409(a) Valuation For Businesses

Issuing options? Equity Compensation? 
Learn about 409(a) business valuation requirements. 

409a Valuation Considerations

A 409a valuation or 409(a) is an important part of tax planning and employee compensation planning for any company thinking of issuing options or other equity based compensation.

409(a) Explained

409(a) refers to the IRS Revenue Code section 409(a). Often referred to as a “non-qualified plan,” this section provides for certain taxes that are payable based upon the issuance of employee stock options or stock appreciation rights (SARs).

If the instrument has an exercise price less than the Fair Market Value (FMV) of the underlying stock as of the grant date could result in adverse tax consequences for the option recipient. The gain is subject to taxation at the time of option vesting rather than the date of exercise, with potentially devastating penalties and interest charges.

The consequences for noncompliance, which affect the individual who holds the options and not the issuing company, are significant.

Valuation for 409(a)

These issues can be mitigated by issuing options with an exercise price at FMV, and section 409A provides clear approaches on how to develop compliant policies. These safe harbors shift the burden of proof of noncompliance to the IRS. That simply means that if a company employs a safe harbor method to value the price of its stock options, the IRS must show that the company was grossly unreasonable in calculating the FMV.

If Section 409A applies to stock option grants because of the failure to meet the fair market value rule, there are adverse tax consequences for the option recipient (“grantee”) and tax withholding responsibilities for the granting entity (“company”). The grantee is taxed when the option vests rather than on the date of exercise, and there is an additional 20% tax as well as a potential increased interest charge. By using a qualified third party valuation, the company can shift the burden onto the IRS to prove that the option exercise price was not set at or above fair market value, or that the presumptive valuation method used was not reasonable. In all other cases, the company has the burden of proving that its stock valuation method was reasonable and complied with the regulations.

Tax Consequences. Failure to comply with 409(a) valuation requirements can have serious consequences. If you’ve already issued options or SAR’s without a valuation… contact us now.

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