The following is excerpted from our book “409A Administration Handbook” (which is about to come out with a new name and an extensive new valuation section).
Q. 25. Are stock options subject to § 409A?
Generally not, though there is one clear area of concern. If an option is granted at a discount (i.e., the option exercise price is less than the fair market value of the underlying stock at the time of grant), the option will be subject to § 409A. The grant of a discounted option could occur for several reasons:
- the discount is intentional as a way to grant more compensation;
- the fair market value of the underlying stock is underestimated at the time of grant;
- the grant occurs on a date different from the date used to determine the fair market value (a frequent issue for option backdating cases);
- the exercise of the option with a promissory note where the interest rate is less than the AFR; or
- because of a mistake or oversight.
Prior to the Final Regulations, the modification of the terms of an option could have resulted in a new “grant” of the option because the exercise price (determined on the original grant date) on the date of the modification could be less than the stock’s fair market value on the date of grant. However, unless one decreases the exercise price below the fair market value of the stock on the date of the change, or another deferral feature is added, most changes are unlikely to cause a problem under the Final Regulations. Even acceleration of the vesting of an option otherwise not subject to § 409A is not a problem despite the fact that acceleration of payment is a real problem under § 409A for other forms of deferred compensation.
Q. 26. Is an option exempt from § 409A if the underlying stock is preferred stock?
No. To qualify or § 409A exclusion, the option (or SAR) must represent the right to purchase “service recipient stock.” In general, this definition includes only common stock of the employer. Thus, preferred stock generally may not be used, although if the stock is preferred only as to voting rights or in certain other small ways, it could constitute common stock for this purpose.
Q. 27. Does it matter who issues the stock underlying a stock option?
Absolutely. The issuer of the stock must be the employer of the optionee or a related company. The related company must own at least 50% of the employer for whom the services are performed, or be another company up the chain (not down) where each company owns at least 50% in a chain ending with the employer. Thus, while subsidiary employees may receive options in parent company stock, the reverse is not true. The required control can be as low as 20% if there is a substantial business reason to grant options in the stock of the 20% owner. Common circumstances could involve a joint venture involving two or more businesses or certain split-off or spin transactions involving employees from each of the entities.
Q. 28. Can a venture or private equity fund grant options in portfolio companies to the equity fund employees?
This arrangement, common prior to § 409A, is unlikely to satisfy the service recipient stock issues.
Q. 29. Why is it a problem if options are subject to § 409A?
Most options permit exercise at any time after vesting (and occasionally before) through 90 or so days after termination of employment, or if earlier, expiration of the option. Only non qualified options (options which do not qualify as ISOs—“incentive stock options”) are potentially subject to § 409A (although care has to be taken if an ISO is modified or for example exceeds the ISO $100,000 limit—also, if the stock is valued too low in violation of the good faith valuation standard applicable to ISOs—the option could fail to be an ISO from the outset with the likely result that the exercise price is less than the true fair market value of the stock). This means that the year of exercise is not tied to one of the six permissible events or dates (death, disability, termination of employment, specified date, change in control or hardship), but rather is at the discretion of the optionee which will not satisfy the distribution rules of § 409A. In this instance, taxation will ccur at vesting, regardless of whether the option is exercised. Also, the optionee will be subject to an additional 20% federal tax and increased interest rates. In addition, California residents will be hit with yet an dditional 20% tax.
Q. 30. Are there circumstances in which a discounted option can avoid violating § 409A?
Yes. For example, occasionally in mergers, the target will be required to grant stock options in target company stock prior to the merger with an exercise price below the per share deal value. In such cases, where a gain is very likely, the option could require that a particular portion of the option be exercised within 2-1/2 months following the end of the year in which that portion vests and if not exercised by then, that portion of the option expires. Thus, the option still avoids § 409A because of the short term deferral rules. Also, the option could be written to require that it be exercised at times that would comply with § 409A. For example, the option could provide that all or a particular portion of the option be exercised, if it is exercised at all, within a specific year—this election could be made by the employee if the employee election rules of § 409A are met.
Q. 31. Does a private company need a valuation to grant stock options?
In practice the question has often been not so much why but why not get a valuation. The IRS has consistently indicated reasonable valuation methods may be applied. Thus, with sufficient effort and knowledge, in many instances a board can adequately determine a value. Indeed, the IRS offers a few “presumptions” that if applicable and if met would eliminate the need for a valuation. However, given the very high stakes, the often low cost of an appraisal and the fact that an objective appraisal is often within the range expected by the board, a significant number of companies are actually obtaining independent appraisals.
Q. 32. How often should a company have a valuation performed?
The Final Regulations generally require that determination of value be made every 12 months, though that does not necessarily mean a formal appraisal or valuation needs to be made every 12 months. There could be circumstances where an appraisal occurs and in the board’s good faith opinion, nothing has materially changed. On the other hand it could be that within a few months of an appraisal, material events occur which make the previous appraisal unreliable. Thus, while the safest course is to perform a formal appraisal every twelve months, that is neither a necessity nor a complete shield.
Q. 33. May the fair market value of a public company’s stock be determined based upon the average trading price for a specified period before or after the grant of an option?
Yes. The average trading price during a specified period that is within 30 days before or 30 days after the date of grant may be used to determine the fair market value of the stock subject to the option. However, an employer may use an averaging period only if the employer irrevocably commits to grant the option with an exercise price equal to such an average trading price before the beginning of the averaging period. For example, if an employer wants to grant a stock option on December 1, having an exercise price equal to the average trading price for the 30 days prior to December 1, the employer would have to irrevocably commit to grant the option with such exercise price prior to November 1.
Q. 34. Are incentive stock options (“ISOs”) subject to § 409A?
No, and this can have real significance. For example, ISOs can apply to preferred stock. While options on preferred stock will have a very difficult time complying with § 409A, if the preferred stock options are ISOs § 409A will not apply. It needs to be remembered that ISOs must have an exercise price at least equal to the fair market value of the underlying stock on the date of grant. This is similar to the requirement to avoid § 409A. However, fair market value of stock to be issued under an ISO can be determined in “good faith” rather than pursuant to a reasonable method under § 409A. This may be a distinction without a difference for the most part. It will be rare where the use of an unreasonable method could constitute a good faith determination, nonetheless, there is a distinction. Of course, if the ISO standard is not met, the option will not be an ISO, and if it has an exercise price less than the fair market value of the underlying stock on the date of grant, § 409A will apply.
Q. 35. May the exercise date of an option be extended after the date of grant?
Yes, the options may be extended for up to the original term of the option (but not more than 10 years from grant) provided the option is not otherwise subject to § 409A—and most options with an exercise price at least equal to the fair market value of the underlying stock on the date of grant are not subject to § 409A. This is a very favorable change from proposed regulations which permitted an extension for a more limited period of time. Of course there are issues with an extension. An additional financial accounting expense is likely. Also, if the option is an ISO and in the money, it will cease to be an ISO as soon as the amendment to extend is adopted. If it is not in the money at the time of an extension, the two year from grant ISO holding period would start from the date of the change.
Q. 36. May an option be modified without causing the option to be subject to § 409A?
In most cases, yes. While a modification constitutes a new grant (which can create a § 409A problem if the option is in the money at the time of the modification), the definition of a modification for § 409A purposes is very limited. Unlike the ISO rules which provide that many relatively minor changes are modifications, for § 409A purposes, only a change having the direct or indirect effect of lowering the exercise price are modifications. While this provision can be surprisingly subtle (for example changing the terms of a promissory note can result in lowering the exercise price if the interest rate is too low), for the most part common amendments to an option will not cause the option to be subject to § 409A.
Q. 37. If an option is modified to decrease the exercise price, is the repricing of an underwater option a problem?
Probably not, though there is some uncertainty under the Final Regulations. While the option may comply with the fair market value of the underlying stock at the date of the repricing, the terms of the plan could in fact create a § 409A problem because a requirement of § 409A is that the plan not permit the exercise price to go below fair market value at the date of grant. If a plan permits re-pricing (as required by Nasdaq or New York Stock Exchange rules in order to avoid obtaining shareholder approval) it is arguable that even if a repricing is never mplemented, the plan documents violate § 409A. Despite this rather hyper-technical concern, numerous repricings have occurred since the adoption of § 409A, suggesting this is not a realistic concern.
Q. 38. An option violates § 409A because it was granted at a discount to fair market value and does not have a fixed exercise date. Can it be fixed and if so, how?
Perhaps only to the extent the option is unvested. Prior to vesting a non-compliant option can be rescinded as to the unvested portion. Also, prior to January 1, 2009, various measures could have been taken though the IRS has steadfastly indicated an option may not be corrected after exercise. The most obvious fix is to raise the exercise price to the fair market value of the underlying stock as of the date of the original grant. Also, prior to vesting, the option can be structured to provide for exercise only at times that would comply with § 409A, although this can be very a tricky and perhaps an unacceptable fix.
Q. 39. Is restricted stock subject to § 409A?
Generally no, though sometimes this is a difficult determination to make. For example, if stock is actually transferred to an employee, subject to the company’s right to repurchase at cost if the employee quits prior to a certain date, § 409A does not apply. However, if there is another deferral feature, the stock could be subject to § 409A. Frequently, a restricted stock unit (“RSU”) will provide that the shares will be delivered in a tax year after vesting. In this case § 409A is likely to apply which means many things, including that the initial election (if any) to choose a distribution date would have to comply with certain election rules under § 409A and as a practical matter the distribution date will be difficult to change once elected.