United States: Section 409A and Private Company Stock Options

On December 23, 2005, the IRS issued Notice 2006-4 which provides interim guidance with respect to the application of the new rules for non-qualified deferred compensation under Section 409A to stock options granted by private companies. Under Section 409A, there are adverse tax consequences for optionees holding options that have exercise prices below fair market value and that become exercisable after December 31, 2004. The guidance provides transitional relief for private company stock options and the determination of fair market value and is welcome news to private companies.

With respect to stock options granted before January 1, 2005, until further guidance is issued, where there was a good faith attempt to set the exercise price at fair market at the time of grant, such options will be treated as being excluded from the requirements of Section 409A. This relief applies to both incentive and non-qualified stock options that do not otherwise provide a deferral feature. Whether there was a good faith attempt to set the option price at fair market value depends on the relevant facts and circumstances. In light of this transitional relief, companies that satisfy this good faith standard do not have to be concerned about the application of Section 409A to pre-2005 option grants unless those options were intentionally granted at a discount or provide a deferral feature.

With respect to stock options granted on or after January 1, 2005 and before the effective date of final regulations (expected to be January 1, 2007), taxpayers may use any reasonable valuation method to determine fair market value. Therefore, private companies now have more flexibility to determine fair market value, and until the issuance of final regulations, do not necessarily have to follow the proposed regulations which require a consistent application of a reasonable method that takes into consideration all relevant facts and circumstances. Nevertheless we urge private companies to be scrupulous and careful in the determination of the fair market value of their stock in connection with option grants.

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