ISO: Extended Expiration Date and Section 409A Consequence

[Guest KingWilson]

Here's a situation that I'm trying to bird-dog for somebody in my extended family.

Basically: his employer, a still-private company, issued him ISOs at time of hire, a few years pass and because an exit event hasn't happened, for employee retention reasons they unilaterally waive a wand and issue an extension to the expiration date before the original option grant expired. During that time, the value of the underlying shares has increased. No other terms were changed. The company did this out of ignorance and good intentions. The employee signed nothing nor did employee protest (or even know about the consequences being set in motion).

The actual numbers don't really matter but it's illustrative to show an example as I understand things. Let's say the options were issued at hire in 2008 for 500K shares @ $2 for a 4-year term and at they were extended another 4 years, same strike price, in 2011. At the time of extension, they were were worth $5. The options had and have never been exercised. My understanding is the simple act of extension in this example would yield ordinary taxable income (not even long term gain) of $1,500,000 (FMV vs strike spread * share quant). There's also a 20% penalty on top of that. And the IRS of course charges interest on back taxes, but that's a rounding error.

Some of this is cut and dry, and probably unavoidable. Kind of dumbfounding how the unilateraction by the optionor can result in so much tax consequence for the optionee. But I'll take any advice you have to offer. Things I'm wondering about:

1) What exactly is the income amount in above example, especially if the option is not exercised?

2) What happens in subsequent years if the underlying shares increase further in value?

3) What influence does employee have to minimize the valuation of the shares at the time of extension? For example, use only book value or go back 11 mos to the last valuation date, even if a subsequent $5 financing round happened 2 mos after the extension.

4) Wouldn't the illiquidity of class B shares under an ISO plan compress their FMV vs the FMV established in financing rounds on class A shares?

5) If there was a way to claim the ISOs are really NQSOs would things be any different? (Maybe there's a gotcha in the ISO plan that makes it fail the test to be one?)

6) Civil recourse?