Section 409A was added to the Internal Revenue Code, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. Section 409A regulates the tax treatment of “nonqualified deferred compensation” paid by a corporate entity (“service recipient”) to all “service providers,” which includes executives, general employees, some independent contractors and board members. The effects of Section 409A are far reaching, because of the exceptionally broad definition of “deferral of compensation.” Section 409A was enacted, in part, in response to the practice of Enron executives accelerating the payments under their deferred compensation plans in order to access the money before the company went bankrupt.
What does this mean to you? Under Section 409A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The tax consequences include taxation at the time of option vesting rather than the date of exercise or sale of the common stock, a 20% additional federal tax on the optionee in addition to regular income and employment taxes, potential state taxes (such as the California 20% tax) and a potential interest charge. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time.