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Wednesday, October 6, 2010

Avoid Noncompliance Penalty; What You Need to Know About IRC Section 409A


In Short…

Internal Revenue Code Section (IRC) Internal Revenue Code Section (IRC) 409A sets more stringent guidelines for private companies when issuing stock options and other forms of non-qualified deferred compensation.

Section 409A regulates the tax treatment of the “nonqualified deferred compensation,” whether paid to executives or any other employees. Under Section 409A, a stock option that is granted with an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement.

Reality Check: Are You in Compliance?

If the fair market value of the common stock is higher than the strike price for the common stock options, then companies are required to withhold applicable income and employment taxes at the time of option vesting.

Generally, the typical, historical fair market value determinations made by private company boards of directors are not permissible under Section 409A. Specifically, to comply with the regulations, the valuation of a private company’s stock must be:

  • evidenced by a written report which takes into account the relevant valuation factors; and
  • performed by a person or persons with significant knowledge and experience or training in performing such valuations.

Due to these and other requirements that make it hard for companies to be in compliance with 409A if they do the valuation internally, the determination of fair market value most likely will need to be made by an independent business valuation expert. Any company that has completed a preferred stock financing with a venture capital firm typically will get a 409A valuation report from an independent appraisal firm. The management and board members of many companies think of an independent valuation as insurance.

IRS Serious About Enforcement

The head of 409A valuation review group at the IRS gave a speech in late 2008 that indicated that the Service was in the process of hiring and training 140 valuation professionals specifically to review valuations prepared for 409A purposes. Our interpretation of the speech is that the IRS is about to launch a program targeting companies that are potentially abusing the provisions of Section 409A. As we have told more than one client, challenging a stock option valuation is extremely easy from the Service’s perspective. All that needs to be done is to review those company’s valuations prepared a few years before a major liquidity event occurs. In short, if a company is acquired for tens of millions of dollars and receives press coverage, all an auditor would have to do is inquire about previous valuations prepared for the company. Since a significant number of technology companies issue stock options when they are privately held and a significant number of technology companies are based in the Bay Area, the chance of some successful high-tech start-up becoming an IRS “example” is rather high.

Noncompliance Means…

Noncompliance with IRC 409A can lead to:

  • acceleration of taxable income for the employee/contractor
  • additional 20% penalty tax, payable by the employee/contractor
  • potential interest charge, payable by the employee/contractor
  • company withholding tax issues
  • potential state taxes
  • potential exposure for board members
  • negative impact on employee morale and potential employee turnover
  • potential impact on the marketability of a business to investors and/or acquirers

All amounts deferred under the plan for the current year and all previous years become immediately taxable (at the time of option vesting), plus a 20% penalty federal tax on the optionee (employee or contractor), to the extent the compensation is not subject to a “substantial risk of forfeiture” and has not previously been included in gross income. Most stock option grants meet both of these criteria. Note: These taxes are payable in the year the option vests, even if the employee has not exercised the options.

Example: An employee receives 50,000 stock options at a strike price of $0.10 per share. The options are all vested at the date of grant. This gives the employee the right to purchase 50,000 shares of stock at a price of $0.10 each for the length of the options (often 10 years). However, the fair market value of the common stock at the date of the stock option grant was actually $1.10 per share. Under IR Code Section 409A, the employee is deemed to have received regular income of $50,000 in the year the options were granted. This is because the value of the common stock was $1.00 greater than the strike price of the option, and 50,000 options were granted. Assuming the employee’s marginal tax rate was 28%, they would owe an additional $14,000 in taxes, plus a 20% tax penalty. If 1,000,000 options were granted in total at the time of this stock option grant, then the recipients of the options would owe taxes on $1,000,000 of ordinary income, plus a 20% tax penalty. The vesting of the stock options is the event that triggers this tax. The company could be years away from a potential liquidity event, with none of its employees having exercised the stock options, and this tax would still be due in the year the stock options vest.

How Can We Help?

Armanino has a dedicated Valuation Services team with over 15 years of experience with start-up to mature companies including equity valuations for both private and public companies. When it comes to valuation services, experience matters. Armanino’s valuations team has completed over 1,500 valuations in its history and has a track record of delivering industry leading expertise and value to clients. No one in our marketplace can compare to our depth of resources, quality and turnaround times, and fee structure.

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