Section 409A May be Delayed Ad Infinitum

November 13th, 2006

The IRS and Treasury Department last month announced that they had not yet completed final regulations for the implementation of Section 409A of the Internal Revenue Code.

To me this sounds like a bureaucratic way of saying “Congress, aren’t there enough stock option issues going on right now, and why did you saddle us with this law anyway?”

This is somewhat remarkable, to me at least, though at the same time I think it is a wise move to avoid adding even more fuel to the fire under stock options right now. I read somewhere that over 150 public companies have announced that they are auditing their past option procedures for backdating problems. Clearly many companies have reason to be concerned that the way they approved options and set prices would not stand up to outside scrutiny.

Section 409A seems well-intentioned, but unnecessarily punitive at the same time. It imposes a 20% penalty on options granted below market, and the penalty accrues not to the company but to the employee/option recipient.

Companies and their managers have suffered (sometimes deservedly) as a result of backdating issues, but under 409A many rank-and-file employees will take hits due to no fault of their own. There are certainly some senior managers who have the ability to control option pricing and should know better. Most grantees have no control over pricing, though, and assume that their employer will treat them fairly by granting options that won’t incur big tax penalties.

On the other hand, delaying implementation of the regs could make the problem worse in the end. At present, companies that move forward in good faith compliance with 409A as it is currently understood will not be penalized. This is well and good for public companies whose stock value can be readily determined on any given date. For private companies it is a completely different matter. Valuation experts do a great job with the information they have, but since no one knows exactly what the IRS is looking for (including the IRS, it seems), their work still falls into the realm of “best guess”. To date, I have not spoken with anyone able to confidently assess the value of private company shares.

In a memorable quote, stock options have been described as “the most magical wealth-creation machine the world has ever seen”. It would be disastrous throw a wrench into the machine by attaching big penalties to potentially an entire crop of early-stage options. I applaud the IRS and Treasury for taking time implementing the regs. At the same time, I hope that the procedures they ultimately put into place take proper notice of the fog in which private companies have operated over the past couple of years.

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