Sutardja vs. United States illustrates the importance of complying with Section 409A of the Internal Revenue Code when granting stock options. The decision also shows the willingness of the IRS to pursue significant penalties against holders of stock options that allegedly fail to comply with Section 409A.
Section 409A of the Internal Revenue Code imposes rules for nonqualified deferred compensation. The IRS considers stock options to be deferred compensation subject to Section 409A if the fair market value of the stock at grant exceeds the option exercise price. In other words, if an option is granted "in the money," the option must meet the myriad requirements of Section 409A. Failure to comply with Section 409A can result in immediate taxation, a 20% excise tax and significant interest payments.
Dr. Sehat Sutardja and his wife Weili Dai were co-founders and officers of Marvell Technology Group. Dr. Sehat and Ms. Dai were granted stock options covering 1.5 million shares of common stock at $36.50 per share. The couple later exercised the options and reported $4,849,791 in federal income tax.
The IRS subsequently determined that the options violated Section 409A and the couple owed additional taxes in excess of $3 million. The government argued that the stock options were granted with an exercise price that was less than the current fair market value and therefore were subject to the requirements of Section 409A. Dr. Sutardja made a number of counterarguments.
In the first reported case of its nature, the court in Sutardja agreed with the government's position that discounted stock options are nonqualified deferred compensation subject to the requirements of Section 409A. The case was then set for trial on the factual issue of the actual fair market value of the stock on the date of grant.
This case is a real-world example of the dangers inherent in stock option grants, especially for private companies without an easily ascertainable stock value. Companies should take steps to ensure that each option's exercise price is based on the fair market value on the date of grant. Clearly the IRS is prepared to pursue substantial penalties against employees for options that the IRS believes do not comply with the technical requirements of Section 409A.
For further information visit Waller's ERISA Exchange blog
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