The U.S. Court of Federal Claims has ruled in Sutardja v. United States (Fed. Cl., No. 11-724T) that stock options granted to an employee were deferred compensation subject to Section 409A, pending a ruling on the fair market value of the underlying stock on the grant date. The court did not come to a complete resolution regarding whether the stock options were subject to Section 409A, because a determination had not yet been made regarding whether the stock options were discounted (i.e., issued with an exercise price less than the fair market value of the underlying stock on the grant date).
The grant of nonqualified stock options that was the center of the case was approved by the compensation committee of Marvell Technology Group Limited on Dec. 26, 2003. But the grant wasn’t ratified until Jan. 16, 2004. The exercise price of the options was set at the trading price of Marvell’s stock on Dec. 26, 2003. In January 2006, Sutardja exercised a portion of the stock options and recognized compensation income equal to the spread of the option. After the exercise of the options, an internal committee of Marvell determined that the grant date of the options was Jan. 16, 2004, at which time the trading price of the company’s stock had increased from the price on Dec. 26, 2003.
Section 409A places strict requirements on nonqualified deferred compensation, which generally includes discounted stock options. If these requirements are not met, the intrinsic value of the discounted stock options can be included in the employee’s income at the time of vesting, even if the options are not exercised, and the income is subject to an additional 20% income tax.
Sutardja argued that if the stock options were in fact discounted, they were not subject to Section 409A for various reasons. First, based on Supreme Court rulings in Comm’r v. LoBue, (351 U.S. 243, 247) and Comm’r v. Smith (324 U.S. 177, 181), stock options are not taxable until they are exercised. Thus, Sutardja argued that Section 409A could not require him to recognize income prior to the exercise of the options, and, therefore, there was no deferred compensation. The court rejected this argument because the Supreme Court’s rulings were based on options that were not discounted.
Second, Sutardja argued that because these options were granted and exercised before the final Section 409A regulations became effective, the definition of deferred compensation should be determined under Treas. Reg. Sec. 31.3121(v)(2)-1(b)(3) and (4), which defines deferred compensation for purposes of FICA taxes. Under these regulations, deferred compensation does not include stock options. The court rejected this argument for two reasons. First, the FICA regulations specifically state that stock options are not deferred compensation for FICA tax purposes only, and the FICA regulations cannot be applied to Section 409A. Second, the court gave deference to Notice 2005-1, which specifically stated that discounted stock options were deferred compensation. This position did not change in the proposed or final Section 409A regulations.
Third, Sutardja argued that he did not have a legally binding right to the compensation until the stock options were exercised, and thus, there was no deferred compensation. For purposes of Section 409A, a plan or arrangement provides for deferred compensation when the employee has a legally binding right to compensation in one taxable year that will or may be paid in a future taxable year. The court concentrated on the definition of a stock option under California law, which provides that an option is a “unilateral contract which binds the optionor to perform an underlying agreement upon the optionee’s performance of a condition precedent.” The court concluded that the “condition precedent” was Sutardja’s meeting the vesting conditions attached to the options, so Sutardja had a legally binding right to the compensation as soon as the options became vested.
The court’s position that Sutardja had a legally binding right when the options became vested is interesting because the Section 409A regulations provide that an employee does not fail to have a legally binding right merely because the compensation is subject to a vesting condition. Thus, under the Section 409A final regulations, an employee may have a legally binding right before the compensation becomes vested. The court’s position seems to conflict with the final Section 409A regulations. The final regulations were issued after the taxable years during which the options were granted and exercised, so those regulations were not considered in the court’s ruling.
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