Chief Counsel Advice 201603025 Released January 15, 2016 Advice

Discounted stock option triggered section 409A income

Apply this to your situation

This page covers one taxpayer's ruling from 2016, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.

Not precedent. Under 26 U.S.C. § 6110(k)(3), this written determination may not be used or cited as precedent. It resolved one taxpayer's situation on its specific facts, and identifying details were redacted by the IRS before release. The official IRS release (linked on this page as a PDF) is the authoritative source.

About this page: The plain-English summary and ruling snapshot below were written by Ezel based on the official IRS release. The full text is the IRS's own document.

View official IRS release (PDF)

Plain-English summary

Chief Counsel rejected taxpayers' arguments against proposed adjustments for a stock option granted with an exercise price below fair market value. The stock was readily tradable on an established over-the-counter market, and transactions on a when-issued basis were actual transactions in the stock for valuation purposes. Even if the stock had not been readily tradable, Counsel concluded that the taxpayers' valuation was unreasonable because it did not account for information and arm's-length transactions available by the grant date. The discounted option deferred compensation under section 409A, and the proposed-adjustment method was consistent with treating the option's entire appreciation as deferred compensation.

Ruling snapshot

Question: Did a below-market stock option defer compensation subject to section 409A?
Outcome: Yes, the market transactions established a higher fair market value, and the alternative valuation was not reasonable
Key authorities: IRC §§ 409A and 1233; Treas. Reg. §§ 1.409A-1(b)(2), 1.409A-1(b)(5), and 1.1233-1(c)(6)

Full text (IRS public release)

        Office of Chief Counsel
        Internal Revenue Service
        memorandum
        Number: 201603025
        Release Date: 1/15/2016
        CC:TEGE:EB:EC
        POSTU-107896-14

UILC: 409A.00-00, 409A.01-00

date: September 30, 2015

  to:   R. Scott Shieldes
        Associate Area Counsel (Houston, Group 1)
        (Large Business & International)

from: John B. Richards, Senior Technician Reviewer
Executive Compensation Branch (Employee Benefits)
(Tax Exempt & Government Entities)

subject: Tax Matter
This Chief Counsel Advice responds to your request for assistance. This advice may not be used
or cited as precedent.

LEGEND

Taxpayers = ----------------------------------------------------------------------------------------------------------------

Parent = ----------------------------------------

Affiliates = ------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------

Common Stock = --------------------------------------------

Grant Date = -------------------

Valuation = -----------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------
POSTU-107896-14 2

Exercise Price = ----------------------------------------------------------

    The Office of Chief Counsel disagrees with the positions taken by Taxpayers in

their Response to the Notices of Proposed Adjustments (NOPAs), dated July 17, 2015
(Response). The NOPAs propose adjustments to Taxpayers’ income tax returns based
on compensation deferred under Taxpayers’ option to purchase Common Stock of
Parent (Option) that is required to be included in Taxpayers’ gross income under section
409A(a) of the Internal Revenue Code (Code). As described in the NOPAs, because
the Common Stock was readily tradable on an over-the-counter market on the grant
date of the Option (Grant Date), the exercise price of the Option must have been based
on actual transactions in the Common Stock reported by such established securities
market. Because the actual exercise price of the Option (Exercise Price) was less than
the fair market value of the Common Stock on the Grant Date as determined by such
actual transactions, the Option provided for the deferral of compensation from the Grant
Date. Even assuming that the Common Stock was not readily tradable on the
established securities market, the valuation of the Common Stock used by Taxpayers to
establish the Exercise Price (Valuation) was not reasonable. See CCA 201521013
(12/18/2014) for discussion of these issues. This memorandum replies to specific
arguments of Taxpayers in the Response.

 The Common Stock Was Readily Tradable On an Established Securities

Market

   For purposes of determining the fair market value of stock that is readily tradable

on an established securities market, §1.409A-1(b)(5)(iv)(A) provides that the
determination must be based on a reasonable method using actual transactions in the
stock as reported by the established securities market. In the Response, Taxpayers
assert that the Common Stock should not be treated as “readily tradable” on the Grant
Date.1 Under §1.409A-1(b)(5)(vi)(G), stock is treated as readily tradable if it is “regularly
quoted by brokers or dealers making a market in such stock.” Therefore, a stock is
readily tradable if brokers or dealers make the stock available to trade by listing it on an
established securities market. The “readily tradable” standard therefore requires only
the ability to buy and sell the stock through a third party. Therefore, the Common Stock
was readily tradable on the over-the-counter market on the Grant Date.

     ------------------------------------------------------------------------------------------------------------

1
Taxpayers’ assertion is contrary to the fact that Parent took steps necessary to establish the over-the-counter
market beginning two days before the Grant Date. ------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------- Because potentially all --------
---------- shares of Common --------------------------------------------------------------------------------- could have been sold on
the first trading date, Parent intended and understood that the Common Stock was readily tradable beginning on
the first trading date.
POSTU-107896-14 3

---------------------------------------------------------------------------------------------------------------------

     In the Response, Taxpayers also assert that contracts to purchase the Common

Stock, rather than the Common Stock itself, were purchased on the when-issued, over-
the-counter market on the Grant Date. Taxpayers argue that there were therefore no
actual transactions in the Common Stock as reported by the over-the-counter market for
purposes of determining the fair market value of the Common Stock under §1.409A-
1(b)(5)(iv)(A) on the Grant Date.2 However, the rule does not require that the Common
Stock must actually exchange hands on the trading date, but rather only that there are
“actual transactions in such stock” on the trading date. Transactions in stock generally
mean either the sale or transfer of stock. Even assuming that only contracts to
purchase the Common Stock were actually purchased on the Grant Date, the contracts
provided for the transfer of the Common Stock. The buyers were contractually
obligated to complete their when-issued purchases of the Common Stock if the -----------
--------------- occurred. The --------------- had already occurred ------------ on the Grant
Date before the over-the-counter market opened for that trading date. Moreover, the
buyers were contractually obligated to pay the auction price that applied at the time that
they purchased the Common Stock on the Grant Date regardless of the auction prices
of the Common Stock on the settlement date. Thus, there is no basis for treating the
when-issued purchases of the Common Stock as anything other than “actual
transactions in such stock” reported by the established securities market.

2
The cases cited by Taxpayers do not support Taxpayers’ position. The Stavisky court assumed that contracts to
purchase stock when issued reflect the fair market value of the stock on the date the contract is entered into: “In
the case at bar the performance of the original contract—that is, the purchase of the shares—at the price fixed—
remained what it had been.” Stavisky v. Comm’r, 291 F.2d 48, 49 (2d Cir. 1961). Furthermore, the Stavisky holding
applied to a transaction that occurred before the enactment of section 1233. Section 1233(e)(2)(A) treats stock
traded on a when-issued basis the same as the stock. Under Example 6 of §1.1233–1(c)(6), the price contracted to
sell stock when issued applies for purposes of determining the applicable gain or loss when the stock is actually
issued.
POSTU-107896-14 4

     Because the Common Stock was readily tradable on an established securities

market on the Grant Date, §1.409A-1(b)(5)(iv)(A) applies to determine the fair market
value of the Common Stock on the Grant Date. The closing auction price per share of
Common Stock on the over-the-counter market on the Grant Date was ----------------------
--------- more than the Exercise Price. Under §1.409A-1(b)(5)(iv)(A), the Exercise Price
was therefore less than the fair market value per share of the Common Stock on the
Grant Date.

  Even Assuming that the Common Stock Was Not Readily Tradable, the

Valuation Used By Taxpayers Was Not Reasonable

    If stock is not readily tradable on an established securities market, §1.409A-

1(b)(5)(iv)(B) provides that the determination of the fair market value of the stock must
be based on the reasonable application of a reasonable valuation method. Whether a
valuation method is reasonable,3 or whether an application of a valuation method is
reasonable, is based on the facts and circumstances as of the valuation date. A
valuation method is not reasonably applied if it is not revised to take into account
information that becomes available after the valuation is calculated that may materially
affect the value of the corporation. Because recent arm’s length transactions involving
the sale or transfer of the stock must be considered under a reasonable valuation
method, such transactions must also be taken into account after a valuation is
calculated. This principle is further reflected under §1.409A-1(b)(5)(iv)(B)(3), which
provides that a reasonable method using actual transactions in the stock as reported by
the established securities market must be used once a stock becomes readily tradable
on an established securities market. These rules reflect that the fair market value of
stock is most accurately determined on the basis of contemporaneous arm’s length
transactions in the stock.4 Thus, contrary to Taxpayers’ interpretation of §1.409A-
1(b)(5)(iv)(B)(3), the exercise price is properly established as of the grant date of an

3
Under §1.409A-1(b)(5)(iv)(B), the factors to be considered for determining whether a valuation method is
reasonable include the value of tangible and intangible assets of the corporation; the present value of anticipated
future cash flows of the corporation; the market value of stock or equity interests in similar corporations and other
entities engaged in trades or businesses substantially similar to the corporation, the value of which may be readily
determined through nondiscretionary, objective means (such as through trading prices on an established securities
market or an amount paid in an arm’s length transaction); recent arm’s length transactions involving the sale or
transfer of such stock or equity interests; and other relevant factors.
4
This principle reflects the basic common law definition for the determination of fair market value, as stated, for
example, under §1.170A-1(c)(2) and §20.2031-1(b) and in Rev. Rul. 59-60, 1959-1 CB 237: “The fair market value is
the price at which the property would change hands between a willing buyer and a willing seller, neither being
under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Rev. Rul. 59-60
also provides that “the prices of stocks which are traded in volume in a free and active market by informed persons
best reflect the consensus of the investing public as to what the future holds for the corporations and industries
represented.”
POSTU-107896-14 5

option only if it takes into account all information that may materially affect the value of
the corporation as of the grant date.

     ------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

   The Methodology for Calculating the Proposed Adjustments is Consistent

with the Requirements of Section 409A

   In the Response, Taxpayers assert that the methodology for calculating the

proposed adjustments based on the proposed regulations is not entitled to deference.
However, Taxpayers do not suggest an alternative method for determining the amount
includible in gross income under section 409A for an option that is treated as a
nonqualified deferred compensation plan. The methodology under the proposed
regulations is consistent with the final regulations. Section 1.409A-1(b)(2) provides that
the entire appreciation in value of the stock underlying an option that is subject to
section 409A is treated as compensation deferred under the option.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.
POSTU-107896-14 6

Please call (202) 317-4572 if you have any further questions.

                             By: _____________________________
                                 John B. Richards
                                 Senior Technician Reviewer
                                 Executive Compensation Branch (Employee
                                 Benefits)
                                 Tax Exempt and Government Entities

cc: Deborah H. Delgado
Jeremy H. Fetter

Get today's answer for your situation

You just read what the IRS ruled for one taxpayer in 2016, and it can't be cited as precedent. Ezel checks the current Internal Revenue Code and IRS guidance and answers your specific situation, with citations.

Opens in Ezel Pro. Every answer cites the authority it relies on.

Apply this to your situation

This page covers one taxpayer's ruling from 2016, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.

On this page

Document type

Chief Counsel Advice

IRS subject

Nonqualified Deferred Compensation; Additional Income and Taxes Generated from the Backdating or Discounting of Exercised Stock Options

Topics

Retirement plans, IRAs, and annuities

Code sections

§ 409A, § 1233

Ruling dated

September 30, 2015

Publicly released

January 15, 2016

View Official PDF