Executive Compensation-Court Of Federal Claims Confirms That IRC Sec. 409A Applies To The Exercise Of A Discounted Stock Option

In Sutardja v. United States, No. 11-724T (Court of Federal Claims 2013), the Internal Revenue Service (the “IRS”) had determined that the exercise by Dr. Sehat Sutardja (” Dr. Sutardja”) of nonqualified stock options granted by his company, Marvell Technology Group Limited, was subject to an additional tax and interest under IRC section 409A. Section 409A provides for a 20 percent surtax plus interest on amounts received under a nonqualified deferred compensation plan, if certain conditions exist. The IRS sought to apply the additional tax and interest on the grounds that stock option arrangement did not comply with section 409A.

In analyzing the case, the Court noted that, at the date of grant, the stock options did not have a readily ascertainable market value. As such, the stock options were not taxable at grant or upon vesting. Further, if the option exercise price was set at or above fair market value at the time of the grant, section 409A taxation would be inappropriate even upon exercise. But does section 409A apply to discounted stock options when exercised (the “discount” being an exercise price set below the fair market value on date of grant)? The Court concluded that the answer is yes, since:

–a nonqualified stock option constitutes deferred compensation, which is subject to section 409A (the FICA rules for defining deferred compensation do not apply);

–the taxpayer obtained a legally binding right (under applicable state law, here California) to the compensation at the time the stock options vested, thus creating the right to deferred compensation; and

— the “short term deferral exception” to section 409A does not apply-at least not here- as nothing required the taxpayer to exercise the stock options within 2 and ½ months after the year of vesting.

The Court ordered a trial on the issue of whther the stock options had in fact been discounted.