Guest Article

(From the February 12, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Announces Compliance Resolution Program for Misdated Options Exercised in 2006

On February 8, 2007, the IRS released Announcement 2007-18 (the "Announcement"), which provides a compliance resolution program ("Program") for employers that want to pay the IRC § 409A-related taxes for employees who exercised misdated options in 2006. Prompt attention is required because employers that intend to participate must notify the IRS of that intent no later than February 28, 2007.

Due to the enactment of IRC § 409A, there is the potential for adverse tax consequences for any option that vests after December 31, 2004, with an exercise price less than the fair market value of the stock on the date of grant, and is still outstanding at December 31, 2005. This includes options that were intentionally granted with an exercise price less than fair market value or are considered "backdated" or "misdated" such that the exercise price (set on the originally stated grant date) is less than the fair market value on the redetermined grant date. This could be because procedures were not carefully applied or employers adopted conventions that simplified grant making procedures but resulted in the granting of options with an exercise price less than the fair market value of the stock on the actual grant date.

The IRS has provided transition relief, extended until December 31, 2007, by Notice 2006-79 for most options, during which discounted stock options can be cancelled and reissued to comply with the stock right exemption or with IRC § 409A. The transition period was not extended with respect to options granted by a public company to a director, officer or principal shareholder ("Section 16(a) individuals") to the extent that a compensation expense related to the grant of such discounted options was not timely reported according to GAAP. For those individuals, action to accommodate the IRC § 409A rules was required to be completed by December 31, 2006.

In many cases, non-Section 16(a) individuals exercised misdated options in 2006 before they were notified that the options were not in compliance with IRC § 409A. Misdated options that vested after December 31, 2004, and were exercised in 2006 might result in an IRC § 409A violation, triggering immediate income inclusion, a 20 percent additional tax and interest charges at the underpayment rate plus 1 percent. Additionally, if there is an IRC § 409A violation, the employer is required to report the violation on the employee's Form W-2 using Code Z.

The Announcement provides a limited time for employers with employees, other than Section 16(a) individuals, that exercised discounted options in 2006 to pay the 20 percent tax for their employees and avoid Code Z reporting. In order to enter the Program, the employer must take the following steps:

Payment would include the 20 percent additional tax and interest. The additional tax is equal to 20 percent of the excess of fair market value of the stock on the date of exercise over the exercise price paid by the employee. The amount of interest is calculated using an interest rate equal to the underpayment rate plus 1 percent and applying it to the income amount which is assumed to be taxed at the 35 percent marginal tax rate. The income amount is the intrinsic value of the option at December 31, 2005. Interest is assessed at this rate from April 17, 2006 until the payment of the tax or April 17, 2007 if earlier. That rate is 8 percent for the quarter ended June 30, 2006, and 9 percent for the next three quarters.

The payment of the IRC § 409A-related taxes must be treated as additional compensation to employees in the taxable year in which the payment is made. This additional payment can, but is not required to, include a gross-up amount to make employees whole. These payments of additional compensation are deductible.

Employers participating in the Program are not required to report the payment of IRC § 409A-related taxes on Form W-2 using Code Z. Employers that have already provided Form W-2s to employees with Code Z may provide Form W-2c to remove the Code Z. Note that the Program does not affect the employer's obligation to report the income recognized on exercise of the option or to comply with applicable withholding requirements with respect to the exercise of the option.

As the initial intent to participate notice is due by February 28, 2007, employers have little time to decide their course of action. However, employers can withdraw from participation any time before June 30, 2007. Thus, employers uncertain of their participation or not yet finished with their investigations and thus not sure which options may be subject to the rule may want to file an intent to participate and make a final decision later. As many employers have already notified employees of IRC § 409A failures and provided Forms W-2 with Code Z reporting, they may find that providing Forms W-2c and communicating their participation in the Program may be more of an administrative burden than paying employees directly for the tax liability to be reported on the employees' Forms 1040.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879-5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.