On February 8, 2007, the IRS announced a new compliance resolution program (the "Program") that will allow employers to pay, on behalf of affected employees, any Section 409A penalties arising from the exercise of discounted stock options or discounted stock appreciation rights ("SARs") during 2006. Employers who participate in the Program will be relieved of their obligation to report the Section 409A inclusion amounts in Box 12 of the 2006 Form W2 using Code Z, and affected employees will be relieved of the obligation to pay the Section 409A penalties.

Discounted stock options and SARs granted after 2004 (or which vest after 2004) generally cannot satisfy the Section 409A requirements without significant modifications. Employees who exercised such discounted rights during 2006 will incur Section 409A penalties, unless the employer participates in the Program. Companies that intentionally or inadvertently granted back-dated stock options or SARs, and private companies that used a valuation formula which does not comply with Section 409A, may have granted stock options or SARs at a discount and may be candidates for the Program.

Participation in the new Program requires prompt action. An employer must —

  • Notify the IRS by February 28, 2007 of its intent to participate (the "first IRS notice").
  • Notify affected employees within 15 days thereafter.
  • Notify the IRS within 15 days following the first IRS notice of the number of affected employees (the "second IRS notice").
  • Remit payment to the IRS by June 30, 2007 of all Section 409A penalties arising from discounted stock options and SARs exercised in 2006 with supporting information.
  • Notify affected employees by July 15, 2007 that the Section 409A penalties have or have not been paid under the Program
  • Issue amended Forms W-2c to affected employees in cases where the employer has already issued Forms W2 which reflect the Section 409A inclusion amounts in Box 12 under Code Z.

Section 16 Insiders Not Eligible. An employer may participate in the new Program on behalf of any employee who exercised a discounted stock option or SAR during 2006 in violation of Section 409A, except for employees who are subject to the disclosure requirements of Section 16(a) of the Securities Exchange Act of 1934 as of the grant date of the discounted stock right, or as of the date of the first IRS notice.

Program Does Not Otherwise Affect Income Tax and Reporting Requirements. Employees must include in income, and the employer must report on Form W-2, the income recognized in 2006 as a result of the exercise of the discounted stock option or SAR. State and local income taxes also may apply. The Program only provides relief for the Section 409A penalties.

Employer's Payment of Section 409A Penalties is Additional Compensation to the Employee. The employer's payment of the Section 409A penalties on behalf of an affected employee must be treated as additional compensation income to the employee in 2007. Such compensation income is subject to all applicable income taxes, as well as FICA and FUTA. Regular withholding and tax reporting requirements apply to the additional compensation income.

The exercise in 2006 of discounted stock options or SARs which were granted (or which vested) after 2004 can lead to significant Section 409A penalties for individual employees — 20% of the amount included in income, plus a relatively modest interest penalty. Employers can ease the burden of tax penalties for their employees by taking advantage of the Program, but they must ACT FAST. Keep in mind that discounted stock options and SARs that have not yet been exercised can still be modified by December 31, 2007 to avoid Section 409A and that all stockbased compensation (such as restricted stock units ("RSUs") and phantom stock) must be reviewed for Section 409A compliance. Contact any member of our Employee Benefits and Executive Compensation Group for further information on the new Program, as well as guidance on how to calculate the Section 409A penalties.

Copyright © 2007 by Ballard Spahr Andrews & Ingersoll, LLP. This newsletter is a periodic publication of Ballard Spahr Andrews & Ingersoll, LLP and is intended to alert the recipients to new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and specific legal questions you have.