409a Valuation For Employees

If you are reading this, you might already have a brief idea of what a 409A valuation report is. While this report informs management of the current valuation of the company, the true impact of this report lies in the ability of the company to offer the employees shares and stock options. That is why a 409a valuation for employees is crucial for companies who share equity with their staff.

409a Valuation for Employees

Before a company can give out options to its employees, it needs to get a 409A valuation of the company done. But before we can talk about the 409a valuation for employees, let us understand what the 409A valuation is all about.

Understanding 409a valuation

A 409A valuation or the fair market value, is the valuation of a private company’s common shares. This valuation is done for tax purposes for employees. Basically, when an employee pays taxes on equity compensation, the amount owed to the IRS would be determined based on the 409A valuation report. The 409A valuation is re-evaluated every year, in addition to any significant company events, such as the issuance of shares or a new investment round.

Normally speaking, as the company grows, the value increases. The appraiser is the one that determines the value by using some of the different approaches available. They might analyze the company’s tangible and intangible assets as the basis of the valuation, analyze the company’s free cash flow, or compare private and public companies of the same type to get the value of the private company in question.

To understand 409A valuations, it is important to understand how private companies offer their employees stock options and how the 409A valuation report influences it. Let us take an example to understand this better.

Let’s say there is a Company named XYZ Pvt Ltd. This company hires a new employee and offers them the option to purchase 2,000 stock options at the current fair market value (FMV). So, let us assume that the options are worth $2 at this time, which is also known as the strike price.

Now, the company tells the employee that they can “exercise” the options that the employee gets after four years of working at the company. This time period and restriction is known as the vesting period. Each company can have different vesting periods that range from 3 to 5 years. Some companies can have other clauses as well, such as reaching a milestone before the shares can be exercised.

The four years pass and the shares are worth $20 per share now. The employee has the option to buy the 2,000 shares at $2 per share. In short, the employee will be paying $4,000 for the shares which are worth 10 times this amount. Once the employee exercises the stock, they can then sell it at $20 per share. This would allow the person to make a huge profit.

Now, the 409A valuation for employees is important in this case so that the company knows the price of the option that is being offered to the employees. This is a requirement as per the IRS, as they do not want the company to just give any value to the options in the company. Although the employees would benefit from buying the shares of the company at a low price, in case your company values itself too low, the company would be accused of offering cheap options as a way to hide their income.

This would also affect the employees as they too would have to pay some penalties along with the company to the IRS. So, it is always a better option to hire an outside firm to do the appraisal. With this, they would be able to determine the FMV by analyzing the financial statements of the company. The evaluator might also analyze the assets, cash flow, or both of these for the company. Using the various methods available, they would be able to determine the most accurate 409A valuation for employees of the company.

Why is 409a valuation important for employees?

The 409A valuation for employees is important as it impacts the employees in the following two ways:

• It helps the company get the strike price of the options given to employees. And the company then sets the strike price as the current 409A valuation amount, as they cannot issue the options at a lower strike price.
• It affects the tax bill of the employee. When the employee exercises their options, they are taxed on the difference between the strike price and the current 409A. For instance, let us assume that you are an employee in a company and are granted options with a strike price of $2 where the 409A is also $2. If you instantly exercise the options (that if the company allows you to exercise early), you would not have to pay the taxes as the difference between the strike price and the current 409A would be $0. On the other hand, if you exercise the options after the 409A reaches $4 at some point in the future, then you will have to pay tax over the $2 difference per option that you exercise.

Fair Market Value and Employee Taxes

Stock options are benefits that allow the employees to purchase the stock of the employer at a discount to the stock’s market price. The market price of the stock is the FMV (fair market value) of the stock. And the FMV is the price at which the property would sell in the market. Basically, it is the price that would be agreed on between the willing seller and the willing buyer, with both having a reasonable knowledge of the relevant facts.

The options given to the employees don’t convey an ownership interest. But once the employee exercises the options to acquire stock, they then hold the ownership interest. The stock options come in two categories:

• Statutory stock options – They are granted under an employee stock option purchase plan or an incentive stock option (ISO) plan.
• Nonstatutory stock options – These are also known as non-qualified stock options that are granted without any kind of plan.

The grant of the ISO or other statutory stock option does not produce any immediate income subject to regular income taxes. In the same way, the exercise of the option to obtain the stock doesn’t produce any immediate income as long as you hold the stock in the year you acquire it. The income is obtained when you sell the stock acquired later on by exercising the option.

Nonetheless, exercising an ISO provides an adjustment for purposes of the alternative minimum tax or AMT. AMT is a shadow tax system designed to ensure that those who reduce their regular tax via deductions and other tax breaks will pay at least a little tax. This adjustment is the difference between the amount paid for the stock and the amount paid for the ISO (if any) and the fair market value of the stock obtained through the exercise.

To find out if you owe any AMT after you exercise an ISO, Form 6251 is used. And in case you sell the stock during the same time you exercised the ISO, no AMT adjustment is needed. The reason behind this is that the tax treatment becomes the same for both AMT purposes and regular tax. In case you have to make an AMT adjustment, increase the basis in the stock by the AMT adjustment. When you do this, you make sure that when you sell the stock in the future, the taxable gain for AMT purposes is limited. This means that you do not have to pay the tax twice on the same amount.

409a valuation tax penalties on Employees

The 409A valuation for employees is an important part of the stock option issuance process for every company. Not getting the 409A valuation report would create issues for the employees in the company as the IRS would impose tax penalties. Let us say that you have a startup company and are very eager to issue stock options to your employees so that they can be happy and help the company grow. In a hurry, you forget to get the specified employee 409A valuation performed. All you did was guess a reasonable share price and began the issuance process.

Now, let us assume that the IRS comes in and audits your company’s valuation. And the actual 409A valuation is very different from what value you gave the stock. This would hurt you and your employees a lot. To begin with, the employee would be taxed at the ordinary income rate for all the vested options. In addition to this, there would be a 20% penalty on them. Moreover, the employee might also have to pay some state penalties, interest on unpaid taxes, and other charges.

409a Valuation for Foreign Employees

Since we are talking about the 409A valuation for employees, it is important to know that Section 409A applies to resident aliens working inside the USA and the US-source income earned by foreign employees working temporarily in the USA (non-resident aliens). Moreover, since Section 409A usually prohibits funding deferred compensation through a foreign trust, this prohibition would inevitably result in unintended tax consequences for expats, resident aliens, and non-resident aliens. This just makes it very important for companies to get the 409A valuation for foreign employees.

To explain further, the compensation earned by any resident alien or expat is subjected to US tax laws, regardless of the state or country they are in. Hence, the deferral of this compensation would be subject to Section 409A. Along with this, the US-source income earned by a non-resident alien will be taxed under US tax laws. So, if a nonresident alien defers their US-source income, the income will be subject to any treaty override.

Due to Section 409A, employers are working to find out if the compensation arrangements they have with their employees will be adversely affected. For the larger multinational companies, this determination would be much more difficult since there are a lot of situations where there would be arrangements that are trying to make whole either the US employees abroad or foreign employees in the US from the consequences of working outside their home country.

However, since the penalties are only given to the participants of deferred compensation arrangements that do not comply with Section 409A, it is important for the employer to scrutinize their arrangements. And it is very important for every company to get the 409A valuation for their foreign employees as well.

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