In Chief Counsel Advice 201603025 the IRS Chief Counsel’s office addressed whether a nonqualified stock option plan in question ran afoul of the provisions of IRC §409A and therefore required an inclusion in income on the date of grant.  The question turned on the proper valuation of the options in question, including whether the stock in question was readily tradable on an established securities market.

If stock is readily tradable on an established securities market, Reg. §1.409A-1(b)(5)(iv)(A) provides the following in part:

For purposes of paragraph (b)(5)(i) of this section, in the case of service recipient stock that is readily tradable on an established securities market, the fair market value of the stock may be determined based upon the last sale before or the first sale after the grant, the closing price on the trading day before or the trading day of the grant, the arithmetic mean of the high and low prices on the trading day before or the trading day of the grant, or any other reasonable method using actual transactions in such stock as reported by such market.

Per Reg. §1.409A-1(b)(5)(i)(A) a nonstatutory option is excluded from the definition of deferred compensation if all of the following conditions are met:

(A) Nonstatutory stock options not providing for the deferral of compensation.

An option to purchase service recipient stock does not provide for a deferral of compensation if --

(1) The exercise price may never be less than the fair market value of the underlying stock (disregarding lapse restrictions as defined in § 1.83-3(i)) on the date the option is granted and the number of shares subject to the option is fixed on the original date of grant of the option;

(2) The transfer or exercise of the option is subject to taxation under section 83 and § 1.83-7; and

(3) The option does not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of the following:

(i) The exercise or disposition of the option under § 1.83-7.

(ii) The time the stock acquired pursuant to the exercise of the option first becomes substantially vested (as defined in § 1.83-3(b))

If the option does not met these requirements, then the program must meet all of the requirements imposed generally on nonqualified deferred compensation arrangements under IRC §409A or the value must be includable in income immediately by the recipient.

In this case there were contracts to purchase the underlying stock, and not the stock itself, could be purchased on the when-issued, over-the-counter market on the date the options were granted.  The option price was less than the price for such contracts to purchase on the grant date.  The IRS argued that with the price of the options set at a lower amount than the price for a contract to purchase, these options could not be excluded from the definition of a nonqualified deferred compensation arrangement.

The taxpayer disagreed.  As the memo noted the taxpayer argued that since the actual stock was not currently being traded, it was not “readily tradable” stock and the price of those contracts did not fix the fair value of the stock.  No actual shares of stock were traded at that time on a market.

However the National Office did not agree with assertion.  The memo holds:

…[T]he rule does not require that the Common Stock must actually exchange hands on the trading date, but rather only that there are "actual transactions in such stock" on the trading date. Transactions in stock generally mean either the sale or transfer of stock. Even assuming that only contracts to purchase the Common Stock were actually purchased on the Grant Date, the contracts provided for the transfer of the Common Stock. The buyers were contractually obligated to complete their when-issued purchases of the Common Stock if the * * * occurred. The * * * had already occurred * * * on the Grant Date before the over-the-counter market opened for that trading date. Moreover, the buyers were contractually obligated to pay the auction price that applied at the time that they purchased the Common Stock on the Grant Date regardless of the auction prices of the Common Stock on the settlement date. Thus, there is no basis for treating the when-issued purchases of the Common Stock as anything other than "actual transactions in such stock" reported by the established securities market.

Because the Common Stock was readily tradable on an established securities market on the Grant Date, § 1.409A-1(b)(5)(iv)(A) applies to determine the fair market value of the Common Stock on the Grant Date. The closing auction price per share of Common Stock on the over-the-counter market on the Grant Date was * * * more than the Exercise Price. Under § 1.409A-1(b)(5)(iv)(A), the Exercise Price was therefore less than the fair market value per share of the Common Stock on the Grant Date.

The memo then goes on to note that even if the shares weren’t “readily tradable on an established securities market” the valuation simply wasn’t reasonable and, thus, there was an inherent discount which provided value to the employee.  That is, the price at which the contracts were being sold had to be taken into consideration in determining the value of the stock at the date of grant. 

The memorandum notes:

If stock is not readily tradable on an established securities market, § 1.409A-1(b)(5)(iv)(B) provides that the determination of the fair market value of the stock must be based on the reasonable application of a reasonable valuation method. Whether a valuation method is reasonable,3 or whether an application of a valuation method is reasonable, is based on the facts and circumstances as of the valuation date. A valuation method is not reasonably applied if it is not revised to take into account information that becomes available after the valuation is calculated that may materially affect the value of the corporation. Because recent arm's length transactions involving the sale or transfer of the stock must be considered under a reasonable valuation method, such transactions must also be taken into account after a valuation is calculated. This principle is further reflected under § 1.409A-1(b)(5)(iv)(B)(3), which provides that a reasonable method using actual transactions in the stock as reported by the established securities market must be used once a stock becomes readily tradable on an established securities market. These rules reflect that the fair market value of stock is most accurately determined on the basis of contemporaneous arm's length transactions in the stock. Thus, contrary to Taxpayers' interpretation of § 1.409A-1(b)(5)(iv)(B)(3), the exercise price is properly established as of the grant date of an option only if it takes into account all information that may materially affect the value of the corporation as of the grant date.

In a footnote the memorandum goes on to explain

This principle reflects the basic common law definition for the determination of fair market value, as stated, for example, under § 1.170A-1(c)(2) and § 20.2031-1(b) and in Rev. Rul. 59-60, 1959-1 CB 237: "The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." Rev. Rul. 59-60 also provides that "the prices of stocks which are traded in volume in a free and active market by informed persons best reflect the consensus of the investing public as to what the future holds for the corporations and industries represented."

The memorandum is a bit short on details, but presumably the employer had brought in someone to perform a business valuation and was attempting to rely upon that even though buyers were being lined up to be the shares at issue.  Very likely if there had not been the sales of contracts to purchase that would have been “good enough” unless the valuation had major clear flaws. 

But valuation does not operate in a vacuum and certainly it seems reasonable that regardless of the formulas and methods used, the best evidence of value would generally be what the market in general is willing to pay to get hands on the shares.  Certainly at the very least the valuation would need to explain why that value was not appropriate.