If You Thought the IRS Would Not Punish 409A Foot Faults, Think Again

The result in the case Sutardja v. U.S., decided by the United States Court of Federal Claims last month is not surprising. We all understood the stock options issued at a discount are subject to Code Section 409A. What is alarming, however, is that the IRS chose to enforce the penalty tax of 409A under the facts of this case in the first place. Here are the undisputed facts:

  • The Board approved a grant of up to two million stock options to Mr. Sutardja on December 10, 2003 – when Section 409A was not even a glimmer in Congress' eyes. The company's stock price on that date was $36.19.
  • The Compensation Committee approved a specific grant to Mr. Sutardja of 1.5 million stock options on December 16, 2003. The exercise price of the option was set at $36.50, the company's stock price on that date.
  • Either the Board or the Compensation Committee (the court does not say) "ratified" the 1.5 million stock option grant on January 16, 2004, when there still was no hint of the coming 409A apocalypse. The company's stock price on that date was $43.64.
  • In January 2006, Mr. Sutardja exercised a portion of 2003-2004 stock option grant. Thereafter (again, the opinion does not specify a date), Mr. Sutardja entered in a "Reformation of Stock Option Agreement" and paid an additional of $5,355,000 for the difference between the original exercise price and the amended exercise price. Note at this time there were no regulation under Section 409A, only Notice 2005-1.

Perfect grant procedures? No. A pattern that is was not at all uncommon before 409A? Definitely. A good faith effort to correct the apparently understated exercise price. You bet.

Yet this was not enough for the IRS, which issued a Notice of Deficiency and imposed a 20% penalty tax (and underpayment interest under 409A) on Mr. Sutardja in November 2010.

Unfortunately, the case before the court was not whether the IRS had shown an ounce of common sense in the Sutardja matter, but only whether a stock option could be subject to 409A as deferred compensation when granted with an exercise price below the company's then-market value. The court rejected Mr. Sutardja's arguments that (i) the grant of stock options is not and cannot be a taxable event, (ii) Treasury regulations (issued by the time of the court case) exclude stock option from treatment as deferred compensation, (iii) he did not have a legally binding right to the company stock until he exercise the options, and (iv) if a compensation deferral existed, it was exempt under the short-term deferral rule.

As noted above, the court's rejection of these arguments is not surprising to those of us who have labored under 409A since its inception. However, it is extremely disappointing that IRS would demand penalties under the facts and timeline in this case.

This entry has been created for information and planning purposes. It is not intended to be, nor should it be substituted for, legal advice, which turns on specific facts.