By Nadia Carey. Finalized in April 2007, Internal Revenue Code section 409A regulates the tax treatment of nonqualified deferred compensation, whether paid to executives or any employee. 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 requires the companies to withhold applicable income and employment taxes at the time of option vesting. This immediate taxation can be avoided by pricing the stock options at fair market value at the time of granting.
Why and When Valuation Matters
Stock option pricing methodology can have major tax consequences for your company and your workforce. If the IRS determines that you’ve violated IRC Section 409A and priced your options below their fair market value, your employees will be liable immediately for taxes on the value of their stock options – plus a 20% penalty. Your company will owe payroll tax on the options and, more significantly, will probably have to placate angry employees by paying their option-related taxes and penalties.
Per IRS rules, you need to perform a 409A valuation as close to the stock option grant date as possible, and you must update the valuation at least once a year. Significant events, such as a round of financing or changes in control, even if foreseeable, also require a new valuation.
In 2014, the IRS increased its scrutiny of stock option pricing and began an audit program for 409A deferred compensation plans. The tax implications of incorrect pricing can be extensive, so this increased oversight makes a strong, supportable valuation process more critical than ever for privately held high-tech and life sciences companies.
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Key Components in a 409A Valuation
Key components depend on the stage of the company and complexity of transactions and capital structure. Some of the factors considered include
- Financial performance, historical and projected
- Capital structure, including the rights and preferences of securities
- Major investors
- Business model
- Management team
- Strategic relationships with major suppliers
- Industry and market outlook
- Comparable public companies and acquisition transactions
- Probability and timing of a successful exit vs. failure
- Existence of proprietary technology, product & services
The best protection against adverse tax consequences for your company and its employees relating to employee stock option plans is to enlist the expertise of a valuation specialist familiar with IRS Section 409A to handle your stock option pricing needs. A strong and supportable process is critical for setting the exercise price and avoiding negative tax consequences.
Armanino provides an integrated set of accounting services — audit, tax, consulting and technology solutions — to a wide range of organizations operating both in the US and globally. To learn more about Armanino visit their website here.