Court Ruling Buoys IRS's Hard Line on Deferred Compensation

Stringent tax rules on deferred compensation have sent companies scouring through their compensation plans in recent years and making fixes to assure that their employees won't be penalized. A recent judicial victory for the Internal Revenue Service, however, has left tax experts wondering if those efforts were adequate.

The U.S. Court of Federal Claims recently sided with the IRS in its $5.28 million dispute with Sehat Sutardja, CEO of semiconductor company Marvell Technology Group, and his wife and co-founder, Weili Dai. The couple sparred with the IRS over whether a stock option grant fell within the reach of Internal Revenue Code Section 409A, enacted to impose penalties on certain types of deferred compensation that were considered abusive tax shelters. That rule was meant to include the awarding of any discounted or backdated stock options, or options that were already “in the money” when awarded.

The court affirmed the view that the IRS was entitled to tax Sutardja's award; however, it handed the case back to a lower court to determine if Sutardja's specific option grant met the standard of a discounted option that would be subject to the penalties of Section 409A.

The case has caught the attention of Section 409A experts because it appears to demonstrate the IRS's zeal for rigid compliance with the statute. “I was not rankled by the result of the case, but by the fact that the IRS brought the case at all,” says Michael Melbinger, a partner and chair of the benefits and compensation practice at law firm Winston & Strawn. “The IRS picked this high-profile individual and his high-profile company— at least in the Silicon Valley— to send a warning and set a precedent.”

The IRS's pursuit of Sutardja has surprised many tax experts because it predates the adoption of Section 409A, not to mention the grace period that the IRS had established to give companies time to comply with it. “For the IRS to slap this penalty on a taxpayer who it seems tried to comply with 409A is a little disheartening,” says Lori Basilico, a partner at law firm Edwards Wildman Palmer.

Congress enacted Section 409A in late 2004 with a broad mandate to address concerns that executives were deferring taxable compensation into the future to delay the tax consequences. Then the IRS got to work writing regulations and transition guidance to specify how it would apply the statute. “It took a long time for the regulations to be issued,” says Basilico. “The IRS engaged substantial good-faith interpretation periods and extended compliance into 2008.”

Yet the IRS pursued penalties against Sutardja, whose options for 1.5 million shares were granted by the company's executive compensation committee in December 2003 and ratified in January 2004. The stock price rose between the grant date and the ratification date, causing the IRS to conclude the options were granted ultimately at a discount, and therefore subject to Section 409A. The court's finding acknowledges that the company and Sutardja took measures to correct the timing problem and true up the difference, but the IRS pursued penalties anyway. “The facts were all in a time period before 409A was even enacted,” says Basilico.

“For the service to slap this penalty on a taxpayer who it seems tried to comply with 409 is a little disheartening.”

—Lori Basilico,

Partner,

Edwards Wildman Palmer

The case serves as an alert to the tax and compensation communities, says Adam Fayne, a partner at law firm Arnstein & Lehr. “The IRS is aggressively enforcing 409A, so companies should be sure when they are granting options that they are in compliance with it,” he says. According to Fayne, companies should review past option grants to assure they meet the requirements of 409A and then seek out self-correction measures that are provided in IRS regulations if they find problems. He cautions companies, however, against trying to fix any problems simply by adjusting dates on related documents. “Backdating is highly illegal,” he warns.

A central fact still to be determined in the Sutardja case is whether his options were indeed discounted based on the events that transpired with his specific grant. “That's something the IRS and the taxpayer are going to have to figure out before we can have a full judgment,” says Jeff Martin, a senior manager in the national tax office of Grant Thornton. It's possible for the grant dates to differ for tax versus financial reporting purposes, he says, but determining the grant date for tax purposes is vital to determining whether penalties will apply.

“As it works its way through the courts, we will keep an eye on this for purposes of knowing when an option is considered granted,” says Tim Daum, a director in the tax group at Crowe Horwath. “If the compensation committee approves the grant, then later ratifies it, when is the option considered granted? When the compensation committee initially approves the grant, or when it is later ratified? Hopefully, we will get some clarity on that.”

SUTARDJA IMPLICATIONS

Below is an excerpt from the Morgan Lewis alert on the effect of the decision in Sutardja v. united States.

This decision underscores the importance of careful attention by issuers of stock options to determining and

documenting the fair market value strike price of options so as to withstand review on audit. The regulations under

section 409A provide procedures for determining fair market value for these purposes, and there are advantages

and disadvantages to the alternatives provided. In the event that the issuer wants to issue a stock right to a

service provider with a built-in discount, a number of methods of accomplishing this goal are available. However,

this decision serves as a good reminder that discounted stock options or discounted stock appreciation rights

must be treated as deferred compensation subject to section 409A payment timing restrictions and must be

properly documented to be compliant with section 409A from the date of the grant, or profoundly negative section

409A tax consequences will apply.

Further, future developments in this case (addressing the factual and legal issues relating to the determination

of the grant date) also merit watching, because the Court of Federal Claims is expected to address in its next

decision issues relating to (i) the compensation committee's authority to make grants; (ii) the effect of ratification

of prior grants; and (iii)the special “good faith” exception, which protects taxpayers from the assessment of any

taxes under section 409A if any option granted before 2005 had been granted in compliance with the incentive

stock option regulations and the parties to the option agreement believed in good faith that the option was not

discounted.

Source: Morgan Lewis.

Sue Lennon, managing director in the human resources practice at PwC, says state law where a company is incorporated plays a part in determining when options are granted. “This case shows how important it is for companies to understand their state corporation law on when and how options are granted,” she says. “You have to assure the exercise price equals the fair-market value at what is determined to be the legal grant date. There's a huge penalty if you don't get that right.”

Bill Smith, managing director in the national tax office at CBIZ MHM, says he's not surprised the IRS aggressively pursued compliance and penalties against Sutardja. “The IRS has said if you issued discounted stock options, they are subject to 409A,” he says. “They are very active in making sure the form is correct with respect to this.”

In light of the Sutardja dispute, Basilico says companies should review their own option granting processes. “Make sure you have a very good grant approval process and that you carefully document it,” she says. “This case doesn't look like there was purposeful backdating. It just looks like it was a matter of poor corporate governance and things didn't get done on a timely basis.”

Melbinger believes there are plenty of other cases that could fall into IRS scrutiny. “The fact that they got it wrong and went back and corrected it puts them in company with a third of employers in all of the United States,” he says. “Everyone knows how awful this was and how hard it is to comply. The IRS is definitely taking a hard line on 409A.”