Tax Facts

3619 / When will a nonqualified stock option constitute deferred compensation that is subject to the IRC Section 409A rules?

NQSOs that are exercisable at less than their fair market value at the date of grant,1 or where there are additional deferral features in the NQSO, will be subject to the rules governing deferred compensation plans under IRC Section 409A ( Q 3541). Where the exercise price can never be less than the fair market value of the underlying stock at the date of grant, and where there is no other feature for the deferral of compensation, a stock option will not constitute deferred compensation subject to IRC Section 409A, which is the desired design objective.2 Plans generally could substitute non-discounted stock options and stock appreciation rights for discounted options and rights until December 31, 2007.3


Under a pre-409A ruling, stock options could be “converted” to a deferred compensation plan free of tax under limited circumstances. Where employees could choose to retain or surrender both ISOs and NQSOs in exchange for an initial deferral amount under a nonqualified deferred compensation plan, the IRS indicated that neither the opportunity to surrender the options, nor their actual surrender, would create taxable income for participants under either the constructive receipt or economic benefit doctrines.4 For a discussion of the theories of constructive receipt and economic benefit, see Q 3542.





1.   See Sutardja v. U.S., No. 11-724T (Ct. Cl. Feb. 27, 2013). To emphasize the IRS’s hard position on the FMV requirement, Sutardja involved a transition case of a grant made before enactment of Section 409A but the IRS successfully applied IRS Notice 2005-1, which was the first guidance on new Section 409A.

2.   Treas. Reg. § 1.409A-1(b)(5). Also see CCM 132502-09 (Jun. 6, 2009), released July 17, 2009 for additional guidance on proper NQSOs release steps for both IRC Sections 162(m) and 409A.

3.   Notice 2006-79, 2006-43 IRB 763.

4.   Let. Rul. 199901006.


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