IRS issues guidelines on Deferred Compensation Plans

On November 30, the IRS provided guidance on the reporting and withholding rules applicable to "deferred compensation plans" (DCPs) subject to tax code section 409A.  Pursuant to new IRS rules, a discounted stock option -- one with an exercise price less than the fair market value of the stock on the grant date -- is a "deferred compensation plan" and is subject to a 20% retroactive penalty tax and interest.  Employers sponsoring such a plan are now required to report as wages any income related to the DCP.  Even if the employee did not exercise the option, the IRS requires the employer to report income as if the option had been exercised on December 31.  Yes, employers are now required to report fictitious income based on transactions that did not occur.

The bad news gets worse.  The IRS treats similar arrangements as a single plan.  Thus, ALL options -- both discounted and not -- are treated as part of the same plan.  A discounted option now violates section 409A, and since each such option is considered part of the same plan as options that did not violate 409A, the income tax calculation includes ALL vested options, not just the discounted ones. 

Employers have generally responded by taking one of the following steps:

• Increasing the strike price to the fair market value on the grant date,
• Amending the option to set a fixed date on which the holder would exercise the option, and
  
• Canceling the old option and issuing a new, compliant option.

However, some of these steps may not work if discounted options were exercised during 2006.  Additional solutions and mitigation techniques may help avoid both a nasty shock to a valued employee and a burdensome reporting and withholding requirement on the employer.  Employers must immediately review their grant practices and evaluate whether they have awarded discounted options.  The IRS has given employers a December 31 deadline to address insider recipients subject to SEC rule 16(b).  For other employees, the IRS extended the deadline to December 31, 2007.