Many commentators were surprised by the recent federal court of claims decision to deny summary judgment in Sutardja v United States. Sutardja, which currently is headed for trial, involves the IRS assessing a public company executive with Code Section 409A penalties, including a 20% additional income tax plus interest, with respect to potentially discounted stock options. What’s surprising isn’t so much the court’s decision, but that the IRS chose this particular fact pattern to assess Code Section 409A penalties. The option grant procedures that the employer followed would not be confused with best practices, but they occurred before Code Section 409A was enacted. The executive and the employer even tried to correct the issue after Code Section 409A’s enactment, despite there being limited other guidance, but the IRS still chose to punish the executive.

We believe that Sutardja offers a couple of lessons for employers. The first is don’t panic—in most cases, executives will still be able to exercise their options when they see fit and thus retain the flexibility to choose when to recognize taxable income. The second is that in order to grant options that provide this type of flexibility, employers need to follow detailed stock option grant requirements under the Code Section 409A regulations. This lesson may be harsh for the executive in Sutardja considering that most of those requirements hadn’t been written yet, but it gives the rest of us a chance to learn from those mistakes. Accordingly, this blog will focus on the opportunities employers have to correct outstanding plan grants and improve grant practices for future grants. We first will provide background on the case itself, highlighting the option grant practices that the IRS punished. Second, we will explain how employers can comply with the stock option grant requirements of Code Section 409A so that executives may retain the flexibility to choose when to exercise those options.


The key to understanding the Sutardja story is that the employer’s grant date practices were flawed in two respects.  First, the process to grant the options took nearly a month to complete.  On December 26, 2003, the employer’s compensation committee initially approved a grant of options to purchase 1.5 million shares of stock at $36.50/share, which was the closing price of the employer’s stock on the NASDAQ National Market Systems on that date.  On January 16, 2004, the same committee ratified this approval.  The closing price of the stock was $43.64/share, but the exercise price did not change.  That may seem like a red flag under Code Section 409A (and Code Section 162(m) for that matter), but back then, Code Section 409A had not yet been enacted, and the IRS had little other guidance on proper grant procedures.  While it seems strange that the same committee would approve and ratify a stock option grant on separate dates, the employer probably felt that there was not much as a tax risk from this practice.

The second flaw was that the employer and executive did not try to correct (i.e. eliminate) the discount until after the executive exercised the options.  The executive exercised some the options in January 2006.  In May 2006, the employer reviewed its stock option grant practices and concluded that the appropriate grant date was the date that the grant was ratified (i.e. January 16, 2004), meaning that the exercise price should have been $43.64/share.  Soon after that, the executive and the employer entered into an amended stock option agreement that increased the exercised price to $43.64/share, and the executive paid the difference between the prior exercise price and the new exercise price with respect to the options he had already exercised.  Trying to correct an option grant after the options have been exercised may seem a bit clumsy, but that probably was the best strategy available back then. 

Again, Code Section 409A had yet to be enacted when the options were granted.  When the employer and executive tried to correct the options, the only guidance under Code Section 409A that had been published were Notice 2005-1 and proposed regulations, both of  which explained that discounted options were subject to Code Section 409A.  Being subject to Code Section 409A means that the options generally may be exercised only upon certain permitted triggers:  (1) a specified date or year; (2) separation from service, (3) death, (4) disability, (5) change in control, or (6) an unforeseeable emergency.  An option that could be exercised at any time would violate Code Section 409A, and the difference between the exercise price and fair market value of the stock at the end of the year would be taxed currently as ordinary income and be subject to the Code Section 409A penalties.  Any appreciation in the future years would incur similar taxes and penalties.  It is easy to see why an employer and executive would want to remove the discount.

The problem is that the IRS would not publish final regulations until 2007 and the corrections program until the end of 2008.  Further, the IRS had said that until the plan document requirements in the final regulations became effective (January 1, 2009), plan documents were under a “good-faith” compliance period.  Given the sparse guidance that was available and the “good faith” transition period, the attempted correction doesn’t seem so crazy.  Unfortunately for the executive, the IRS claimed that the exercised options were discounted options that were subject to Code Section 409A, and it did not accept the amended option agreement as a valid correction of the exercise price.  Because the discounted option did not limit exercise to Code Section 409A’s permitted triggers, the IRS assessed the executive with an additional 20% income tax (on top of his ordinary income tax), plus interest, which totaled over $5,282,125.  Thus, the executive repaid the discount to the employer and still had to pay the Code Section 409A penalties on top of that!

The executive filed a claim for a refund, and that challenge is now proceeding through the court of claims.  Our companion blog describes the procedural history here.  The next stage is full trial, which will decide the factual issue of whether the executive’s options truly were discounted options, or whether the exercise price was equal to the stock’s fair market value on the date of grant (which would exempt them from Code Section 409A).  While it is possible that the executive could prevail at trial, in many ways, the outcome is irrelevant to most employers.  This case history shows that the IRS is auditing option grant practices, and it will punish executives if the employer has defective grant procedures.  So, how do employers avoid letting their executives fall into a similar situation?  The following discussion will help answer that question.

Procedures for Granting Flexible Stock Options

Employers who want to ensure that their option grant procedures are proper should review (1) their currently outstanding option grants and (2) the procedures for future grants. 

  1. Currently Outstanding Options.  Review of current option grants is critical because unlike in Sutardja, the IRS now offers a Code Section 409A corrections program.  The program generally requires the exercise price to be corrected before any options are exercised.  Also, for options granted to insiders, the correction typically must be completed by the end of the year in which the option was granted.  So, while the corrections program exists, employers should realize that they may not always be eligible to use it.  A prompt review will increase the chances of being able to utilize this program.
  2. Future Grants.  If the employer is considering a future stock option grant, it should make note of the following procedures:
  • Determine whether the options will be discounted.  Code Section 409A does not prohibit the grant of discounted options, but it imposes strict limits on when they can be exercised.  Non-discounted options generally are exempt from Code Section 409A, which gives executives much more flexibility in choosing when to exercise their options and thus when to recognize taxable income.  For these reasons, employers typically grant non-discounted options.
  • Establish a process for determining the exercise price and document that process. A non-discounted option means the exercise price is equal to the fair market value of the underlying stock on the date of grant.  Determining fair market value is fairly easy for publicly traded companies.  Fair market value typically equals the closing price on the grant date, although there is some flexibility to use an average of various prices.  Privately held companies have a much more difficult process because they don’t have a readily established market for their shares.  The regulations under Code Section 409A contain safe harbors, which generally require the employer to get an appraisal or consistently use a the same fair market value formula for most other stock transfers involving the employer.  These approaches contain detailed requirements that can make them difficult and expensive.  Alternatively, employers may use a “reasonable application of a reasonable valuation method.”  A “reasonable” valuation method considers several factors, including:  (1) the value of the employer’s assets; (2) the present value of the expected cash flows; (3) the market value of stock of similar businesses; (4) recent arm’s-length transactions involving the sale of employer stock; and (5) other relevant factors.

The lack of clarity in these rules shows how easily the IRS could challenge a private company stock option’s exercise price.  Accordingly, privately held companies either should use one of the safe harbor methods or carefully document the process it used to establish that the exercise price of the option was equal to the fair market value of the underlying stock.

  • Establish detailed grant date procedures.  Establishing the exercise price is an important step.  Making sure the exercise price corresponds to the proper grant date is just as important.  Code Section 409A describes the grant date as the date when the granting corporation completes all corporate action necessary to create the legally binding right to purchase shares under the option.  The IRS further explained this rule in a 2009 Chief Counsel Advice Memorandum that applied the Code Section 409A rules to Code Section 162(m)’s grant date standards.  The Memorandum added that it is entirely within an employer’s control to complete and document the steps to affect the grant of the option contemporaneous with or before the intended grant date.  That is a strict standard, and one the employer did not satisfy in Sutardja.  Employers should review their grant date practices and make sure there is no room for challenge.
  • Consider granting other awards besides stock options.  If employers have trouble granting options that fit within these rules, they may want to consider granting alternative equity compensation awards.  Restricted stock is exempt from Code Section 409A.  Restricted stock units or phantom stock can be easily designed to comply with Code Section 409A or be exempt from Code Section 409A.  These awards can provide the same incentives to employees as options, and they do not involve the pricing and grant date issues that accompany options.

Final Thoughts.

Sutardja shows that the IRS is auditing stock option grant procedures aggressively.  Employers who want to grant options that give their executives the maximum flexibility in choosing when to recognize taxable income, still need to satisfy the detailed requirements in the Code Section 409A regulations.  Employers should review their option grant date and exercise practices and take any steps necessary to mitigate the risk of the IRS imposing Code Section 409A penalties on their executives.