Some employers offer their employees deferred compensation in the form of stock options. These private call options give owners the right, but not the obligation, to buy shares of company stock on or before an expiration date at an exercise price established on the date the options were issued. If the options do not carry certain tax benefits, they are deemed “non-qualified stock options” (NQO) and may be subject to Internal Revenue Service Section 409A.
IRS Section 409A
IRS Section 409A became law in 2005 in the wake of deferred compensation practices at Enron Corporation. Section 409A regulates the definition of deferred compensation, the penalties for noncompliance with the regulation, deferral and distribution rules and reporting requirements. All stock options subject to the rule are non-qualified, which means they do not qualify for long-term capital gains taxation on profits. A deferral plan’s failure to comply with 409A can result in penalties that include: taxation of vested amounts; a 20 percent excise tax; and late payment interest.
Stock Options as Deferred Compensation
Section 409A defines a stock option as a form of deferred compensation if service is provided and subject to payment in one year (the service year) but is not paid until a future year. Stock options are issued in the year when service is performed and exercised in subsequent years. The rule excludes options granted as part of qualified plans such as IRAs, 401(k)s, disability plans, and other tax-deferred plans. Other exclusions include severance pay and options deferred for only a short time — up to two and a half months.
A distribution in this context is the exchange of non-qualified stock options for the receipt of shares or the equivalent cash amount. Distributions are allowed at only certain events according to Rule 409A. These events include disability, death, separation from service, an unforeseen emergency, new controlling management at the company and/or at an agreed schedule. Non-qualified distributions are taxed at regular income tax rates, not capital gains rates. Section 409A adds an extra half-year distribution waiting period to separating “key” employees – generally defined as the top 50 earners having annual pay above $150,000 each.
Initially, deferral elections must be made before the start of the service year. The usual timing for new employees is a 30 day period to negotiate initial elections. These decisions, made by both employer and employee, refer to the amount, form and timing of the deferred compensation. Once established, the rule does not permit an accelerated schedule of payments unless the change is made a year before the scheduled payment and the modification postpones the payment for at least an additional five years.Click here for reuse options!
Copyright 2017 Eric Bank, Freelance Writer