Home

Quick Links

Legal

navigation

Case Studies

Thursday, June 18, 2020

Company Seeks Advice on Dealing With an Outdated Valuation & Avoiding Tax Penalties


At a Glance

Challenge

A company experienced a material change in the value of their business. Their outdated 409A valuation set them up for several near-term tax penalties. In particular, they had employees who wanted to exercise stock options based on the outdated valuation.


Solution

We advised the company to inform the employees that the spread value would be based on the upcoming 409A valuation, not the outdated valuation. We also advised that they increase the frequency of their valuation going forward.


Result

The company informed its employees that they could exercise their options, but based on the forthcoming valuation, and they should keep the resulting tax implications in mind. The company also increased the frequency of their valuation.


Client Challenge

There can be numerous reasons why a company might not know the fair market value of their business at any given time, such as:

  • A major disruption, such as an unexpected pandemic, significantly impacts commerce and the overall economy.
  • A company’s valuation is more than 12 months old.
  • A recent funding round or product launch occurs.

This client experienced the last bullet point — a new financing round. Anticipating an increase in the stock price, several employees who held stock options expressed a desire to exercise those options using the last 409A valuation. Due to the financing round, the company was going to experience a material change in value to the business, which meant their existing valuation wasn’t valid.


The Tax Issue

If the existing valuation was used to determine the spread on exercise, the company risked underreporting income from the exercise of the options to the IRS. This could result in a failure to report compensation, failure to withhold income and employment tax, and a loss of the deduction on compensation charges. In such situations, the company, not the employees, would be liable for the underreported taxes and penalties.


Our Solution

Because Armanino was already handling the company’s equity compensation administration, they requested assistance with their option exercise concerns. Our team informed them that using the old valuation had inherent risks for the reasons mentioned above.

We advised the company to inform the employees that the spread value would be based on the upcoming 409A valuation, not the old valuation. As the spread is taxed as compensation instead of capital gains, the employees had to decide whether to exercise before they knew the fair market value from the forthcoming valuation. We also advised the company to consider adjusting their compensation plan for all new stock option grants.


The Result

Heeding our advice, the company informed its employees that they could indeed exercise their options, but that the exercise would be based on the forthcoming valuation, and they should keep the resulting tax implications in mind. Ultimately, the company also chose to increase the frequency of their 409A valuations from annually to quarterly.

Finally, while the company cannot stop employees from exercising options, they did change their overall stock compensation plan. The adjustment noted that if and when the fair market value of the company cannot be determined based on the current valuation, optionees should wait until the new valuation is in hand before exercising their options.


COMMENTS

comments powered by Disqus