A 2004 law turned option pricing into a compliance duty

The record

Section 885 of the American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code on 22 October 2004, according to the statute's own text as compiled by Cornell's Legal Information Institute. The provision does not regulate how a company prices an option; it sets a tax timing rule for 'nonqualified deferred compensation,' a category reaching beyond pension arrangements into stock rights, severance and bonus plans. If a plan fails the statute's distribution-timing requirements or is not operated as written, Section 409A requires that all compensation deferred under it, for the current year and every earlier year, be included in gross income as soon as it is no longer subject to a substantial risk of forfeiture, whether or not the money has been paid. The statute adds interest at the underpayment rate plus one point and a further 20 percent additional tax on the included amount. The IRS's first interpretive guidance, Notice 2005-1, issued once Treasury began implementing the new section, describes it as reaching 'all amounts deferred under a nonqualified deferred compensation plan' and notes that other tax doctrines, including constructive receipt, keep applying independently.

What the documents establish

The statute sets the distribution triggers a plan must use: separation from service, death, disability, a fixed date set at the time of deferral, a change in ownership or control, or an unforeseeable emergency. An option granted at fair market value with no further deferral feature generally falls outside this regime, which is why option pricing became a compliance question: granting below fair market value creates a deferral subject to Section 409A's timing rules and its income-inclusion penalty. Notice 2005-1 was later described, in the same Internal Revenue Bulletin series that carried the final regulations effective in 2007, as 'obsoleted in part': early interpretive guidance, not the current operative text, to be checked against the final regulations instead.

The operating read

For a founder, an option's exercise price is not only a cap-table decision; it determines whether Section 409A applies at all. Editorially, a founder reading a deferred compensation plan, an offer letter, or a severance agreement should treat the income-inclusion-plus-penalty structure as the baseline consequence of a drafting error, not a remote risk. The penalty falls on the individual who holds the compensation, not only the company, which is why the questions below matter to an employee as much as the business.

What to check before you decide

Before treating an equity or deferred-pay arrangement as compliant, confirm the following against the plan's own documents, not this summary.

• Does the arrangement grant the option at fair market value on the grant date, or does it otherwise defer compensation to a later year?
• Does the plan specify a permitted distribution trigger from the statute's list, fixed at the time of deferral rather than chosen later?
• Has the plan been operated exactly as written, since the statute penalizes operational failures as well as drafting failures?

None of this is tax advice; a plan raising any of these questions should go to counsel who can read the plan language against the current final regulations.