Section 409A: Impact on LLC Incentive Compensation?

Section 409A of the Internal Revenue Code (IRC) deals with certain deferred compensations. Most businesses know that they need to get a valuation if they want to issue employee stock ownership plans (ESOPs). However, the Section also deals with non-stock deferred compensations like bonuses and performance-linked incentives.

So, even limited liability corporations (LLCs) that cannot issue shares must take note of Section 409a if they want to issue incentive compensation.

In this article, we will discuss Section 409A, how it affects LLCs taxed as corporations, some compliance challenges, some strategies for compliance, and how expert valuators can assist LLCs in being 409A compliant.

409A valuation and incentive compensation in LLC taxed as a corporation

Here we will explore 409A valuation effects on incentive compensation by LLCs taxed as corporations.

409A and how it affects LLCs taxed as corporations

Non-qualified deferred compensations such as stock options, phantom stocks, restricted stock units (RSUs), bonuses, and performance-linked incentives are taxed as per Section 409A of the IRC. When an employee gains the right to a certain compensation which will be payable at a future date, it is a form of deferred compensation. 

Until paid, employer contributions to non-qualified deferred compensations (NQDCs) are not tax-deductible, unlike qualified plans. However, there are no contribution limits or restrictions against discrimination in NQDCs.

So, NQDCs can be a powerful tool to conserve cash and motivate employees.

Although an LLC cannot issue shares and thus cannot issue ESOPs, a popular form of NQDCs, they can do something very similar by issuing membership interests. Since an LLC can issue a non-voting membership interest, offering such compensation can be even more attractive for the owners.

Additionally, as mentioned earlier, incentives like bonuses and performance-linked compensation are a type of NQDC that LLCs can issue. So, just because it cannot issue ESOPs, it does not mean that they can ignore Section 409 A’s provisions.

What are the key provisions of Section 409A that apply to LLCs taxed as corporations?

Some key provisions of Section 409A that apply to LLCs taxed as corporations are:

Requirements

If you are issuing membership interest to your employees as an LLC, you might need to get a 409A valuation. With such compensation, the tax liability of your employees depends on the value of the membership interest they gain, which depends on your company’s valuation.

Fair market value determination

The purpose of a 409A valuation is to determine the fair market value (FMV) of your business, which is the price at which someone will buy your business without any pressure and after knowing all the relevant details of your business.

Compliance with exercise price rules

Incentive compensations give employees an option to buy membership interest in the LLC they work for at an exercise price. The exercise price of the membership interest is usually at a discount to the intrinsic value, which must be calculated via a 409A valuation.

Alternative compensation methods

Alternative compensation methods like incentives are taxed as per Section 409A when they meet certain conditions like deferral of payment and difference in amounts issued to employees. You must be mindful of these conditions.

Safe harbor methods

The IRS will assume that your valuation is reasonable instead of challenging it right away if it meets the safe harbor requirements, i.e. is calculated using the following methods:

1. Illiquid startup method
2. Independent appraiser method
3. Binding formula method

They will assume that you calculated the exercise price based on the FMV. If the IRS wants to challenge the exercise price, it must prove that your valuation was unreasonable beyond any doubt, instead of you having to prove that it was reasonable. 

Exemption for retirement payments

Qualified retirement plans like 401(k) plans and pension plans are also a form of deferred compensation plans but they are exempt from Section 409A. Such retirement plans must meet the requirements of a separate IRC section and the Employee Retirement Income Security Act (ERISA).

409A compliance challenges for LLCs taxed as corporations

Some 409A compliance challenges you might encounter as an LLC taxed as a corporation are as follows:

• Lack of equity instruments– As an LLC, you cannot issue shares or related options. Instead, you must issue membership interests. If you are not familiar with any state-specific regulations regarding membership interests, it could land you in legal trouble.
• Valuation considerations – Getting a fair and unbiased valuation of your business is key to establishing the value of membership interests and any related options. This will involve selecting an appropriate methodology and analyzing your financial history, assets, liabilities, and the market price for equity in a company like yours, among other things.
• Documentation and administration – You must properly document deferred compensation plans involving membership interests. If you fail to do so, it will be difficult to prove that you followed all relevant regulations in the event of an audit. Additionally, such plans must be administered, or rather distributed, as per the requirements of Section 409A. One key requirement is that such compensation plans cannot be accelerated, i.e. you cannot distribute the membership interest ahead of schedule.

Strategies  to ensure tax compliance

Some of the strategies you can utilize to ensure compliance with incentive compensations are as follows:

• Carefully design the plan – If you want to defer some of the compensation to your employees, you must understand the provisions and requirements of Sections 409A and 401. These sections pertain to NQDCs and qualified pension, profit-sharing, and stock bonus plans, respectively. Then, you can test scenarios with varying levels of qualified and non-qualified deferred compensation. This will help you design a deferred incentive plan, or a combination of deferred incentive plans, that minimizes liability and ensures compliance.
• Timely valuations – You must note that a 409A valuation is valid for safe harbor provisions only if it is less than 12 months old and no material events have occurred since it was performed. To maintain your safe harbor status, you should get it timely .
• Utilize alternative compensation methods – Be flexible in how you design your incentive plans. You need not rely on only membership interest-related incentives. You could also offer plain monetary incentives that do not require 409A valuations. If you can afford not to defer paying out these incentives, you should consider doing so. If you offer the same incentives for all employees, see what other changes you could make to the incentive plan to qualify since qualified incentive plans can be deducted from the business’ income immediately.
• Carefully structure profits interests and capital interests – When you distribute profits interest and capital interest, you should carefully select a vesting period. Through an 83(b) election, your employees can reduce their liability by recognizing their income when the interest was granted rather than at vesting. This reduces the taxable amount since valuations are typically lower at the time of granting than at vesting.
• Robust documentation and administration – Meticulous documentation of your valuation process for issuing membership interests is key to maintaining tax compliance. As mentioned earlier, this helps you prove that it was reasonable. You must also document how the membership interest distribution plan was administered in compliance with requirements like non-acceleration of benefits.
• Engage qualified professionals – Performing a valuation can be challenging for the uninitiated due to the extensive and ever-changing regulatory requirements and the required private equity market knowledge. Instead, you can rely on a qualified professional experienced in valuing private entities such as yours. They’ll have a better chance of keeping up with changes in regulations and movements in the private equity market.
• Stay informed on regulatory changes – Understanding the tax laws is the first step in complying with them. To do so, you must keep track of any changes to the IRC. Additionally, you must keep note of changes in the interpretation of the IRC. You can do so by following all relevant Revenue Rulings.

Role of an expert valuator in compliance for LLC taxed as a corporation? 

Some ways in which expert valuators like Eqvista can assist LLCs be tax-compliant are:

Conducting 409A valuations

If an LLC wishes to offer incentives in the form of membership interests, it will need to get a valuation that is compliant with Section 409A. The easiest way to do so is to hire one of the experts to perform.

To help you issue membership interests with agility and execute your hiring plans, Eqvista delivers 409A valuations in just 3-5 working days.

Providing expertise and guidance

An expert valuator will know the current best practices for ensuring tax compliance from their experience with various businesses similar to yours. This will enable them to guide you on tax compliance.

Eqvista’s expertise is a result of building a NACVA-certified team of analysts that have served over 15,000 companies in just 6 years since inception.

Ensuring accurate and defensible valuations

By definition, an expert evaluator will have extensive knowledge of all key methodologies and regulations. This gives them a better chance of delivering accurate and defensible valuations.

The audit readiness can be further improved through thorough documentation. So, Eqvista provides detailed reports that can run up to more than 50 pages.

Maintaining credibility and objectivity

Since an external valuator has no stake in your business, they can provide an unbiased assessment of your business.

Eqvista’s 409a valuation reports are not just a means to gaining tax compliance but they can also give valuable insights about a business’s health and prospects.

Improving accounting and reporting processes

Expert valuators can compare your accounting and reporting processes to those of businesses they have already valued and make suggestions for improvement.

To make compliance even easier to achieve, Eqvista offers consultations and filing services. We also offer cap table management services.

Get affordable 409A valuations from Eqvista and ensure tax compliance!

If you are an LLC taxed as a corporation thinking of incentive compensations, you may have considered granting profits interests or capital interests. However, many LLCs mistakenly assume that they do not need to pay attention to Section 409A since they are not issuing ESOPs. On the contrary, as long as the incentives offered can be classified as NQDCs, you must comply with Section 409A.

If you are granting profits interests and capital interests, you would even need to perform a 409A valuation.

However, if valuations and tax compliance are not your strong suit, you need not worry. At Eqvista, we offer unlimited 409A for as little as $990 per year. You can also rely on us for tax planning and filing services. Get in touch with us now on this page!