The Internal Revenue Service issued Announcement 2007-18, which implements a compliance resolution program for employers whose employees exercised stock options or stock appreciation rights during 2006 that did not comply with the requirements of Section 409A of the Internal Revenue Code of 1986. The program is available for the exercise of stock options with exercise prices less than the fair market value of the stock on the date of grant and stock appreciation rights that provided for compensation in excess of the increase in fair market value of the stock between the date of grant and the date of exercise. The program allows the employer to report and pay the additional 20% income tax and interest charge under Section 409A due from employees, other than certain Section 16(a) reporting persons, that result from employee exercises of these discount stock rights during 2006. The deadline for filing a notice of intent to participate in the program is February 28, 2007. In addition to announcing the terms of the compliance resolution program, the Announcement contains information regarding the views of the Internal Revenue Service on correction of discount stock rights.

Background

Section 409A of the Internal Revenue Code of 1986, as enacted by the American Jobs Creation Act of 2004, applies to nonqualified deferred compensation that is earned and vested after December 31, 2004, or earned and vested prior to such date under an arrangement that is materially modified after October 3, 2004. Stock options and stock appreciation rights issued by an employer to its employees with exercise prices equal to or greater than the fair market value of the underlying stock on the date of grant are generally not covered by Section 409A. However, stock options granted with exercise prices less than the fair market value of the underlying stock on the date of grant and stock appreciation rights that permit a holder to receive an amount that exceeds the increase in the fair market value of the underlying stock between the date of grant and the date of exercise are treated as providing nonqualified deferred compensation, which is subject to the payment rules of Section 409A. Prior IRS guidance has dealt with correcting these discount stock rights to avoid coverage by Section 409A. Pursuant to IRS Notice 2006-79, on or before December 31, 2007, a stock right may be amended to comply with Section 409A or replaced with a stock award that is not discounted to avoid the application of Section 409A to the stock right. However, the deadline for amending or replacing discount stock rights held by persons who were subject to the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 on the date of grant with respect to a company whose financial statements are to be restated due to option backdating issues was December 31, 2006.

409A Consequence of Exercise of Discount Stock Right

Employees and their advisors have considered whether stock options that were issued with exercise prices less than fair market value and that were exercised prior to being corrected may be retroactively corrected. No opportunity for retroactive correction of an exercised stock award is contemplated by the Announcement. The IRS’s position regarding discount stock rights that are exercised before being corrected as set out in Announcement 2007-18 and prior IRS guidance is as follows:

  • Discount stock rights exercised in 2005 resulted in no adverse consequences under Section 409A. This is because under Notice 2005-1 a deferred compensation arrangement could have been terminated during 2005 without adverse consequences.
  • Discount stock rights exercised in 2006 are subject to adverse tax consequences under Section 409A in 2006 if the term of the stock right extended beyond 2006.
  • Discount stock rights held by persons who were Section 16(a) reporting persons on the date of grant, that were not corrected by December 31, 2006, and with respect to which a restatement of financial statements is required are, whether or not exercised, subject to adverse tax consequences under Section 409A in 2006 or, if later, the year in which a substantial risk of forfeiture ceases to exist with respect to such stock right.
  • Discount stock rights held by persons who were not Section 16(a) reporting persons on the date of grant and that are not corrected by December 31, 2007, are, whether or not exercised, subject to adverse tax consequences under Section 409A in 2007 or, if later, the year in which a substantial risk of forfeiture ceases to exist.

Compliance Resolution Program

The compliance resolution program is intended to allow an employer with discount stock rights that were exercised by employees during 2006 to pay the additional 20% income tax and interest charges due under Section 409A as a result of the exercise of the discount stock right. The program applies only to employees or former employees who are not (and were not on the date of grant) subject to Section 16(a). Employers intending to participate must provide notice to the IRS of intent to participant by February 28, 2007, and must pay the amount of the additional tax liability by June 30, 2007. The amount of the tax paid must be based upon a reasonable, good faith interpretation of the applicable guidance. The program details include several additional notices to both the affected employees and the IRS. The tax payments by the employer on behalf of its employees are treated as additional taxable compensation to the employees during 2007.

For amounts covered by the compliance program, the program relieves employers of the obligation discussed in our Client Alert of December 21, 2006, to report the amount of income subject to tax under Section 409A in box 12 of Form W-2 under code "Z". Otherwise, the program does not relieve an employer of its general income reporting and withholding obligations with respect to the exercise of the discount stock right during 2006. In addition, the program provides no relief for the additional income and employment taxes that may be due as a result of discounted options failing to qualify as incentive stock options or for the loss of any Federal income tax deduction by the employer under Section 162(m) of the Internal Revenue Code, as discussed in our Client Alert of October 5, 2006. The full terms of the compliance resolution program are included in Announcement 2007-18.

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