Structuring Stock Options to Avoid 409A Penalties

On the back of $80 billion in funding via the Inflation Reduction Act (IRA), the Internal Revenue Service (IRS) is ramping up audits, particularly targeting large corporations and partnerships. With the heightened scrutiny, you must stay compliant with tax laws, especially those related to stock compensation which constitutes a significant portion of income for most top employees, executives, and founders.

In this context, 409A penalties are an important concern. They can lead to penalties as well as immediate taxation of vested stock options.

However, you could avoid the 409A penalties by structuring stock options better. In this article, we will guide you on how you can optimize ISOs as well as NSOs so that you would be exempt from Section 409A’s requirements. Read on to know more!

What are 409A penalties?

Non-compliance with Section 409A of the Internal Revenue Code (IRC) can result in the following adverse tax consequences for your employees and other service providers:

• Immediate taxation of vested income – If you violate Section 409A’s requirements relating to distributions, accelerations of benefits, and elections, then any vested stock options, from the current and previous years, will be immediately taxable if they do not carry a substantial risk of forfeiture and have not been included in the gross income.
• Penalty tax – The Internal Revenue Service (IRS) will charge a penalty tax of 20% on the vested stock option income mentioned in the previous section.
• Higher interest rate on unpaid taxes – The IRS charges a certain underpayment interest on unpaid taxes. Under Section 409A, this interest rate is increased by 1 percentage point for unpaid taxes on vested stock option income.
• State Penalities – In addition to federal penalties,individuals may also face state-imposed penalties for non-compliance with section 409A.

Correction Program of IRS

The IRS provides a correction program that allows for reducing or avoiding penalties if errors are identified and corrected within two years of occurrence.

Section 409A imposes heavy penalties on employees or service providers for violations related to deferred compensation plans, showing the importance of strict adherence to its regulations. Failing to correct arrows can result in immediate taxation,additional penalties, increased audit risks and costly burdens to administration.

How to structure stock options to avoid penalties under Section 409A?

Stock options can be classified as NSOs and ISOs. The 409A penalties exemption requirements for both these types are discussed in the following sections.

Structuring NSOs to avoid 409A penalties

If your nonqualified stock options (NSOs) meet the following requirements, they will be exempt from 409A penalties.

Pricing

The exercise price of the NSOs should be at least equal to your company’s fair market value (FMV). If the beneficiary receives any dividend or dividend equivalents at the time of exercise, it will be considered a discount on the exercise price.

For instance, if your company’s stock’s FMV is $20 and the exercise price of your NSOs is $20 but the beneficiaries receive dividends of $2 per share, then the effective exercise price will be $18 ($20 – $2) and these NSOs will not be exempt from Section 409A.

A public company can use its last trading price, closing price, or average price over a week, month, or any other specified period to establish its FMV as long as the FMV calculation method is specified before the grant date.

On the other hand, a private company must establish its FMV by conducting a valuation using acceptable methods, taking all relevant facts, figures, and market conditions into account. Essentially, you would need to get a valuation that meets the requirements of Section 409A.

To simplify tax compliance, consider qualifying for safe harbor provisions. You can achieve this by getting a 409A valuation using the illiquid startup presumption method, the binding formula presumption method, or by hiring an independent appraiser such as Eqvista to get a 409A valuation.

Nature of the stock grantor

Your NSO will be exempt from the requirements of Section 409A only if you are offering an opportunity to buy shares of the service receiver or the entity with a controlling interest in the service receiver or another company controlled by the service receiver’s ultimate parent company.

To put it in simpler terms, NSOs that grant an opportunity to buy shares of the service provider or its controlled group companies will meet this criterion. While control is defined as a minimum 80% stake in Section 414 of the IRC, in this context, it can be adjusted to a 50% stake. Also, if there is a legitimate business reason for the relationship between the service provider and the stock grantor, this threshold can be further adjusted to 20%.

Nature of the stock itself

You must offer common stocks without any dividend preferences. These can have liquidation preferences and be subjected to restrictions. However, there cannot be a repurchase obligation where the exercise price would be different from the FMV.

Non-deferral

Your NSOs must not be deferred compensation of any form. So, you must not allow deferring the delivery of the shares upon exercise or issue the NSOs in exchange for deferred compensation.

Other requirements

• If you modify the NSO in any material manner, it will be treated as a new grant and must be re-priced.
• You may allow exercise extension up to the original period or 10 years.
• If the option is underwater, i.e. its exercise price is higher than its current FMV, you can extend its exercise period without any restrictions.

Structuring ISOs to avoid 409A penalties

By structuring stock options as per Section 422 or Section 423 of the IRC, your incentive ISOs will be exempt from the requirements and penalties of Section 409A. However, you must ensure that your ISOs consistently meet the requirements of Sections 422 and 423 to maintain this exemption.

The prescribed structures as per Section 422, which governs ISOs, and Section 423, which governs stock compensation granted as part of employee stock purchase plans (ESPPs), are as follows.

Requirement	Section 422	Section 423 (Employee stock purchase plans)
Plan approval	The plan must be approved by the shareholders within 12 months before or 12 months after it is adopted.
Eligibility	Only employees	All employees of your company, its parent company, or subsidiary. Allowed exclusions are employees with: a. Less than 2 years of service b. Employment of 20 hours or less per week c. Not more than 5 months of employment in any calendar year d. Highly compensated employees as per Section 414(q)
Requirements related to rights	N/A	Uniform rights for all participants
Exercise price	a. For employees owning at least 10% voting power: Exercise price must be at least 10% higher than the FMV on the grant date b. For others: Exercise price must be at least equal to the FMV on the grant date	The exercise price must be at least 85% of the stock’s FMV on the grant date or exercise date, whichever is lower.
Expiration period	a. For employees owning more than 10% voting power: 5 years from grant date b. For others: 10 years from the grant date	a. Exercise price is not less than 85% FMV on exercise date: 5 years b. Exercise price cannot be determined as per subparagraph (A) of Section 423: 27 months
Non-transferability	ISOs should not be transferrable unless by will or laws of descent and distribution.
Employment requirement	A stock option will be treated as an ISO only if the receiver was an employee from the grant date to at least three months before the exercise date or 12 months before the exercise date in case of disability.	A stock option will be treated as an ISO only if the receiver was an employee from the grant date to at least three months before the exercise date.
Fair market value (FMV) measurement	Grant date
Exercise limits	If ISOs exercisable in a year exceed $100,000 (FMV at grant date), the excess is treated as NSOs.	If ISOs exercisable in a year exceed $25,000 (FMV at grant date), the excess is treated as NSOs.

Eqvista – Valuations that unlock compliance!

If you do not comply with the requirements of Section 409A, your employees may face immediate taxation of vested income, penalty tax, and higher interest rates on unpaid taxes. To avoid this, you can structure your stock options such that they are exempt from the requirements of Section 409A.

For NSOs, achieving this exemption requires you to adhere to rules regarding pricing, non-deferral, grantor, and stock-related requirements.

ISOs can also be structured to meet the exemption requirements.

However, whether you are issuing regular ISOs or ISOs as part of employee stock purchase plans (ESPPs), you must comply with requirements relating to FMV measurement, transferability, exercise limits, employment, expiry, exercise price, eligibility, rights, and plan approval that are specified in Section 422 and Section 423 of the IRC.

If you want to ensure that your employees are not subject to 409A penalties, you can also get a 409A valuation from an independent appraiser such as Eqvista and qualify for safe harbor provisions. Contact us to know more!