Discounted Stock Options

[Chaz]

Company wants to grant discounted stock options. Can the grants be structured to comply with 409A by requiring that the options be exercised either within the ST deferral period after vesting or only upon a 409A-permitted event (as specified in the grant agreement)? If so, how would it work?

[jpod]

You've answered your own question: yes, it can be done, along the lines you described. Unfortunately, the relatively short window for exercising will cause it to not resemble a typical option.

[Chaz]

Two questions:

1-When will "payment" be made with respect to a discounted option (or other option subject to 409A)?

2-If the answer to #1 is upon exercise, what if the option is never exercised (because it is underwater, the optionee can't or won't come up with the exercise price, or whatever)? Will there be an income recognition event nonetheless?

[Steelerfan]

Two questions:

1-When will "payment" be made with respect to a discounted option (or other option subject to 409A)?

2-If the answer to #1 is upon exercise, what if the option is never exercised (because it is underwater, the optionee can't or won't come up with the exercise price, or whatever)? Will there be an income recognition event nonetheless?

1. The discount causes the grant to be a deferral of income subject to 409A, so the grant is a "payment", but how to calculate this amount I think is currently unknown.

2--yes. If you have a discounted option and haven't complied with 409A, you would have income tax and penalties from the date of grant, but no actual source of money until exercise. So at exercise, you would have to pay the 20% tax and interest from the date of grant, but at the time of grant there would be a requirement to pay income taxes on some amount, which is the amount deferred. This is why I belive it is prudent to provide in all plans that are or could be subject to 409A a provision to accelerate payment of enough money to cover any amount that must be included in gross income (including tax witholding)--which in a stock option plan would mean the optionee must exercise immediately. Guidance is expected.

I think 409A is being used to essentially irradicate discounted options, as there appears to have been a nuclear bomb dropped on them.

[Chaz]

Let me clarify my question #2: If I have a discounted option and have "complied" with 409A in the sense that, say, the option is only exercisable during the short-term deferral period after vesting, is there an income recognition event if I do not exercise?

[Steelerfan]

Let me clarify my question #2: If I have a discounted option and have "complied" with 409A in the sense that, say, the option is only exercisable during the short-term deferral period after vesting, is there an income recognition event if I do not exercise?

Absolutely, you have to meet the exception operationally. The strange thing is if, as you say, the option is underwater. I would think the plan would have to require the option to either be exercised or lapse automatically after the expiration of the ST deferral period

[Chaz]

That's the nub of my question: Can such an option agreement (or plan) provide for (i) exercise within the ST deferral period and (ii) if not exercised, the option lapses? If, under such circumstances, the option is not exercised and therefore lapses, is there an income recognition event (in some amount) nonetheless?

[namealreadyinuse]

No income recognition unless the IRS pushes deemed exercise (deep discount). You are exempt from 409A and there is not taxation under other theories (ecomonic benefit, constructive receipt, assignment of income, etc. . . ) because of Section 83.

[Steelerfan]

The question is whether at the time of grant there is any possiblility of deferred compensation. If the option must be exercised or else it lapses within the ST deferal period and option does in fact lapse, then there is no possibility for payment outside of the ST deferral period, and therefore there will be no income taxable event at all.

Your OP only talked about if the person doesn't exercise, and seemed to assume that the option was still outstanding. If you are trying to draft a discounted option plan to comply with ST deferral rule, there must not be any possibility that an amount can be paid later than 2.5 months into the taxable year following the year of grant. So if not exercised, the options must lapse within the ST deferral period and there will be no taxable event.

Seriously, why would you want to do this?

[Steelerfan]

No income recognition unless the IRS pushes deemed exercise (deep discount). You are exempt from 409A and there is not taxation under other theories (ecomonic benefit, constructive receipt, assignment of income, etc. . . ) because of Section 83.

Yes. The employee would be taxed at grant and then upon ultimate sale, it would be cap gain. But I don't think its clear how steep of a builit in gain can would cause taxation under 83. I was always under the impression that the IRS wouldn't push this since the result is capital gain treatment upon ulitmate sale. In addition, the regs make it clear that you must meet the 4 part test to have an ascertainable FMV. This is uncertain territory, but a good point.

[401 Chaos]

Your OP only talked about if the person doesn't exercise, and seemed to assume that the option was still outstanding. If you are trying to draft a discounted option plan to comply with ST deferral rule, there must not be any possibility that an amount can be paid later than 2.5 months into the taxable year following the year of grant. So if not exercised, the options must lapse within the ST deferral period and there will be no taxable event.

Seriously, why would you want to do this?

Steeler,

I am confused. Would you have to exercise / lapse within 2.5 months of taxable year following year of grant or year of vesting (i.e., no longer subject to a substantial risk of forfeiture)?

I agree that wanting to grant discounted options to comply with 409A would be a very unusual thing.

I have, however, seen folks suggest that tying vesting and exercise to a change in control of the issuer as defined in 409A may make some sense under 409A in cases where an employee is unlikely to really have much gain or exit possibility unless and until a change in control occurs. Would welcome your thoughts on that.

[namealreadyinuse]

I have, however, seen folks suggest that tying vesting and exercise to a change in control of the issuer as defined in 409A may make some sense under 409A in cases where an employee is unlikely to really have much gain or exit possibility unless and until a change in control occurs. Would welcome your thoughts on that.

Ok, wouldn't many employers that were working towards a liquidity event care about the accounting treatment? Discounted options still hit the accounting books.

If you are suggesting an option that does not become exercisable until a CIC and then HAS to be exercised within 2 1/2 months from the close of that year, then you have to make sure that exercisability = risk of forfeiture for 409A. There has got to be a better way to do it, though.

[Steelerfan]

I assumed the options were vested when granted. If there is a vesting schedule or event, then the year of vesting would be the approprate year to start the clock for the short term deferral rule.

Accounting treatment asside, a CIC can be a vesting event. In that case, you do not even need to use the 409A definition because you are not using it as a payment event (i.e. not relying on an exception to the anti-acceleration rule) but rather relying on that event as a vesting event. As suggested above, you must be certain that the SRF is real. There is support in the regulations to do it that way.