The IRS recently issued two chief counsel advice memorandums (CCAs) addressing the application of Section 409A. In CCA 201518013, the IRS addressed a situation whereby an employer attempted to correct a Section 409A written document failure before the deferred compensation became vested. Through the application of Proposed Treas. Reg. Sec. 1.409A-4, a failure of a deferred compensation plan document to comply with Section 409A can be corrected, without any penalties applying to the participant, prior to the vesting of the deferred compensation.
However, for purposes of Proposed Treas. Reg. Sec. 1.409A-4, deferred compensation is treated as vested for the entire taxable year if it becomes vested on any day during that taxable year. In this situation, the Section 409A failure was corrected before the date the compensation became vested, but the compensation became vested during the same taxable year in which the correction was made. The IRS ruled that the correction did not apply and the deferred compensation plan violated Section 409A in the year it became vested. As a result, the employee was required to include the deferred compensation in income on the vesting date under Section 409A and pay regular income taxes and the additional 20% penalty.
In CCA 201521013, the IRS addressed the application of Section 409A to stock options. Stock options are exempt from Section 409A if certain conditions are met, including that the exercise price must be greater than or equal to the fair market value of the underlying stock on the grant date. Under the facts of the CCA, the taxpayer, a corporation, had stock traded through a "when, as and if issued" (commonly called a "when-issued") market for securities yet to be issued. The IRS noted that it is common practice for new issues of publicly traded stocks to be traded on a when-issued basis days prior to when the issuer actually issues and distributes the securities to holders. A when-issued trade is made between a seller and a buyer contingent on actual issuance of the securities, after which settlement of the trade is made.
The employer's stock was traded on a when-issued basis in an over-the-counter market on the date the options were granted. The IRS stated that the fact that the employer's common stock is traded on an established securities market in anticipation of, and contingent on, its actual issuance does not negate that the when-issued public trading indicates the fair market value of the stock on the trading date. To meet the requirements for a stock option ― the stock of which is readily tradable on an established securities market ― to be exempt from Section 409A, the fair market value of the stock must be determined based on a reasonable method using actual transactions in the stock. In this instance, that included an actual transaction in the when-issued, over-the-counter market.
The IRS ruled that the exercise price of the stock options was less than the fair market value of the underlying stock, which was determined by the IRS based on trading prices of the stock in the when-issued market. As a result, the stock options were subject to Section 409A and violated those rules. The IRS also addressed the calculation of the amount of income the employees were required to include in income under Section 409A on the option vesting date.
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