Option Exercise Timing - different from Payment Timing right?

[ERISAatty]

Hello, all,

I'm drafting/designing a 409A-compliance plan for an LLC. Under the Plan, participants will be granted the option to buy service-recipient stock at a future date (for date of grant FMV).

While the equity option design *should* satisfy the exemption from 409A, company/client wants to comply with 409A for a long list of business reasons, including the risk of inadvertant loss of the exemption (i.e. by an unintentional modification or extension).

(I'm generally treating the 'stock right' rules under 409A as analogous to the LLC setting based on IRS Notice 2005-1, Q&A 7 and the Final Regs Preamble Section III(G)).

Under the Plan,

-Each grant will specify a vesting date; and

- (change in control will accelerate vesting).

Here's where I've hit a conceptual stumbling block:

I am thinking (given the 409A 'permitted payment' concept,) that all vested equity units must be *exercised* (and included in income) in a single block (or, alternately, in sub-blocks, if different exercise dates are pre-assisgned, such as: "you may exercise 50% of units in Year A and 50% in Year B").

Client, of course, wants increased flexibility, and wants me to report back that the following would by OK:

1. once vested, participant may choose how many units to exercise when (i.e. participant could *decide* to exercise [and be taxed on] 30% [or other participant-elected percentage] in whatever year he or she chooses prior to the end of the exercise period.); or

2. If specifed exercise dates must be used, client hopes that the choice, *not* to exercise in a specified year would be permissible if such choice results in a forfeiture of the right to exercise those units [ever]).

Other than as described the BNA "Section 409A Handbook" on p. 425, below, I don't see how the client can have the flexibility under point 1. (Unless, of course, they abandon the idea of complying with 409A and just use the exemption).

As to point 2, I'm inclined to think that might work, but without any actual identified authority to rely on.

On point 1, the BNA "Section 409A Handbook" (which is great), provides the following on p. 425:

"If a stock option or stock appreciation right [sAR] does not qualify as a short-term deferral and is not otherwise excluded from coverage under 409A, the award may be structured to comply with the requirements of 409A. Stock options and SARs, if traditionally structured, will not comply with 409A because the right may be exercised by the service provider (and the income accrued) in any one of a number of taxable years, at the discretion of the service provider.

However, a stock option or SAR may be structured to comply with 409A by providing that stock or other cash property delivered in settlement of the award must be delivered only on one or more permitted payment dates.

For example, an option may be structured to comply with 409A by providing that it is only exercisable in a specific year or upon an earlier separation from service or change in control within the meaning of 409A. However, because this structure eliminates much of of the optionality of the award, it is generally not an attractive alternative. A

second alternative preserves some of the optionality of the award but still complies with 409A: to structure the award to be exercisable at any time during the term but paid, the the extent exercised, only upon a permissible payment event (such as the last year of the term or an earilier separtion from service)

."

(Emphasis added).

Question 1: I'm just looking for a reality check to confirm that I'm not crazy, and that under 409A, the units must be either: (i) exercised only upon the pre-specified date/year (and that the participant can't just decide not to exercise them in a specified year [as least notwhile retaining the right to exercise those in a future year]); or (ii) the options may be exercised at any time [and I gather that income would accrue], but receipt of the actual equity would be delayed until the speicifed payment event. Thoughts??

Question 2: Anyone ever seen a 409A option plan under which, if participant doesn't exercise upon a specified date, the right to exercise is forfeited??