United States

Stock options and section 409A: Frequently asked questions

A look at stock rights, deferred compensation and the tax code


Stock options are a form of equity compensation that can directly reward the holder when the company stock price increases. Stock options typically require employees to pay the exercise price in order to realize the benefits of the option award. Upon exercising an option, the holder receives back stock in the company—an asset he or she then holds until future disposition.

Section 409A of the Internal Revenue Code governs the taxation of deferred compensation. Stock options that satisfy several conditions are regarded as “stock rights” that are excludable from section 409A rather than “deferred compensation” subject to section 409A. However, if any of the conditions necessary to qualify for the exclusion are not satisfied, the stock options will be regarded as deferred compensation subject to section 409A such that the options would have to either conform to section 409A or suffer the consequences of failing section 409A.

The following questions and answers explain the section 409A considerations that companies need to be aware of when issuing stock options.

What conditions must be met in order for stock options to be regarded as stock rights excludible from section 409A?

  1. Stock options that qualify as incentive stock options (ISOs) are not subject to section 409A. (Companies may decide to use ISOs or non-qualified stock options (NSOs) for various reasons.) Non-qualified stock options will be regarded as stock rights excludable from section 409A provided they meet each of the following conditions:
  2. The stock option is a right to purchase “service recipient stock,”, that is, common stock of the corporation for which the service provider (option grantee) performs direct services or certain eligible parent entities that possess at least 50 percent of the voting power or value of the service recipient corporation’s ownership. Options on preferred stock are not section 409A-excludable stock rights even if all of the other conditions identified below are satisfied.
  3. The exercise price may never be less than the fair market value (FMV) of the underlying stock on the date the option is granted. Section 409A regulations provide guidelines for valuing stock that is readily tradable on an established securities market and stock that is not so traded. The regulations also establish with respect to stock that is not readily tradable on an established market certain safe harbor valuation approaches.
  4. The number of shares subject to the stock option must be fixed on the initial date of grant. The date of grant can be no earlier than the date on which the corporation completes the corporate action necessary to create a legally binding right to the options for the service provider.
  5. The transfer or exercise of the option is subject to taxation under section 83 and Reg. section 1.83-7. (Note: Section 83(b) elections are not available for stock options, but that is separate from taxation falling under section 83.)
  6. The option does not contain any feature for the deferral of compensation beyond the later of the exercise or disposition of the option or the time the stock acquired pursuant to the option becomes substantially vested. The taxable income resulting from the exercise or disposition of the option must be fully includable as income at the time of exercise/disposition of the option.

If stock options do not satisfy any one (or more) of the above conditions and are subject to section 409A, what does that really mean?

Options that are subject to section 409A must either (1) be designed to conform to the requirements of section 409A and the regulations, or (2) suffer the potential adverse tax consequences of failing section 409A if they do not conform.

What are the potential adverse tax consequences if an option grant subject to section 409A does not conform to the section 409A requirements?

The options result in a section 409A failure with the following consequences:

  1. Any inherent unrealized gain in the options as measured on December 31 of the vesting year is reportable as section 409A income and taxable to the option holder in the year of vesting whether or not the options have been exercised. Further, in each subsequent year prior to the exercise of the options, any additional unrealized gain as measured on December 31 of such year is includable as section 409A income. (The amounts so taxed as income serve to increase the option holder’s tax basis in the options to avoid “double taxation” of the previously taxed income in the year the options are actually exercised.)
  2. The employer is required to report the section 409A failure on the employee’s Form W-2 and to withhold tax on the “409A income.” Failure to do so could result in penalties to the employer.
  3. The 409A income is subject to an additional 20 percent tax imposed under section 409A on the option holder. This is in addition to the option holder’s regular income tax.
  4. An additional premium interest tax may also be imposed on the section 409A income at the rate of 1 percent above the IRS underpayment rate. Although computed like interest, this is a tax that itself may be subject to interest and penalty charges.
Observation: The adverse potential tax consequences to the option holder, namely the acceleration of the option income to the year of vesting (regardless of exercise), the additional 20 percent section 409A tax, and potential interest and penalties for non-compliance, and to a lesser degree, the potential penalties on the employer, place a premium on the importance of qualifying an option grant as excluded stock rights. One of the critical requirements being that the grant be at the FMV exercise price.

What are the requirements that must be satisfied in order for options to conform to section 409A if they are not otherwise excludable?

  1. In order to conform to section 409A, the option grant must be documented in writing and as of the grant date and:
  2. Specify the number of options granted.
  3. Specify the term during which the options may be exercised.
  4. Specify the amount of the exercise price or an objective formula by which the exercise price can be determined.
  5. Provide an objective non-discretionary exercise event or date that is permitted under section 409A. Permitted events or dates include:
  • A “change in control event” as defined in section 409A
  • The date of the option holder’s “separation from service” from the employer
  • Death
  • Disability (as defined in section 409A)
  • A specified future exercise prescribed at the time of grant
  • The earliest to occur of a section 409A qualifying change in control event or a specified future date prescribed at the time of grant

Neither the option holder nor the employer are allowed to possess discretion over the timing of the exercise of the options.

Must an employer whose stock is not readily tradable on an established securities market obtain a professional independent appraisal to establish the FMV of its stock for purposes of setting the exercise price of the options?

Section 409A does not require the use of an independent professional appraisal. However, with respect to stock that is not traded on an exchange, such an appraisal, provided it is fresh (i.e., the valuation date of the appraisal is within 12 months of the date the option is granted), is the section 409A safe harbor valuation approach that is most commonly used. If the appraisal was challenged by the IRS, the appraised value would be entitled to a presumption of reasonableness such that the IRS would bear the burden of having to establish that the appraised value was unreasonable. Absent such an appraisal (or an alternative safe harbor methodology), if the IRS challenged the employer’s valuation, the employer would bear the burden of having to establish that its valuation of the stock was reasonable.

Given the onerous potential tax consequences that could result from a determination that the option exercise price represented a discount to FMV, unless an option grant is specifically designed to conform to the requirements of section 409A, an independent professional appraisal is generally recommended. However, it is not required and FMV of the employer stock may be established based on the factors identified in guidance contained in the section 409A regulations and given the particular facts and circumstances.

Besides an independent professional appraisal, what other safe harbor valuation methods exist with respect to stock that is not readily tradable on an established securities market?

If the specific conditions noted below are satisfied, the following valuation methods may constitute a safe harbor valuation method:

  1. Formula-based method. A formula-based valuation method can be utilized for companies that use a formula based on book value, a reasonable multiple of earnings or a reasonable combination of the two to set option exercise prices. A formula method will not qualify as a safe harbor method unless (i) the stock acquired is subject to a permanent restriction on transfer that requires the holder to sell or otherwise transfer the stock back to the company, and (ii) the formula is used consistently by the company for that class of stock for all (both compensatory and non-compensatory) transfers to the company or any person who possesses more than 10 percent of the total combined voting power of all classes of stock of the company, other than an arm's-length sale of substantially all the outstanding stock of the company.
  2. Illiquid stock of a start-up corporation. A valuation of the stock of a private company that has no material trade or business that it has conducted for 10 years or more, if done reasonably and in good faith and evidenced by a written report will be presumed reasonable if (i) the valuation is performed by a person with significant knowledge, experience, education or training in performing similar valuations (“significant experience" generally means at least five years of relevant experience in business valuation, appraisal, financial accounting, investment banking, private equity, secured lending or other comparable experience in the line of business or industry in which the company operates), (ii) the company does not reasonably anticipate, as of the time the valuation is applied, that the company will undergo a change in control event within the 90 days following the grant or make a public offering of securities within the 180 days following the grant, and (iii) certain additional conditions contained in the regulations are satisfied.

How is the value of stock determined with respect to stock that is readily tradable on an established securities market?

Options that are granted on stock that is readily tradable on an established securities market (note: this includes any over-the-counter market that uses an interdealer quotation system such as “pink slips”) must generally utilize one of the following approaches for purposes of determining the grant date value: last sale price before the grant, first sale price after the grant, closing price on the trading day before the grant, closing price on the trading day of the grant, the arithmetic mean of the high and low prices on the trading day before the grant or the arithmetic mean of the high and low prices on the trading day of the grant.

Alternatively, the value may be determined on the basis of a 30-day (or fewer) average price in certain limited circumstances. Such an approach is only permitted if each of the following conditions are met:

  1. Prior to the beginning of the applicable 30-day (or fewer) averaging period, the board had specifically identified the individual(s) who would receive the grants and specified the number of shares/options being granted.
  2. Prior to the beginning of the applicable 30-day (or fewer) averaging period, the board had specified the number of days that would be used for purposes for calculating the average value.
  3. The commitment to grant the specified number of shares to the named individual based at the above specified exercise price must be irrevocable.
  4. The “average selling price” must be calculated either as: i) the arithmetic mean of the selling prices on all trading days during the specified period, or ii) such arithmetic mean weighted based on the volume of trading on each trading day during the period.

What consequences may result if an excludable stock right that is not subject to section 409A is later modified or extended?

  1. Modifications. A modification is any change in the terms of a stock right that may provide the holder of the stock right with any direct or indirect reduction in the exercise price of the stock right regardless of whether the holder actually benefits from the change. When a stock right is “modified” it is treated as the grant of a new option grant. As such, the “new” option must be re-evaluated to determine whether it satisfies each of the conditions in order to be regarded as an excludable stock right. Certain modifications are not regarded as the grant of a new option so any changes need to be carefully considered.
  2. Extensions. An extension of a stock right (e.g., lengthening the exercise period) is treated as having an additional deferral feature retroactive to the date of the original grant. This is far more problematic than a modification because the addition of a deferral feature retroactive to the original grant results in the option losing its section 409A exclusion all the way back to its original grant date since not having a deferral feature was one of the requirements to receive exemption in the first place. As such, if the option did not conform to the section 409A requirements as of the original grant date, the extension results in triggering a retroactive section 409A failure with adverse tax consequences.

Several actions can constitute the extension of a stock right so changes should be carefully considered.

An extension of the exercise period of an option that is effected when the option is underwater (i.e., when the exercise price equals or exceeds the FMV of the underlying stock) is not characterized as an extension, but rather as a modification and is regarded as the grant of a new option.

If options are inadvertently granted at an exercise price that is below FMV, what can be done?

Limited correction procedures permit the exercise price to be amended (increased) without having to re-issue the options to the FMV of the shares as of the date of the original grant. The correction is subject to specific requirements and involves an increase to the exercise price that would generally require the written consent of the affected option holders. An experienced professional should be consulted for assistance with any issues in this area.

Employers may consider offering stock options to employees for various reasons. Section 409A is not a hurdle that should dissuade the use of an otherwise valuable compensation tool, but its implications should be considered during planning so that no unintended tax consequences arise.


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