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Option Exercise Price


EBECatty

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Does anyone know whether the price an employee pays for the grant of an option can count toward the price of the exercise of the option for 409A-exemption purposes?

In other words, say employer's stock is worth $10 per share on the date it grants an option to an employee. The employee pays $9 per share for the grant of the option itself, and the price of exercise is $1 per share. A few years later, employer stock is worth $20 per share. The employee pays $1 per share to exercise the option. 

Under the 409A definition of "exercise price" it seems that only the $1 is considered ("...the consideration in cash or property that, pursuant to the terms of the option, is the price at which the stock subject to the option is purchased...").

Under 83, both the $9 paid for the grant and the $1 paid for the exercise would be part of the "amount paid" for tax-calculation purposes.

But would this blow the 409A option exemption?

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11 hours ago, EBECatty said:

But would this blow the 409A option exemption?

First, I've never heard of someone doing this, so your client is pretty unique, I think, EBECatty, and the optionee is as well.

Second, are you sure that the $9 would go towards the amount paid? Is there a case or PLR on point? (I'm guessing there isn't, given your 409A question, or at least not a recent one.) 83(a) talks about the "amount paid ... for such property," but 83(e)(3) says 83 doesn't apply to the transfer of a nontraded option, so I would be somewhat concerned. You might be under the noncompensatory option tax rules.

Third, while it may seem intuitive that this is not a discounted option for 409A purposes, just a partially prepaid option that is not very favorable to the service provider, given that the 409A rules for options are entirely made up by the IRS, I would be very wary of reading into them that the $9 paid for the option privilege is really part of the option exercise price and "in substance" raises the exercise price of the option to FMV without seeking a ruling.

Fourth, I would check with my securities lawyer to make sure that the sale of the options complies with state and federal securities laws.

 

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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Luke, appreciate your thoughts. It's an odd situation with a lot of other context (and likely not to work for many other reasons) but this was one of the issues that came up during review. I had never encountered the question.

To your second point, 1.83-3(g), defining "amount paid," includes the following: "When section 83 applies to the transfer of property pursuant to the exercise of an option, the term “amount paid” refers to any amount paid for the grant of the option plus any amount paid as the exercise price of the option." So it seems like the full $10 would be considered when calculating the amount of tax upon exercise. 

I can't find any other option-related Code provisions that include a similar provision (421-424, 409A). They generally just refer to the amount paid to buy the stock upon exercise of the option. 

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3 hours ago, EBECatty said:

When section 83 applies to the transfer of property pursuant to the exercise of an option, the term “amount paid” refers to any amount paid for the grant of the option plus any amount paid as the exercise price of the option."

OK. Good to know, EBECatty. Interesting that the IRS apparently answered the question in the right way for 83, even though the statute was at best unclear. So I guess my conclusion would be that on a substance over form basis, one would hope it would work, but you're rolling the dice when your justification is substance over form and the reg (here the 409A regs, not the 83 regs) seems to have form going the other way. If there is a significant amount involved, I would go for a ruling. Note, however, that the provision of the 83 regs that you quote above might be ammunition in any conversation with the IRS regarding whether exercise price was no less than FMV. Even though 409A and 83 are two separate code sections, with their own regs, in theory IRS would want to interpret consistently. But again, that ammunition would be even better in a ruling request than an exam.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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