Modification of Discounted Options Under 409A

[401 Chaos]

Not my idea and I suspect this is a strange question but what if somebody wants to modify discounted stock options subject to 409A in order to comply with the new 409A requirements rather than convert them to fair market value options. I assume that in order to modify you would have to make exercise mandatory either on a fixed schedule or one of the various 409A distribution / payment events (e.g., change of control, termination of employment, death or disability).

In order to comply with 409A, would not the exercise have to be mandatory upon the stated payment event? If so, what happens from a tax standpoint if the option is underwater at the time of the stated event and the optionee does not exercise. How would the IRS assess taxes and penalties in that event?

Also, can you grant new discounted stock options given 409A? Obviously, I assume any discounted options would need to be subject to the specified distribution events as discussed above but would there also be a 409A issue in terms of the "deferral election"--i.e., if you received the grant of a discounted stock option would you automatically violate 409A if the grant was made without a "deferral election" the year prior to the option grant.

Thanks for any thoughts or guidance on these issues. I cannot imagine wanting to use discounted options in the current environment but have a client that wants to know exactly how this plays out and have not seen anything discussing these issues.

[401 Chaos]

Just wanted to bump this up. Does anybody have thoughts on discounted option modifications? Thanks.

[Guest Harry O]

Why not use Q&A 19© (extended through 2006 by the proposed regulations) and have the employee elect a fixed delivery date for the "profit" shares upon exercise. The employee could elect to exercise earlier but share delivery (and tax) would be deferred to the fixed delivery date. This is essentially the stock option gain deferral arrangement that has been around for several years.

[401 Chaos]

Harry O,

Thanks for your thoughts. We have been talking about that option, particularly for the modification of outstanding options. I'm assuming the fixed delivery date could be drafted to be a change of control so that the executive would receive his money upon a liquidity event. Is there any requirement that the options be exercised at some point in such a situation or could they go unexercised if the FMV of the stock fell below even the discounted exercise price?

Also, will such an arrangement work in granting new discounted options going forward rather than just with the modification of new options. For example, how would a discounted option grant comply with the 409A deferral election rules. I am curious whether many others are seeing proposals for grants of new discounted options in light of 409A. Thanks

[Guest Harry O]

Yes, the delivery date can be conditioned on an in-the-money exercise.

Yes, in my opinion, stock option gain deferrals are still viable under the proposed regulations. However, they can't be as flexible as they used to be since the delivery date now has to be selected prior to grant.

[401 Chaos]

Thanks for your thoughts. With respect to the deferral issue, if you wanted a portion of a discounted option to vest immediately upon grant--do you think that can be accomplished under 409A as well? Seems any grant of a vested discounted option raises deferral election problems.