IRC SECTION 409A

Houlihan is assisting companies with becoming compliant with IRC Section 409A ("Section 409A"). The American Jobs Creation Act added Section 409A and significantly changed the rules for nonqualified deferred compensation plans. The new rules became effective on September 29, 2005 and apply to any deferrals after December 31, 2004. Under Section 409A, any stock option having an exercise price less than the fair market value of the underlying stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and tax withholding responsibility for the granting company. These adverse tax consequences include taxation at the time of option vesting rather than the date of exercise (or later), a 20% additional tax on the optionee in addition to regular income and employment taxes and a potential interest charge. The granting company is required to withhold applicable income and employment taxes at the time of option vesting and possibly additional amounts as the underlying stock value increases over time.

Stock Valuation and Option Pricing Alternatives

As described in detail below, the proposed regulations under Section 409A provide guidance on valuation for purposes of setting option exercise prices. Companies may respond to the proposed regulations in any of the following ways:

• Status Quo-A company may choose to retain its existing option pricing practice. If the company's option exercise prices equal or exceed the fair market value of the underlying stock, Section 409A generally will not apply to such options. This is true whether or not the company applies any of the rules or factors set forth in the proposed regulations. If the company's option exercise prices are later found to be below fair market value (for example, on audit by the IRS), then the burden will be on the company to prove that its stock valuation method was reasonable by reference to the standards and rules found in the proposed regulations. If the company's current valuation practice makes no reference to the factors and methods set forth in the proposed regulations (or if it uses no valuation method at all), it will fail to satisfy this burden and the adverse consequences of Section 409A will apply.
• Informal Valuations Using Specified Factors-A company may choose to perform its own internal stock valuation based on specified factors set forth in the proposed regulations. If the company's option exercise prices are later found to be below fair market value, then the burden will be on the company to prove that its stock valuation method was reasonable. However, the company improves (but does not guarantee) its chances of satisfying this burden if it employs the factors specified in the regulations.
• Adopt One of the New "Presumptive" Methods-A company may choose to adopt one of the "presumptive" stock valuation methods set forth in the proposed regulations, thereby putting the burden on the IRS to prove that both (i) the company's stock option prices are below fair market value, and (ii) the company's application of the presumptive method was "grossly unreasonable." These presumptive methods involve either a written valuation by an independent appraiser or other person with knowledge and experience in stock valuation or a binding formula.

Current Status of Section 409A

On December 23, 2005, the IRS issued Notice 2006-4 in an apparent attempt to assuage concerns of private companies regarding their compliance with the recent option pricing guidance under Section 409A of the Internal Revenue Code.

Under notice 2006-4, taxpayers with stock options and stock appreciation rights (collectively "stock rights") granted before January 1, 2005 may consider such rights to satisfy the Section 409A fair market value pricing requirement if there was a "good-faith attempt" to set the exercise price at not less than the stock's fair market value on the date of grant. Additionally, for stock rights granted on or after January 1, 2005 and until Final Treasury Regulations under Section 409A become effective (anticipated to be January 1, 2007), taxpayers may use any reasonable valuation method or may use the guidance provided in the Proposed Treasury Regulations under Section 409A of the Internal Revenue Code (the "Proposed 409A Regulations") to determine whether the exercise price of the right is at or above fair market value on the grant date.

Please contact us at 312-499-5900 to discuss your situation and to learn more about Section 409A and the valuation process.