair market value nor do we expect private companies with a low stock price or that expect to go public grant options at below fair market value. However, a private company that expects to be acquired at or near its current fair market value may find that a below fair market value option solely exercisable upon a change of control is a better compensation tool than an option at fair market value that may be exercised at any time after vesting.

When is an amended stock option subject to Section 409A?

Any amendment to an option that is deemed to be a modification under Section 409A, other than an extension or renewal, is treated for purposes of analysis as a new option grant. Therefore, if on the date of the modification the fair market value of the underlying stock is greater than the exercise price of the option, then the option will become subject to Section 409A as of the date of the modification. The proposed regulations clearly state that the following are NOT modifications:

• shortening the period during which the option may be exercised
• adding the ability to use previously acquired stock to pay the exercise price
• accelerating the vesting and exercisability of an option

Modifications that are administrative in nature and do not change the amount or the timing of the income to be received by the optionee will most likely not be subject to Section 409A.

How are extensions and renewals treated?

An extension of the exercise date of an option to a later date (for example from 90 days post-termination to 1 year post-termination) subjects the stock option to Section 409A from the original grant date of the option. This causes the option to be subject to Section 409A regardless of whether the option was initially granted at fair market value, was an ISO at its original grant date, or whether the exercise price is equal to or above the fair market value of the underlying stock at the time of the extension.

However, the proposed regulations provide a safe harbor for an extension that would not subject the option to Section 409A. The safe harbor provides that an option may be extended until a date not later than (a) the fifteenth day of the third month following the date the option otherwise would have expired or (b) December 31 of the year in which the option would have expired. For example, an option granted on January 1, 2005, that expires upon the earlier of January 1, 2015, or three months after the optionee’s termination of employment will not be considered modified under Section 409A if the optionee is terminated on March 15, 2009, and his exercise period is extended from June 15, 2009, until December 31, 2009.

Please note, under current IRS guidance, the extension of an underwater option seems to subject the option to Section 409A, however, the IRS has indicated that it is considering changing its position on this issue in the final regulations.

Is the assumption or substitution of an option in an acquisition treated as a modification under Section 409A?

Generally no, the option will not be considered modified upon assumption or substitution by an acquirer as long as the ratio of the exercise price to the fair market value of the underlying stock immediately after the transaction is not greater than the ratio of the exercise price to the fair market value of the underlying stock immediately before the transaction and the option otherwise satisfies the modification requirements regarding maintaining ISO status in an acquisition set forth in Regulation 1.424-1 of the Internal Revenue Code.

Has the IRS issued any guidance regarding valuation of the underlying common stock?

Yes. The proposed regulations provide guidance on acceptable methods of determining the fair market value of the underlying stock and represent a significant change in the process for determining the fair market value of private company stock. The advantage of using one of the methods set forth in the regulations is that it places the burden on the IRS to prove that both (i) the company’s exercise price of its stock options is below fair market value, and (ii) the company’s method of valuation was unreasonable. We expect that private companies will revise and better document their fair market value determination process as the risk of undervaluing stock now has more costly consequences to both the optionee and the company.

Companies which are considering IPOs in their near future should be careful in choosing and employing their valuation methodology as it is expected that this will be of particular interest to the SEC during the IPO process.

The regulations specify three methods that will be presumed reasonable if consistently used for all of the company’s equity-based compensation arrangements:

Illiquid Start-Up Presumption. A special presumption is provided for “illiquid stock of a start-up corporation.” A start-up corporation is a corporation with no publicly traded stock that has conducted business (directly or indirectly through a predecessor) for less than 10 years. A valuation of illiquid stock of a start-up corporation will be considered reasonable if the following five requirements are satisfied:

1. The valuation is performed by a person with significant knowledge and experience or training in performing similar valuations;
2. The valuation is evidenced by a written report;
3. The stock being valued is not subject to any put or call right, other than the company’s right of first refusal or right to repurchase unvested stock at original cost;
4. The company does not reasonably anticipate an IPO, sale or change in control of the company within 12 months following the equity grant to which the valuation applies; and
5. The valuation takes into account the following factors:
   1. the value of tangible and intangible assets of the company;
   2. the present value of future cash flows;
   3. the market value of stock or other equity interests in similar entities whose value can be readily determined through objective means;
   4. control premiums and discounts for lack of marketability;
   5. whether the method is used for other purposes; and
   6. whether all available material information is taken into account in determining value.

A valuation applying these factors will be considered reasonable only if it is less than 12 months old. In addition, significant events occurring even before the 12-month anniversary of the valuation will require the valuation to be updated.

Binding Formula Presumption. A valuation based on a formula used in all transactions in a company’s stock whether or not compensatory, such as regulatory filings, loan covenants, and sales of stock to third parties.

Independent Appraisal Presumption. A valuation performed by a qualified independent appraiser using traditional appraisal methodologies will be presumed reasonable if it values the stock as of a date that is no more than 12 months before the applicable stock option grant date. However, this presumption would not apply if events after the appraisal date had a material effect on the company’s stock value and a new appraisal was not performed.

The Independent Appraisal Presumption is the safest but most costly way to value a company for purposes of Section 409A. We expect there will likely be significant pressure on private companies to undertake regular independent appraisals. Given that emerging growth companies experience frequent value-changing events, it may be desirable for such companies to obtain quarterly or semi-annual updates to valuation appraisals and cluster grant dates around scheduled appraisal dates.

Early stage companies who have financially sophisticated directors on their board, such as a venture capitalist, may choose to rely on the Illiquid Start-Up Presumption. The Illiquid Start-Up Presumption may be satisfied by a written report produced by a person with experience or training in stock valuation which could include a director. This choice of valuation methodology would be less expensive than independent appraisals, but cannot be used if the company reasonably anticipates an IPO or acquisition in the 12 months following the date of grant of an option.

Companies that do not adopt one of these methods and instead continue to rely on their existing valuation practices will have the burden of proving to the IRS that its valuation methodology was reasonable.

What questions should be asked to determine whether outstanding options are subject to Section 409A?

• Have any options been granted at below fair market value that were not fully vested as of December 31, 2004? (If they have become vested after that date and were exercised in 2005 then the option would not be subject to Section 409A.)
• Have any options been issued or modified since
  October 3, 2004?
• What is the valuation methodology being utilized to determine the exercise price of a fair market value stock option?

What if a company has granted options that do not comply with Section 409A?

The deadline for compliance with Section 409A is generally December 31, 2006. Until that time, noncompliant options may be cancelled and replaced without penalty with options that are not subject to Section 409A or that comply with Section 409A. However, if a company wants to compensate an employee in cash or vested equity for the loss of the discounted stock option, such payments will need to be made to the employee by December 31, 2005.

If a company has options subject to Section 409A, there are a number of things it can do to comply with Section 409A, some of which must be done by the end of this calendar year:

1. Exercise prior to December 31, 2005;
2. Increase the exercise price of the option to the fair market value of the underlying common stock as of the original date of grant; and/or
3. Exchange the option for shares of restricted stock (this may have tax consequences to the individual).

If a company wants to compensate the optionee for the elimination of the discount with cash or vested stock, the company must do so by December 31, 2005. However, a promise to replace the option with restricted stock or other equity subject to vesting restrictions can be done by December 31, 2006.

Not withstanding the date sensitivity tied to actions prior to December 31, 2005, it may be in the best interests of companies that cannot easily fix their Section 409A deficiencies now to wait until the final regulations (which we hope will provide additional clarity on certain issues) to make changes to outstanding options.

Are other types of equity grants subject to Section 409A?

Restricted stock grants and stock purchased under an Employee Stock Purchase Plan that complies with Section 423 of the Internal Revenue Code are NOT subject to Section 409A.

Stock Appreciation Rights, whether payable in cash or common stock, are subject to the same rules as discussed above for options.

Restricted Stock Units (when shares are delivered on or after the date of vesting and vesting is subject to time or performance) are potentially subject to Section 409A. However, if the stock is delivered within 2 1/2 months after the end of the year in which vesting occurs, the restricted stock unit will be exempt from Section 409A.

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If you have any questions or want to discuss a
specific issue, please consult your Mintz Levin attorney
or contact one of the attorneys listed below.

Pamela B. Greene / Business and Finance
617.348.1623 PBGreene@mintz.com

Thomas M. Greene / Employment, Labor, Benefits
617.348.1886 TMGreene@mintz.com

Alden J. Bianchi / Employment, Labor, Benefits
617.348.3057 ABianchi@mintz.com

Charles A. Grace / Employment, Labor, Benefits
617.348.1685 CAGrace@mintz.com

Thomas R. Burton / Business and Finance
617.348.3097 TRBurton@mintz.com

Eric M. Roth / Business and Finance
212.692.6758 EMRoth@mintz.com

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