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EBECatty

409A Exempt Stock Right?

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Under the 409A exemption for stock rights, an "option":

means the right or privilege of an individual to purchase stock from a corporation by virtue of an offer of the corporation....

If you have an otherwise exempt option (i.e., it meets all the substantive exemption requirements of nonqualified stock options) but the option is to purchase employer stock from the majority shareholder of the employer, do you still meet the 409A exemption? 

The definition in the 409A regs is carried over from Section 421. Also, Section 83 has rules governing the purchase of employer stock from another shareholder in connection with the optionee's performance of services for the employer. It treats the transaction as being routed through the employer for tax purposes. I see no cross-reference or carryover of a similar concept under the 409A regs.

Thoughts?

EDIT: On further reflection, because the tax treatment is already fixed under Section 83, could the option be issued directly from the employer, then the controlling shareholder could have the same number of his shares redeemed by the employer upon the optionee's exercise? That avoids dilution of the minority shareholders, which was the original goal. 

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So EBECatty, on your first issue, i.e., employee has option to purchase stock from majority shareholder, I would think that, depending on facts and circumstances, the arrangement is either (a) not compensatory, e.g. if the employee pays the shareholder for the option, or, more likely, (b) just as you describe, i.e., a deemed transfer of the stock on exercise by the majority shareholder to the corporation, followed by transfer of the stock by the corporation to the employee under 83, if the arrangement is clearly in connection with performance of services. Either way, should not be a 409A issue.

As for the rest, whether there is a redemption as in your second scenario, or even just a payment by the employee to the shareholder to exercise the option, there is a set of corporate tax issues (i.e., potential dividend treatment) under Section 302 and related provisions of the Code, and you need or a corporate tax lawyer or CPA need review those carefully.

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