The IRS has recently issued additional guidance in the form of Notice 2006-4 (available at  http://www.irs.gov/pub/irs-drop/n-06-04.pdf) granting interim relief from the stock option valuation requirements included in the proposed regulations issued under Section 409A of the Internal Revenue Code ("Code").  As discussed in more detail below, Notice 2006-4 applies the good faith valuation regulatory provisions that have historically been available for improperly-valued incentive stock options ("ISOs") to both ISOs and non-statutory stock options ("NSOs") issued prior to January 1, 2005.  The relief offered by the Notice will remain available until the proposed Section 409A regulations are finalized.[fn1]

Background

Section 409A, as adopted by the American Jobs Creation Act of 2004, broadly regulates "non-qualified deferred compensation arrangements."  In addition to regulating traditional non-qualified deferred compensation plans for executives, Code Section 409A encompasses a variety of less-obvious vehicles that can have the effect of deferring compensation from one taxable year to another, including discounted NSOs and ISOs that are inadvertently granted at less than fair market value.  To address the valuation issues inherent in stock options and other forms of equity compensation granted by non-public companies, the proposed Section 409A regulations issued by the IRS in October 2005 (available at http://www.irs.ustreas.gov/pub/irs-regs/15808004.pdf) generally require that the stock underlying equity awards be valued using a "reasonable valuation method."  In the proposed regulations, the IRS identifies a variety of factors that it will use to judge the reasonableness of a proposed valuation method and describes three "safe harbor" valuation methods that are generally deemed to be reasonable.

Because of the number of practical difficulties in designing stock options that comply with Section 409A, and because noncompliance triggers a 20% excise tax and interest penalties on the grantee, many companies have now begun to reassess the accuracy of the valuations relating to their past equity awards, particularly those that are not "grandfathered" under Section 409A (i.e., fully vested on or before December 31, 2004).  This reassessment process has generated significant concerns from the employer community about the reliability and reasonableness of valuations that pre-date the adoption of Section 409A.  Notice 2006-4 is intended to address these concerns.

Valuing Pre-January 1, 2005 Equity Awards

The Code requires that ISOs be granted at (or above) fair market value, determined as of the date of grant; a failure to properly value ISOs can cause the loss of ISO status and its accompanying tax benefits.  However, both the Code and the ISO regulations provide some leeway for inaccurate valuations that are performed in good faith.  Notice 2006-4 expressly adopts this approach and applies it to NSOs and stock appreciation rights ("SARs") granted prior to January 1, 2005.  Under this approach, where a company made a good faith attempt to set a fair market value exercise price for an option or a SAR granted before January 1, 2005, the option or SAR will be deemed to have been granted at fair market value for purposes of Section 409A.  An option or SAR that meets this standard will not be subject to Section 409A, assuming the other 409A requirements applied to options and SARs are satisfied.

Valuing Post-January 1, 2005 Equity Awards

For options and SARs granted on or after January 1, 2005, the Notice indicates that the general valuation requirements included in Notice 2005-1 will remain effective: Notice 2005-1 specifies that fair market value can be determined using any "reasonable valuation method."  As an alternative for SARs, the valuation method described in the proposed regulations will also be available, and for purposes of applying this method, the "any reasonable method" standard will be applicable.

As Notice 2006-4 suggests, companies should be prepared to demonstrate that the valuation method they used for grants on and after January 1, 2005 was reasonable under the relevant facts and circumstances.  If the valuation method is reasonable, the resulting valuation will be deemed to satisfy Notice 2005-1, and the options or SARs at issue will not be subject to Section 409A.

Reliance on Notice 2006-4

Notice 2006-4 indicates that the relief it offers will be available until final regulatory guidance is issued under Section 409A.  The IRS expects that the proposed Section 409A regulations will be finalized in 2006 and will be effective as of January 1, 2007.

1:  As proposed, the Section 409A regulations (available at http://www.irs.ustreas.gov/pub/irs-regs/15808004.pdf) will effective for taxable years beginning on or after January 1, 2007.