Put option on an option?

[Guest Mr. Kite]

Here's an executive comp feature I haven't come across, and it seems to violate 409A, but I can't put my finger on what's wrong with it.

The executive has been granted a 5-year option to purchase up to 1 million shares at $1/share under the company's stock option plan (which has provisions consistent with the exclusion from 409A for stock options). The option vests at the end of 2009.

However, the executive's individual employment agreement adds a wrinkle to his option holdings. For the month of February 2011, if he has not yet exercised the option, and if he is still employed by the company, he may surrender the option to the company in exchange for $500,000.

Part of me thinks that this agreement establishes a value for the stock options, so that at the time the option vests it becomes taxable to him under IRC 83 based on the present value, at that time, of $500,000 in 2/2011.

Part of me thinks that this is conditional deferred compensation that is subject to a substantial risk of forfeiture that becomes fully vested in Feb. 2011 -- and is taxable at that time, even if he does nothing (if he doesn't exercise the option).

Has anyone seen this kind of animal? Any ideas about how to approach this?