IRC 409A establishes a tax system through which “equity compensation” and other forms of deferral can potentially create significant issues. Specifically, if a plan does not comply with Section 409A’s requirements (e.g., it is administered mistakenly), the affected service providers may be subject to immediate taxation upon inclusion, plus an additional 20% tax and a premium that will be calculated based on the interest rate.

The most significant areas of “risk” associated with the 409A compliance regime for start-up companies are equity awards (stock options/SARs and related timing/term changes (e.g., extensions, repricing’s, dividend-equivalent features)) in conjunction with a lack of adherence to fair market value and valuation standards (i.e. compliant valuation). A practical compliance check-list when addressing the 409A risk is to: (i) always set the exercise price of any option/SAR at or above the fair market value of the underlying stock on the date of grant; (ii) always use a safe-harbor valuation method and perform at least an annual update, or after a material event; (iii) always maintain rigorous corporate governance practices and timely documentation; and (iv) promptly utilize correction procedures as set forth in the IRS guidance when something goes awry (i.e., detrimental events occur with respect to service providers).

What Creates 409A Exposure in Early-Stage Companies

IRC 409A governs “nonqualified deferred compensation plans” which are any type of arrangement (unless excluded) that provides for compensation to be paid in a subsequent year.

There are two patterns found in start-ups that result in 409A compliance issues:

Formerly, the definition of and rules governing “discounted” equity interests is clearly set out in Treasury Regulations. In this regard, a no statutory stock option is this defined and treated as deferred compensation unless it satisfies four specific tests including the requirement that “[t]he exercise price may not [emphasis added] be less than the fair market value” as of the grant date and total option shares are determinable on the grant date.

The same rules apply with respect to stock appreciation rights (SARs).

Second, “ordinary” (wages or salary) earned within a certain time frame can inadvertently be transformed into deferred compensation due to Section 409A’s short-term deferral exclusion. There are provisions within Section 409A that establish how deferred compensation bonuses are treated. The regulations provide that bonuses paid after a 2½ month period are considered deferred. When a bonus is deferred in this manner, Section 409A regulations would apply. Also, a bonus that is paid earlier than the 2½ month period is an impermissible acceleration.

The 409A Penalty Landscape

If a nonqualified deferred compensation plan does not comply with Section 409A or was not operated in accordance with the rules, all deferred compensation earned in the year and in prior years would be included in gross income to the extent there is no substantial risk of forfeiture and have not been included in income within the Code.

If there is a trigger for inclusion, the Code also imposes an additional penalty of interest on the amount included in income (at the underpayment rate plus 1%) as well as an additional 20% penalty on the amount included in gross income.

From a reportability/payroll perspective, the IRS audit technique guide provides that amounts that should be included in income due to violations of Section 409A must be reported separately on Forms W-2 (Box 12, Code “Z”) and 1099 (if applicable), and are subject to the additional 20% penalty and imputed interest a type of “premium interest tax” whenever it exists.

Valuation Discipline: Safe Harbors and Refresh Triggers

For private companies, the principal question will be common stock’s FMV on the date granted. The Treasury regulations provide that when stock is not readily tradable, the FMV shall be determined based on the reasonable use of a reasonable valuation method that takes into account such things as: tangible and/or intangible assets; discounted cash flows; comparable companies; an arm’s-length transaction, marketability discounts; whether the valuation was used elsewhere and with a material economic impact.

According to the same rules, an adjustment for a previous valuation is not reasonable if it overlooks new material information (e.g. resolution of a major lawsuit, patent issuance) or the valuation date is more than 12 months prior to the date of use.

A “presumption of reasonableness” is established by the regulations (a powerful safe harbor for taxpayers): it can be rebutted only by the IRS showing that the method or its application was grossly unreasonable.

Specific safe-harbor paths include:

1. Independent appraisal of the subject property within 12 months before the relevant transaction (e.g., option grant) and
2. a formula-based valuation that meets certain parameters.
3. A written valuation of the illiquid common shares of a startup corporation, prepared by a person that the taxpayer reasonably considers qualified (with “significant experience” generally being defined as having at least five years of experience in valuation/appraisal, finance, investment banking, etc.). This startup method is not available for a valuation if a change of control is expected to occur within the 90 days or an IPO is expected to occur within 180 days after the valuation is utilized.

Common 409A Pitfalls in Equity Compensation (and How to Mitigate Them)

The “classic” pitfall is to grant options/SARs with a strike price below the FMV. The regulations will treat such a discount stock right as deferred payment; therefore, they will not constitute short-term deferrals even What is involved in fixing process errors? Use of the IRS Safe Harbor rules will assist to ensure that the exercise date of an award is well documented and has Board approval. Once this is done, it is essential to provide clarity regarding the Fair Market Value (FMV) determination regarding the FMV of the Company as well as ensuring that there is a Grant Calendar established and used by the Company.

Inappropriately using an “innovative payment” or “payment feature” in relation to an option can lead to a mistake if that option is granted with an incorrect strike price and/or an incorrect dividend equivalent.

The IRS will consider the total value of the strike price and the fair market value of shares at the time of the extension/making modification to the option in determining if a new stock option has been created.

Tips: If you plan to reprice or extend an option prior to granting it, you should conduct a tax review prior to moving forward.

If you have a tax issue with respect to your stock options, there are several ways to achieve compliance; however, you will need to act quickly to document the issue and correct the issue as soon as possible.

Correcting 409A Failures: IRS Relief Programs

The IRS has issued Notice 2010-2006 outlining formalized correction procedures for certain taxpayers who have failed to properly correct an operational failure under IRC 409A. Notice 2010-2006 states that taxpayers may voluntarily correct third-party documentation errors to mitigate the taxpayer’s income recognition and/or additional tax based upon failure to provide third-party documentation for tax years 2010 and 2011.

Notice 2008-2013 provides for methods of correcting operational failures and methods for making a retroactive operations correction, as well as providing a limited number of (relatively low) cost methods of correcting operational failures to mitigate the attributing taxable income for the next tax year.

Although there are multiple methods provided by the IRS for correcting operational failures under IRC 409A, the most important takeaway for startups is to identify operational failures before they occur, preserve the documentary record and promptly correct all operational failures.

FAQ

How does the 409A independent tax penalty affect me?
In essence, 409A imposes a tax liability on employees for any unrecognized amount at the time an employee exercises their NSO if they have previously received an award involving a 409A operational failure; additionally, 409A imposes a second tax penalty of 20% plus 39% (interest plus additional underpayment tax) on the employee’s tax liability at the time the employee has to pay taxes.

Do all stock options qualify for IRC 409A?
Stock options that qualify as a No statutory Stock Option (NSO) are not deferred compensation if the strike price is greater than or equal to the fair market value of the underlying stock at the time the award is granted along with any other 409A requirements.

How often do I need to re-value my company’s 409A valuation will be needed?
The IRS states that an asset will be considered excessively valued if it has existed for more than 12 months and/or if there have been any material events that will impact the value of the asset, therefore a valuation should be updated at least once per year and also at any time there has been an event that would materially impact the value of the asset.

Is there any safe harbor from liability for purposes of 409A valuations?
The IRS has established safe harbors for purposes of presuming value for assets under IRC 409A. Examples of these safe harbors include a properly prepared and obtained independent appraisal, performed within 12 months of the date of valuation.