Section 409A provides a set of tax standards for nonqualified deferred compensation. With limited exclusions, any plan that defers taxable compensation for employees or service providers is covered, including stock appreciation rights and stock options. Non-statutory stock options generally are taxable at the date of their exercise and not at their grant or vesting. Section 409A preserves this treatment, but only if it can be shown that the stock option is granted with an exercise price at or above the fair market value of the underlying stock on the date of grant. A stock option granted with an exercise price that is less than the fair market value per share of a company’s underlying stock on the date of grant is treated as current compensation under the Section 409A. In addition to the normal income tax due, a 20% penalty tax is added for the “underpriced” options. The company is also obligated to withhold income taxes from the option holders with respect to this tax liability and the income is subject to other withholding taxes such as FICA.
Private companies that grant stock options should consider obtaining an independent valuation to support the fair market value of their common stock. As a benefit, a valuation report that provides the fair market value of the common stock to satisfy Section 409A may in some cases also provide the fair value of the common stock to satisfy financial reporting requirements under SFAS No. 123R.
