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Correcting Stock Options granted over Non-Service Recipient Stock

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A company grants a stock option with typical option features (subject to a vesting schedule and then exercisable over a set period of years with shortened exercise period based on the occurrence of certain events (death, disability, etc.)). However, the option is granted over shares of preferred stock that have a dividend preference, such that the preferred stock will not qualify as "service recipient stock" under Section 409A. Therefore, the exemption for "stock rights" is not available. The stock option also does not comply with the requirements of Section 409A because it is not exercisable solely upon a permissible payment event under Section 409A. Therefore, the stock option violates Section 409A.

A formal IRS correction for this type of failure is not available. Any substitution of a replacement stock option that meets the requirements for exemption from Section 409A would violate the substitution rule under Section 409A. Therefore, the stock option is an uncorrectable failure subject to the penalties under Section 409A. Anyone see a better outcome in this situation?

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