A New Year, And 409A Tax Bomb Explodes

Companies with backdated stock options are scrambling to fix a host of problems before recently issued tax guidance hammers them and their employees with income taxes, penalties, and withholding requirements.

Companies like Nvidia Corp. even hurriedly issued tender offers asking employees if they’d like to turn in their improperly granted options for properly dated (and presumably higher-valued) options in lieu of paying immediate income taxes and penalties for the unexercised options they hold. Employees had until Dec. 31 to make their decisions.

Tse

Marion Tse, a partner with the law firm of Goodwin Procter and chair of the firm’s employee-benefits practice, says companies had to make big decisions under tight deadlines following recent guidance issued by the Internal Revenue Service in relation to how Section 409A of the Internal Revenue Code applies to backdated options.

Section 409A became effective in 2005 to wrap new rules around deferred-compensation arrangements, which by definition now includes stock options that were granted at a discount. The 200-plus companies that are entangled in improperly issued stock options—backdating them upon grant so they have instant value—are now struggling with the consequence that what they believed was deferred compensation is actually viewed by the IRS as current compensation.

Throughout 2006, companies already had been bracing for the earnings and tax consequence of revaluing those options, tallying up their tax bills on the unreported income, and, in some cases, restating financials. They also wrestled with the reality that classifying discounted options as current income may push many executives’ annual earnings beyond the $1 million cap on deductibility—so whatever companies paid executives beyond the $1 million mark also must slide back into the “taxable earnings” category.

But then, with only a month remaining in the 2006 tax year, the IRS dropped its bombshell: that under Section 409A, all existing options—even the unexercised ones—are subject to current income-tax withholding and reporting for the employees who hold the options. That means companies must start withholding money from employees’ paychecks in relation to their unexercised discounted options and pay the employer-payroll tax on that amount as well.

“We’re in a transition period because the law is so new,” says Tse. “The IRS generally had said companies would have until the end of 2007 to fix any arrangement that was not compliant, as long as the option was not exercised. But now the IRS has said if you’re caught in a backdating situation and have to take a charge to earnings, they’re not going to give the extra year. With the beginning of 2007 companies will have withholding and reporting obligations, so companies with employees holding these options must either fix them or start reporting income and withholding.”

For an employee holding an affected option, the tax would hit in several ways. First, the discounted value of the option would be taxable immediately as current income, plus a 20-percent penalty, plus future payroll-tax withholdings if the employee decides to hang on to the option. For the company that issued the option, an employer-payroll tax must be paid as well, not to mention the intangible cost of the loss of goodwill with employees, who will be none-too-pleased with the tax news.

No Good Options Anymore

Compensation and benefit experts say companies generally have few choices, and none of them are pleasant.

EXCERPT

Below is a portion of the IRS guidance on Section 409A, including how the transition relief does not apply to backdated stock options.

Amendment and operation of plans adopted on or before Dec. 31, 2007

A plan adopted on or before December 31, 2007 will not be treated as violating section 409A(a)(2), (3) or (4) on or before December 31, 2007 if the plan is operated through December 31, 2007 in reasonable, good faith compliance with the provisions of section 409A and applicable provisions of Notice 2005-1 and any other generally applicable guidance published with an effective date prior to January 1, 2008, and the plan is amended on or before December 31, 2007 to conform to the provisions of section 409A and the final regulations with respect to amounts subject to section 409A. For such periods, to the extent an issue is not addressed in an applicable provision of Notice 2005-1 or other published guidance with an effective date prior to January 1, 2008, the plan must be operated consistent with a good faith, reasonable interpretation of section 409A, and, to the extent not inconsistent therewith, the plan’s terms.

Compliance with the proposed regulations, or the final regulations prior to their effective date, is not required. However, for periods before Jan. 1, 2008, compliance with the proposed regulations or the final regulations will constitute reasonable, good faith compliance with the statute. To the extent that a provision of either the proposed regulations or the final regulations is inconsistent with a provision of Notice 2005-1, or a provision of the proposed regulations is inconsistent with a provision of the final regulations, the plan may comply with the provision of the proposed regulations, the final regulations or Notice 2005-1.

A plan will not be operating in good faith compliance if discretion provided under the terms of the plan is exercised in a manner that causes the plan to fail to meet the requirements of section 409A. For example, if an employer retains the discretion under the terms of the plan to delay or extend payments under the plan in a manner that violates section 409A and exercises such discretion, the plan will not be considered to be operated in good faith compliance with section 409A with regard to any plan participant. However, an exercise of a right under the terms of the plan by a participant solely with respect to that participant’s benefits under the plan, in a manner that causes the plan to fail to meet the requirements of section 409A, will not be considered to result in the plan failing to be operated in good faith compliance with respect to other participants. For example, the request for and receipt of an immediate payment permitted under the terms of the plan if the participant forfeits 20 percent of the participant’s benefits (a haircut) will be considered a failure of the plan to meet the requirements of section 409A with respect to that participant, but not with respect to all other participants under the plan …

Transition relief not extended for certain discounted stock rights

The transition relief provided in the preamble to the proposed regulations and described in this notice is not extended for any stock option or stock appreciation right (stock right) that …

[W]ith respect to the grant of such stock right, such corporation either has reported or reasonably expects to report a financial expense due to the issuance of a stock right with an exercise price lower than the fair market value of the underlying stock at the date of grant that was not timely reported on financial statements or reports for the period in which the related expense should have been reported under generally accepted accounting principles.

Source

IRS Bulletin 2006-43 (Oct. 23, 2006)

They can reprice the option, Tse says, “to increase the exercise price to what it should have been.” Nvidia chose that option, filing a tender offer with the Securities and Exchange Commission last month.

In a memo to employees, Nvidia’s CFO Marvin Burkett said the tender offer “will allow [affected] employees to amend their impacted options in a way that we believe will minimize or avoid the adverse tax treatment of Section 409A and state tax laws that have a similar effect.”

Deloitte conducted information sessions for Nvidia’s employees to explain the situation, describe Nvidia’s plan to navigate it, and clarify that the plan requires employees to consent and voluntarily participate. But Deloitte warned of the consequences for employees who opt out: “If you do not participate, you may have adverse personal income tax consequences for which you will be solely responsible,” said Deloitte’s presentation materials.

Neither Nvidia nor Deloitte responded to Compliance Week’s request for comment.

Buyniski

Ted Buyniski, a senior vice president with Radford Surveys + Consulting, an Aon Consulting subsidiary, says some companies may try to soften the blow to employees by offering a cash bonus. If they ask employees to trade in their options for new options that have a lower value, “that takes something away from the employee,” he says. “You have to pay the employee something to do that, or just get the employee to agree to take one for the team.”

Tse expects that companies generally won’t offer cash bonuses to everyone affected. “They’re doing that for the rank-and-file, but not for the management that is culpable,” she says.

Another alternative is to get an employee to agree to exercise the affected options on a fixed date, Tse says. That, however, requires an employee to give up one of the key benefits that makes stock options so appealing to employees: timing the exercise of the option according to market conditions and their own preferences or circumstances.

No single scenario is most beneficial for companies or employees, Tse says, because the outcome depends on a wide range of circumstances: how many shares are outstanding, how much they are worth, how their value has changed, and the tax consequences of exchanging, holding, or exercising the option, to mention a few.

Nixon

John Nixon, a compensation and benefits attorney with the law firm of WolfBlock, says companies at first took Section 409A a little more in stride because the IRS didn’t yet have a plan in place for how it wanted companies to report income related to nonqualified deferred compensation. It was, he said, a “reporting holiday.”

“Some folks were more diligent than others in determining if their plans were 409A-compliant,” he says. “Now it’s time to fish or cut bait.”

Although companies with backdated options are scrambling to comply with the newest Section 409A guidance, the provisions of 409A are not specific or exclusive to backdated stock options, Nixon says. “If companies haven’t done a real hard analysis of compensation that could be subject to 409A, they need to do that immediately,” he says. “People are seeing this as a securities issue or an SEC issue, but it’s also an IRS issue.”

Bishop

Keith Bishop, a partner with the law firm Buchalter Nemer, agrees that Section 409A is “a real sleeper” that is now catching companies by surprise. “I don’t think people have fully realized the implications of it, but it’s turning individuals who are normally cash-basis taxpayers into accrual-basis taxpayers,” he says. “They’re paying taxes on things that aren’t putting more cash in their pockets.”

Tse notes another dimension to the issue that even the IRS apparently hasn’t yet addressed, let alone companies or employees: What happens if employees have already exercised backdated options that are affected by the Section 409A provisions?

“The IRS hasn’t really said anything, but these people probably now have to pay that additional 20 percent tax,” she says.