Section 409A of the Internal Revenue Code (IRC) applies when an employee earns compensation in one year, but the employer actually pays the compensation in a future year. Section 409A requirements apply when compensation is considered paid under a “nonqualified deferred compensation plan,” in contrast to “qualified” plans such as a 401(k), where income is deferred from taxation under different rules.
When invoking section 409A to defer compensation from taxation, the Internal Revenue Service (IRS) requires that the deferred compensation be valued at its fair market value. Failure to follow the valuation requirements of Section 409A will result in adverse tax consequences to the employee, including a 20% penalty on the actual fair market value of the deferred compensation.
An Example: Stock Options
Section 409A and the valuation requirement are best understood by working through an example. Let’s say that management of a company wants to incentivize the company’s key personnel to bring out their best work. Management decides to offer the employees not only a salary but also stock options. Management can do this whether the company is a startup or an established business. The procedure is the same.
Section 409A Requirements for Valuation
For the company to grant stock options to its employees and defer taxation of them to later years, when the employees exercise the stock options, the company must comply with Section 409A. The section requires that the company value, or appraise, the fair market value of the stock of the company. Of course, this is more difficult to do with a startup, but the company must do it nonetheless.
Appraisals of a variety of assets take into account three approaches and contrast them to produce the most accurate appraisal. Section 409A requirements include the same approaches. They are the market approach (what would someone pay for the stock?), the income approach (how much income will the stock produce?) and the asset approach (what is the value of the company’s assets?).
A company can perform an appraisal itself, but if the IRS challenges a company’s self-prepared valuation, the company has the burden of proving that its valuation is correct. If the company hires an outside firm to perform the valuation and the IRS challenges it, then the burden is on the IRS to prove that the valuation is incorrect. The outside-firm valuation offers a “safe harbor” for valuations.
When Must the Company Value its Stock?
There are two specific times that the company must value its stock to meet Section 409A requirements. For startups, the company must value the stock every time it closes a new round of funding. Even without the new round of funding, the company must perform a 409A valuation every twelve months because the valuation is good only for the current tax year. There are tools available to help startup companies prepare the 409A valuation. Carta, for instance, is a SaaS platform that helps companies manage their cap tables and offers them the ability to perform 409A valuations with greater frequency than a company hired an outside valuation firm.
Valuations performed by outside service providers typically start at $1,500 for a SEED stage company and increase from there, with a VC-backed Series C or Series D company often paying in the range of $5,000 to $10,000 for the valuation by an outside firm.
Noncompliance with Section 409A Requirements
If there is no Section 409A valuation, or if the IRS audits the employee and finds the valuation to be too low, then the employee can suffer substantial tax problems. To return to the stock option example, the IRS will consider the value of the option to be part of the employee’s gross income in the year the company granted it to the employee, rather than in the future. This might well push the employee into a higher tax bracket. Further, there will be an underpayment penalty and interest on unpaid taxes. Finally, and perhaps worst, the IRS will impose a 20% penalty on the value of the stock options to the extent that they were undervalued. Given how much is at stake, companies should seriously consider obtaining professional assistance to meet Section 409A requirements,
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