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Something to Marvell At: An Actual Case Involving Section 409A

We have been thinking and talking about Section 409A for more than 8 years now, but most of that discussion has been hypothetical. We have pursued compliance with Section 409A, but have been left to wonder: What would actually happen if an arrangement violated Section 409A? Is the IRS monitoring compliance or enforcing these requirements?

Well now we have some answers.

A federal court recently issued a ruling (here) dealing with the consequences under Section 409A of a discounted stock option arrangement. In addition to providing some specific legal analysis on Section 409A issues, the court’s decision provides some insights into how a case like this might arise.

Background. The case involves a founder and senior executive of a technology company (Marvell Semiconductor) who was granted stock options in 2003. In the wake of the various stock option backdating scandals, the company reviewed its option program and repriced the 2003 option grant. As a result, the executive paid over $5,000,000 in additional exercise price, presumably reflecting that the options had been substantially discounted when awarded.

The IRS Takes Notice. Disclosures regarding this repricing must have caught the IRS’s attention. In 2010, it issued the executive a notice of deficiency to the executive assessing additional taxes and penalties under Section 409A in excess of $3,000,000. The executive paid the assessed amounts and then sued to obtain a refund, arguing that the option arrangement was not governed by Section 409A.

The Court’s Analysis. The court made several important rulings regarding the impact of Section 409A for stock options:

(1) Discounted options are subject to 409A. The court first ruled that Section 409A applies to discounted stock option arrangements that fail to meet the requirements of Section 409A. This is consistent with the final 409A regulations and the IRS’s other Section 409A guidance, going back to Notice 2005-1.

(2) Deferral of compensation. The court then ruled that discounted stock option arrangements provide for the deferral of compensation within the meaning of Section 409A, even though they are not treated as providing for the deferral of compensation for purposes of the FICA tax rules applicable to nonqualified deferred compensation plans.

(3) Legally binding right. The executive argued he had no legally binding right to the compensation represented by the options unless and until he exercised the options. However, the court ruled that the grant of the options was itself compensatory and that the executive had a legally binding right to the compensation once he became vested in his right to exercise the options.

(4) Short-term deferral exception. The court ruled that the option arrangement did not qualify for the short-term deferral exception, which applies when compensation is paid within 2-1/2 months after the end of the year in which it first becomes vested. Under the option plan, if the executive terminated employment, he had only 30 days to exercise any vested, unexercised options. He argued this meant he had nothing more than a rolling 30-day right to exercise his vested options. But the court concluded the short-term deferral exception was no longer available after the options vested and could be exercised at any time, at the executive’s election.

Takeaways. Although the court’s rulings related specifically to an option plan, they may be more broadly characterized as giving considerable deference to the IRS’s interpretations of Section 409A. Also, if there was any doubt, it is clear the IRS is paying attention to Section 409A and will seek to enforce it when non-conforming plans are identified.


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Don Berner, the Labor Law, OSHA, & Immigration Law Guy
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Boyd Byers, the General Employment Law Guy
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Jason Lacey, the Employee Benefits Guy
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