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.

Purpose of a 409a Valuation For Employees

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.

Key Points on 409A Valuation for Employees

• Establishes the exercise price (strike price) for employee stock options, which must be at or above the FMV of the company’s shares. 
• Required by IRS regulations (Section 409A) when issuing stock options or equity compensation to employees of private companies. 
• Ensures employees are not subject to unfavorable tax treatment if their stock options are potentially undervalued. 
• Provides a legally defensible, independent assessment of the company’s value to justify the strike price of employee equity grants. This creates a “safe harbor” by following IRS guidelines.
• Typically performed annually or after major events that impact the company’s valuation, such as fundraising rounds or acquisitions. 

Case Study

Here is a case study illustrating how a 409A valuation impacts employees receiving equity compensation from a private company.

Technovate Corp. offers stock options to employees. The 409A valuation impacts the exercise price of these options:

Early employees have a lower exercise price ($5) than new employees ($15). The impact of tax is that early employees benefit from lower exercise prices, which increases their initial taxable income but could potentially result in greater overall gains.

Higher 409A valuations increase the exercise price for new employees, potentially lowering immediate tax upon exercise but reducing overall gain.

The main reason for conducting a 409A valuation for employees is to establish the fair market value (FMV) of a private company’s common stock. This valuation is crucial when issuing stock options or other equity-based compensation to employees, as it establishes the strike price for those options.

Why is 409a valuation for employees important?

The primary goal of conducting a 409A valuation for employees is to establish the fair market value (FMV) of a private company’s common stock, which in turn determines the strike price for employee stock options. 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.
• To comply with IRS regulations, the strike price of employee stock options must be set at or above the fair market value (FMV). If the strike price is set below the FMV, the difference is considered income and is subject to taxes and potential penalties for the employee.
• It impacts the taxes an employee pays when exercising their stock options. If the 409A valuation increases after receiving options, the employee owes taxes on the gain between the original strike price and the new higher 409A price when exercising.
• For foreign employees working in the U.S., their U.S.-source income is subject to 409A rules. An accurate 409A valuation protects them from penalties on their equity compensation.
• Companies must get a new 409A valuation at least annually and after any events that could impact the company’s value, like funding rounds. This ensures the strike price remains compliant over time.

How Employees can be prepared for 409a Valuation?

While not directly involved, employees benefit from being informed about the 409A valuation process and its impact on their equity compensation and taxes.

Understand the stock option details

• Know the number of stock options granted and the strike price
• Understand the vesting schedule and when the options can be exercised.

Be aware of the tax implications

• A lower 409A valuation results in higher potential taxes when options are exercised
• When exercising options, employees will owe taxes on the difference between the strike price and the FMV determined by the 409A valuation.

Review company documents (if provided)

• The company may share the 409A valuation report summary with employees.
• Employees can review details like the valuation methods used, key assumptions, and the determined fair market value.

Ask questions

• Employees can inquire with the company’s finance/HR team about the 409A process and how it impacts their equity compensation.
• Understanding the rationale behind the valuation can help manage expectations

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.

Example

Take for example, Emily is granted stock options at a strike price of $2 per share. The company performs a 409A valuation that also pegs the stock’s fair market value at $2. Ideally, the strike price and fair market value should be close to ensure compliance with Section 409A.

Emily was not aware, the actual fair market value of the company’s stock is higher, say $4 per share. The IRS audits the company and discovers the valuation mistake. This triggers a reclassification of Emily’s stock options as falling under an NQDC plan.

Since the fair market value was underestimated, the difference between the strike price ($2) and the actual fair market value ($4) is considered taxable income for Emily at the time of vesting. Not only does Emily owe income tax on the $2 difference, but she also faces a 20% penalty on that amount.

Tax Impact:

• Let’s say Emily received options for 1,000 shares. The valuation error creates a tax burden of ($2/share difference) x (1,000 shares) = $2,000 in income tax.
• Adding the 20% penalty, Emily owes an additional ($2,000) x 20% = $400.
• In total, Emily ends up paying $2,000 + $400 = $2,400 in unexpected taxes due to the company’s faulty valuation.

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.

Applicability and Importance

• Resident aliens working in the U.S. are treated similarly to U.S. citizens regarding stock options and 409A valuations. 
• For non-resident aliens, the 409A valuation becomes important if the stock options are considered U.S.-source income.

Tax Implications

• Section 409A usually prohibits funding deferred compensation through a foreign trust, which can result in unintended tax consequences for expats, resident aliens, and non-resident aliens.
• If a company fails to comply with Section 409A, it can result in significant tax penalties. 

Equity Allocation

• When employees receive stock options, the taxes owed to the IRS are calculated based on the 409A valuation.

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 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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Get Your Company 409a Valuation from Eqvista

A 409A valuation directly affects employees’ taxes when they exercise their stock options by determining the fair market value (FMV) strike price. Proper independent valuations protect the company and employees from potential IRS scrutiny and penalties related to equity compensation. 

Eqvista is a leading provider of 409A valuations for companies interested in issuing stock options or other equity compensation to employees. Eqvista aims to offer companies accurate, affordable, and defensible 409A valuations conducted by certified experts to issue equity compensation to employees while minimizing risks in compliance with regulations.