Section 409A

Section 409A regulates the timing of income and payment under nonqualified deferred compensation arrangements. Stock options granted at a strike below the fair market value on the grant date are treated as deferred compensation under 409A. Violations cause the option spread to be taxed as ordinary income at vest rather than exercise, plus a 20% federal penalty, plus interest. California imposes an additional 5% penalty.

Example: an employee receives 25,000 options with a $4 strike while the FMV on the grant date was $10, based on a later IRS audit. Each year’s vested tranche triggers ordinary income on the built-in spread, a 20% penalty, and interest, even without exercise. The cumulative tax and penalty can exceed 60% of the option value.

Common mistake: accepting a strike below the 409A FMV in exchange for fewer shares at a higher strike. The tax outcome is catastrophic. The safe approach is always to set the strike at or above the most recent 409A.

Section 409A matters at grant (setting strike and vesting), at repricing (new 409A required), at deferred bonus design, and at severance payments that might qualify as deferred comp.