Compliance
A Discounted Option Has Two Repair Deadlines: December 31 for Insiders, a Year Later for Everyone Else
An option priced below grant-date FMV can still be fixed. IRS Notice 2008-113 resets the price and erases the 409A tax, but insiders have until December 31.
By 409.AI Team - 2026-09-21
# A Discounted Option Has Two Repair Deadlines: December 31 for Insiders, a Year Later for Everyone Else
The call usually comes in September. A new 409A lands, the common stock comes back at $3.40, and the valuation date on the report is January 1. The problem is the grants the board approved in March at $1.12, priced off a report from the previous June. Those options went out below their grant-date fair market value, and nobody noticed until the new report put a date on it.
Most founders assume that's over and done, and the conversation turns straight to who pays. It isn't over. The IRS runs a self-correction program for exactly this failure, and it lets you reset the exercise price and treat the option as clean from the day it was granted. What it doesn't do is wait. The program runs on the calendar, and for your officers and directors the calendar ends on December 31.
How a stale report produces a discounted option
An option escapes Section 409A only on conditions. Under [Treas. Reg. 1.409A-1(b)(5)(i)(A)](https://www.law.cornell.edu/cfr/text/26/1.409A-1), a nonstatutory option doesn't provide for a deferral of compensation if it's on service recipient stock, carries no additional deferral feature, and has an exercise price that "may never be less than the fair market value of the underlying stock" on the date of grant. Stock appreciation rights get the same treatment on the same conditions under (b)(5)(i)(B).
Miss the price condition and the option becomes deferred compensation from grant. That's a different animal from an option that simply went underwater later, and it's why the [trigger events that make a report stale](https://409.ai/articles/409a-valuation-frequency-how-often-should-you-get-one) matter more than the twelve-month clock most cap tables run on. A grant dated after a material event, priced off the report that preceded it, is the classic way companies end up here.
The bill falls on the employee. Under [Section 409A(a)(1)(A)](https://www.law.cornell.edu/uscode/text/26/409A), the deferred amount goes into income as it stops being subject to a substantial risk of forfeiture, which for a normal option means as it vests, not when it's exercised. Then (a)(1)(B)(i)(II) adds an additional tax of 20 percent of the included amount, and (a)(1)(B)(ii) adds interest at the underpayment rate plus 1 percentage point, running from the year the compensation was first deferred. The individual underpayment rate [stayed at 7 percent for the quarter beginning October 1, 2026](https://www.irs.gov/newsroom/interest-rates-remain-the-same-for-the-fourth-quarter-of-2026), so the premium rate is 8 percent. California adds its own tax on top, reduced from 20 percent to 5 percent by [Revenue and Taxation Code section 17508.2](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC§ionNum=17508.2) for taxable years beginning on or after January 1, 2013, which puts a California employee at 25 percent in additional tax alone.
Run it on one person. An engineer holds an option on 40,000 shares at $1.12 against a corrected grant-date FMV of $3.40, a spread of $2.28 a share. If 10,000 of those shares vest this year, roughly $22,800 goes into her 2026 income. On top of ordinary income tax she owes $4,560 in federal additional tax, another $1,140 to California, and premium interest on the underpayment. She has not sold anything, exercised anything, or received a dollar of cash.
Incentive stock options mostly avoid this, which is its own trap
Statutory options sit outside the regime. Under 1.409A-1(b)(5)(ii), incentive stock options under Section 422 and ESPP options under Section 423 don't provide for a deferral of compensation, so 409A doesn't reach them. Section 422 has its own pricing rule at [422(b)(4)](https://www.law.cornell.edu/uscode/text/26/422), requiring that "the option price is not less than the fair market value of the stock at the time such option is granted," and 422(c)(1) forgives a miss where "there was a failure in an attempt, made in good faith" to meet it.
That good-faith rule has no counterpart in 409A, and founders draw the wrong conclusion from it. An ISO that keeps its status keeps the exemption. An option that loses ISO status lands in the nonstatutory bucket carrying its discount with it, and then 409A applies in full. The routes out are ordinary: the [$100,000 limit converting the excess into an NSO](https://409.ai/articles/iso-100k-limit-409a-grant-date-fair-market-value), a grant to a consultant who was never eligible for an ISO, an exercise window that ran past the statutory period after termination. Each one turns a pricing error into a 409A problem, which is why the [ISO and NSO distinction](https://409.ai/articles/iso-vs-nso-how-stock-options-are-taxed) belongs on the grant sheet rather than in hindsight.
The fix, and what it actually buys
[Notice 2008-113](https://www.irs.gov/pub/irs-drop/n-08-113.pdf) is the operative correction program for operational failures under 409A, and section IV.D covers this one specifically. The relief is not a reduced penalty. Section IV.D.1 says that where it applies, "the stock right is treated from the date of grant as not providing for a deferral of compensation for purposes of § 409A." The failure is unwound, not settled.
Two conditions carry it, both in section IV.D.2(b). The exercise price has to be reset to an amount not less than the grant-date fair market value, and that reset has to happen before the stock right is exercised and "not later than the last day of the service provider's taxable year in which the service recipient granted the service provider the stock right."
For a calendar-year employee holding a 2026 grant, that is December 31, 2026. Not the filing deadline, not the date you found the problem. The last day of the year the option was granted.
Non-insiders get one more year
Section V of the notice extends the same repair into the following year, and section V.E is the stock rights provision. The condition tracks IV.D except on timing: the reset has to come before exercise and no later than "the last day of the service provider's taxable year immediately following the service provider's taxable year in which the service recipient granted the service provider the stock right." A 2026 grant to a calendar-year holder can be fixed through December 31, 2027.
The catch is who qualifies. Section V.A limits that relief to service providers who are not insiders at any time during the year of the failure or at any time during the following year, so a promotion into an officer role in 2027 can pull a 2026 grant back to the shorter clock. Section III.G defines an insider as a director or officer of the service recipient, or the direct or indirect beneficial owner of more than 10 percent of any class of any equity security, determined under the SEC's rules under Section 16 of the Securities Exchange Act of 1934 and applied "without regard to whether the service recipient has any class of equity securities registered." Private company status buys nothing here. Your founders, your board, your executive team and your larger holders are all on the December 31 clock, and they tend to hold the biggest grants.
Exercise closes the door share by share
The notice's own example in section IV.D.3 is worth reading closely, because it describes what happens in practice. An employee holds an option on 100 shares priced below FMV by mistake. She exercises 40 and keeps an option on 60. The 60 can still be corrected. The 40 cannot, because the price wasn't reset before that exercise. Section III.D makes the same point as a general rule: no relief is available "with respect to any exercise of a stock right that otherwise would result in a failure to comply with § 409A."
That is the argument for freezing exercises the moment you suspect a pricing gap, before you have finished counting the damage. Every exercise that clears meanwhile is permanently outside the program.
The filings are a condition of the relief, not cleanup
Section III.D conditions relief on the timely filing of the information required by section IX, so the paperwork is part of the fix. For a same-year correction, section IX.A requires the company to attach to its timely-filed original return, extensions included, for the year the failure occurred a statement titled "§ 409A Relief under § IV of Notice 2008-113." It has to name each affected service provider and their taxpayer identification number, say whether each is an insider, identify the arrangement, describe the failure and the amount and date, describe the correction and when it was completed, and assert that the failure was eligible and every requirement met.
One piece of that is easy to get backwards. For a section IV.D correction, and only for that one, the notice says the company "is not required to provide a statement to such service provider," and the obligation to flag your reliance to an examining agent is waived too. Employees receive nothing and attach nothing.
Take the same grant down the non-insider route and the burden changes. Section IX.B ties the company's statement to the year it discovered the failure, requires a statement to the affected employee no later than the Form W-2 or 1099 due date for the calendar year of discovery, and under IX.B.3 the employee has to attach a copy of that statement to their own return. Fixing an insider's option in the year of grant is quietly the lighter path, and it's the one with the earlier deadline.
What takes you out of the program
Relief under the notice reaches only failures that are "inadvertent and unintentional," per section III.D. A company that used a valuation it knew was stale is describing a decision, not an error. Section III.B withholds relief unless the company takes commercially reasonable steps to avoid a recurrence, and for repeat failures requires established practices and procedures that were already in place. Section III.C blocks the section V route where the employee's return for the year of the failure is already under examination with respect to the plan, and section III.A puts the burden of proving eligibility on the taxpayer claiming it while leaving every correction open to examination. That burden is a documentation problem, and it looks a lot like [what the IRS asks for when it examines a 409A](https://409.ai/articles/irs-audit-409a-valuation-document-request).
Worth naming what the program is not. It isn't the Employee Plans Compliance Resolution System, which handles qualified retirement plans, and it doesn't reach plan document failures, which Treasury addressed separately.
Then there's the repricing itself
Resetting a strike price is a corporate action with its own consequences. The board has to approve it, affected holders generally have to consent, and the change is a modification under ASC 718 that produces incremental expense. The mechanics match what companies work through when they [reprice underwater options after a down round](https://409.ai/articles/down-round-409a-underwater-options-repricing), with one difference that matters: here you are raising the strike, and the people affected did nothing wrong.
You also need a defensible number to reset to, which means the grant-date fair market value, not today's. If the original report was wrong rather than merely stale, that is a different diagnosis with a different remedy, and it is worth [establishing which one you have](https://409.ai/articles/dealing-with-incorrect-409a-valuations) before the board votes.
The five-minute version
Pull your 2026 grant approvals and put each grant date next to the valuation date and stated validity window of the report in force. Any grant outside its report's window is a candidate, and so is any grant made after a financing, a large secondary, or a signed term sheet, whatever the date.
If you find one: stop exercises on the affected grants, get the corrected grant-date FMV, then sort the holders into insiders and non-insiders, because that decides whether you have weeks or another full year. Board action and amended agreements have to be finished by December 31 for anyone on the insider list, and the statement goes on this year's company return, not next year's. [409.ai's 409A reports](https://409.ai/products/409a) carry the valuation date and the window on the face of the report, which is what makes this audit take five minutes instead of a week.
The deadline that costs companies the most is the one nobody calendars, because it falls due before the mistake is old enough to feel urgent.