Court Delivers Harsh Ruling to Taxpayer in 409A Case
In proceedings before the Court of Federal Claims, the IRS won a significant victory over a taxpayer who appealed penalties and interest levied against him by the IRS for having received undervalued stock options. In the ruling, the IRS persuaded the court to make a number of judgments upholding its position that certain stock options constitute deferred compensation and are subject to IRC 409 penalties and interest.
It appears the next step in the litigation will be a trial. Whether the IRS will prevail depends on a finding that the options were not issued at fair market value (FMV), i.e., they were priced at a discount to FMV. If the IRS succeeds and California assesses it’s corresponding penalties and interest then much of the gain will be absorbed by the penalties and interest from both the IRS and CA Franchise Tax Board!
Taxpayer lost Round 2 against the IRS
The essence of the taxpayer’s case (Sutardja v. United States PDF) involves a claim for refund of taxes and 409A penalties and interest paid by Dr. Sehat Sutardja and his wife relating to an option granted to him in 2004 and partially exercised in 2006. In Round One, the IRS was not impressed by the taxpayer’s arguments and assessed penalties and interest against him for deferred income subject to IRC 409A. In Round Two, the Court of Federal Claims upheld the IRS’ defense of motions brought by the taxpayer.
Dr. Sutardja is the CEO and one of the founders of Marvell, a $3.4 billion publicly traded semiconductor company with USA headquarters in Silicon Valley. The amount in dispute exceeds $5 million and is calculated from the time of vesting, not exercise, as specified in the Code.
In the ruling issued on February 27, 2013, Judge Thomas C. Wheeler dismissed Dr. Sutardja’s claims that the option grant is not:
- a taxable event, or
- deferred compensation, or
- his legal property prior to exercise, or
- it qualifies under the short term deferral exception
409A: a cautionary tale for companies with option plans
A number of interested followers have commented on the outcome of these rulings, including Morgan Lewis and Winston & Strawn. While none is surprised that the IRS has found a 409A case to pursue, there is some surprise that it has decided to do so given the facts.
Although this case deals specifically with circumstances involving a publicly traded company, the findings of the court will have broad implications for all companies issuing incentive stock options to their employees and management.
There are very consequential outcomes if the IRS prevails at trial not only for Dr. Sutardja relating to any penalties and interest due the IRS but also those that California may assess (their statute also requires a 20% penalty and interest on income subject to 409A). Perhaps not so lingering is the matter of what recourse Dr. Sutardja may seek from Marvel and the Board.
The critical message to this action by the Tax Court? Many companies offer deferred compensation packages such as stock option plans and all would be advised to make sure they are in compliance with 409A provisions: produce no less than an annual independent fair market valuation of the common stock and do so with a proven and credible provider whose valuation will stand up to IRS scrutiny.
John Heath is Executive Vice President, Valuations & Financial Advisory Services of The Brenner Group. John joined The Brenner Group® in 1994 and manages the firm’s Valuations and Financial Advisory Services Groups. John has more than thirty-five years of experience in corporate finance, and has assisted more than 600 companies with financing, public underwritings, mergers, acquisitions, and valuations. Prior to joining The Brenner Group, John held executive management positions at Smith Barney, The First National Bank of Chicago, and Price Waterhouse. He received an MBA in Finance from The Wharton School of Business, and a BA degree from the University of Pennsylvania. John is an Accredited Senior Appraiser and a member of the Appraisal Issues Task Force.
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