February 28 Deadline to Take Advantage of IRS Settlement Program for Stock Options and SARs Subject to Section 409A That Were Exercised in 2006

February 9, 2007

On February 8, the IRS Released Announcement 2007-18. Pursuant to the Announcement, employers may take advantage of a special settlement program (the "Program") to address the payment of additional taxes arising under Section 409A of the Internal Revenue Code as a result of an employee’s exercise of a "discount" stock option or stock appreciation right in 2006. An employer that chooses to participate in the Program must make an initial filing with the IRS no later than February 28, 2007.


Section 409A imposes various rules that deferred compensation must satisfy in order for employees and other service providers to avoid adverse tax treatment. Failure to comply with Section 409A results in immediate income tax for the employee or other service provider, as well as a 20% additional tax and an interest charge.

Most stock options and stock appreciation rights (collectively, "stock rights") that are issued at a "discount" (i.e., with an exercise price less than the fair market value of the underlying stock as of the date of grant) that were not vested as of December 31, 2004 are subject to Section 409A. Unless such stock rights have a "hard-wired" fixed exercise date (which is unusual), discount stock rights automatically violate Section 409A because of the grantee’s ability to choose the year in which the rights are exercised. Discount stock rights that were not vested as of December 31, 2004 generally are subject to Section 409A regardless of when granted, even if the date of grant was before the enactment of Section 409A in 2004.

The IRS has provided several transition rules to permit employers to bring discount stock rights into compliance with Section 409A. There are two basic ways to do so: raising the exercise price to the fair market value as of the date of grant or imposing a fixed exercise date. See our publication at IRSExtendsSection409ATransitionReliefThroughDecember
for more details. In general, employers have until December 31, 2007 to implement one of these fixes (except for certain discount stock rights granted to Section 16 officers; the transition period to fix those options generally expired on December 31, 2006). Also, any discount stock right exercised in 2005 did not violate Section 409A due to a special transition rule in effect for that year only (and some have argued that the "short-term deferral rule" would cover discount stock rights exercised by March 15, 2006 and thereby avoid the Section 409A penalties, but the IRS may not agree with this position).

However, if a discount stock right that was not vested as of December 31, 2004 was exercised in 2006 before the right was modified to comply with Section 409A, the additional tax and interest charge under Section 409A apply to that right. In addition, the employer generally is required to report the Section 409A violation on Box 12 of Form W-2, and the employee will have to pay the 20% additional tax and any interest charge when filing his or her 2006 Form 1040. The Section 409A violation often will be an unpleasant surprise to non-executive employees, who typically had no control over the granting of the noncompliant stock rights and no knowledge there was any special tax problem with the grant.

The Program

The Program is designed to permit employers to pay the additional tax and interest charge on behalf of the employee and avoid having to report the Section 409A violation in Box 12 of the employee’s 2006 Form W-2 (or to issue an amended Form W-2 if one has already been issued with an amount included in Box 12). The employer’s payment of the additional tax and interest charge in 2007 will be taxable compensation income to the employee in 2007, but the employer’s participation in the Program relieves employees from personal responsibility for paying those amounts with their 2006 tax returns.

The Program is limited to discount stock rights that were exercised during 2006 by employees who (i) are not Section 16 officers currently and (ii) were not Section 16 officers as of the date of grant of the discount stock right. Announcement 2007-18 provides guidance on how to calculate the 20% additional tax and the interest charge. The 20% additional tax is obtained by multiplying (i) the "spread" on the discount stock right as of the date of exercise by (ii) 20%. The interest charge applies to the "spread" as of December 31, 2005 on any discount stock rights that were vested as of that date, multiplied by 35%. The interest rate is the federal underpayment rate plus 1% and is applied from April 17, 2006 through the earlier of April 17, 2007 or the date the employer pays the IRS under the Program.

Timeline for Taking Advantage of the Program


Actions Required

By February 28, 2007

The employer must provide the IRS with notice of the employer’s intent to participate in the Program.

With 15 Days After the IRS Notice is Submitted

All employees that the employer reasonably anticipates may be affected by the Program must be provided notice.

The employer must provide an additional notice to the IRS stating the number of employees to whom the notices referred to immediately above were provided.

By June 30, 2007

Extensive information regarding the applicable facts must be submitted to the IRS along with payment of the additional taxes and interest charges.

By July 15, 2007

Affected employees must be provided notice of the additional IRS submission and a certification that the additional tax and interest charge have been paid.


The Program may be a good way for employers to avoid major employee relation problems with employees who thought they had been granted "normal" stock rights and instead are subject to the taxes under Section 409A in addition to ordinary income tax. It allows employers to satisfy option-related Section 409A penalties for 2006 on a group basis without having to deal with individual employees, so it may be especially helpful for employers that issued discount stock rights to a large number of employees. Because the employer’s payment of the Section 409A additional tax and interest charge will result in "phantom" compensation income to employees in 2007, it can be expected there will be pressure to provide gross-ups to those employees.

Employers will need to decide quickly whether to participate in the Program. An IRS submission must be filed no later than February 28, 2007, less than three weeks after the IRS announced the Program. In addition, as noted above, the Program does not apply to stock rights granted to Section 16 officers, so participation in the Program will not provide relief from the Form W-2 reporting requirement or the obligation of any such officer to pay the Section 409A penalties in connection with 2006 discount stock right exercises.  

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or
Stephen W. Fackler (650-849-5385, [email protected]),
Charles F. Feldman (212-351-3908, [email protected]),
David West (213-229-7654, [email protected]),
David I. Schiller (214-698-3205, [email protected]),
Michael J. Collins (202-887-3551, [email protected]),
Sean Feller (213-229-7579, [email protected]),
Amber Busuttil Mullen (213-229-7023, [email protected]),
Jennifer Patel (202-887-3564, [email protected]) or
Chad Mead (214-698-3134, [email protected]). 

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.

© 2007 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.