Employee stock options and 409a valuations
This article will explain all you need to know about stock options and 409A valuations, along with what makes them important.
A lot of companies issue employee stock options to get the best talent in their company and retain them for longer. And these options, in fact, can be worth a lot of money which is why it is a great way to retain employees. It is normally used by owners as an overall part of their employee compensation package. This benefits both the company and the employee. But the benefit only comes in when all the rules are followed, including getting the stock options with a 409A valuation performed on time.
This article will explain all you need to know about stock options and 409A valuations, along with what makes them important.
Employee Stock Options
Employee stock options, also called ESOs, are the kind of equity compensation offered to the employees and executives as compensation commonly used by many companies. Basically, instead of offering the shares directly, the company offers derivative options on the stock. These options come in the form of regular call options and offer the employees the right to purchase the company’s stock at a specified rate for a defined period of time. Each of the terms of the ESO is mentioned in an employee stock options agreement which is prepared by the company.
Moreover, stock option benefits are commonly associated with startup companies, which may issue them in order to reward early employees when and if the company goes public. In short, stock options are offered by fast-growing companies as an incentive for employees to work towards growing the value of the company’s shares. It also acts as an incentive for those employees to stay with the company. But if the employee decides to leave the company in between, the options are typically canceled (according to the vesting schedule).
There are two main stock types in the ESOs, including:
- Incentive stock options (ISOs): This is also known as qualified or statutory options and is normally offered to top management and key employees. In short, they get preferential tax treatment in many cases as the IRS treats gains on options as long-term capital gains.
- Non-qualified stock options (NSOs): These options are granted to the employees at all levels of the company as well as to consultants and board members. Also called non-statutory stock options, profits on these are recognized as ordinary income and are taxed as such.
Tax differences for employee stock options
From the above, you know that each kind of employee stock options are taxed differently. So let us understand how each one of them is taxed in detail.
#1 Taxation of nonqualified stock options
When the NSOs are exercised, the difference between the market price of the stock and the grant or exercise price is counted as ordinary earned income. This is even if the employee exercises their options and continues to hold them. Earned income is always subject to payroll taxes, Medicare and Social Security, along with regular income taxes.
An employee should remember to exercise their employee stock options based on their own tax decisions. With this said, if they exercise the NSOs in the year where they do not have any other earned income, the person will be paying a lot of payroll taxes than they would be paying otherwise.
Along with the payroll taxes, all the income from the spread is subject to ordinary income taxes. Also, remember that along with payroll taxes, the income from the sale is also subject to ordinary income taxes. If the employee holds the stock after exercise, and the additional gains beyond the spread are achieved, the additional gains are taxed as capital gain (or capital loss, if the price went down).
#2 Taxation of incentive stock options
ISOs are very different from NSOs, as they are not subject to payroll taxes. However, they are subject to taxes and it is a preference item for AMT (alternative minimum tax) calculations. In fact, when an employee exercises their ISOs, there are a few different tax possibilities. Each has been shared below:
- The ISOs are exercised and sold within the same calendar year: In this case, the tax is paid on the difference between the market price at sale and the grant price at the ordinary income tax rate.
- The ISOs are exercised but not sold instantly: Here, the difference between the grant price and the market price becomes an AMT preference item, so exercising ISOs might mean that the employee will have to pay the AMT (alternative minimum tax). Credit for excess AMT tax can also be offered, as it would take years for the employee to use the credit. In case the employee holds the shares for one year from the exercise date (2 years from the grant date of the option), then the difference between the grant price and market price when the options are sold is taxed as long-term gains instead of as ordinary income. Additionally, if the ordinary income exceeds the AMT tax rate of the person, they would get to use some of the previously accumulated AMT credit. For high-income earners, holding the stock for the required time period can mean paying tax on the gain at 15% vs 20%. But keep in mind that there are risks to this strategy and should be evaluated properly.
IRC 409a Valuation for Companies
A business valuation is the process of finding the economic value of a company. It helps in getting the fair market value (FMV) of the business, which is the current value of the company, which is key when using ESOs. And the right way to get a business valuation is with a 409A valuation.
But why a 409A valuation? Let us understand more.
What is IRC Section 409a?
There was a huge scandal that took place in 2001 with Eron, where executives were taking advantage of equity loopholes and avoiding paying the right amount of tax that had to be paid to the government. The IRS subsequently introduced Section 409A in 2005 to prevent this from happening. And it was in 2009 when the 409A was finalized. It comes with a framework for private companies to follow when valuing private stocks.
When the valuation is conducted by an unaffiliated or independent party, it establishes a safe harbor, meaning the 409A is presumed to be “reasonable” by the IRS. So, valuation is not something that you can take lightly. When your company doesn’t adhere to 409A rules, and the equity gets mispriced, the IRS can assess penalties. And the people who end up paying these include the shareholders and employees. So, it is better to follow the rules.
But why do you need a 409A valuation for the stock options? The next sections would help you understand.
Why does a company need a 409a Valuation?
If you are about to give out stock options, you need the 409A valuation done as it is an IRS requirement. Getting the 409A valuation allows your business to follow all the tax laws and avoid any of the IRS audit sessions that can cause your company legal troubles, tax issues, and even interfere in the company’s functions if problems arise. Additionally, the need to hire new lawyers and consultants for defending your company while the case drags would cost you a lot more.
And the worst part is that the employees in your company would suffer the most with the immediate tax issues for them, which is not good for any company. It would leave a really bad impression on the employees and could affect company morale. And in all this, it is important for you to remember that you offered the stock options to your employees to reward them and not leave them with huge penalties from the IRS.
Stock options and 409a valuations
From the above, you know that the stock options are a form of equity compensation offered to the employees in the company. It is important for the employees to pay the exercise price to get the benefit of the option. Once the employee exercises the option, they get the stock in the company and can sell it or hold onto it for later.
Now, before a company can offer stock options, it has to be set at the right price as per IRS standards. For this, the company has to get the 409A valuation done. Section 409A of the Internal Revenue Code governs the taxation of deferred compensation. However, some stock options that satisfy certain conditions are considered to be “stock rights”, that are excludable from section 409A, rather than “deferred compensation” subject to section 409A.
Nonetheless, if any of the conditions that are important to qualify for the exclusion are not satisfied, the stock options will be regarded as deferred compensation subject to section 409A, such that the options would have to either conform to the section 409A or suffer the consequences of failing section 409A.
The following questions and answers explain the section 409A considerations that companies need to be aware of when issuing stock options.
Are stock options subject to a 409a Valuation?
To be clear, the stock options that qualify as ISOs are not subject to Section 409A. NSOs, however, have to follow the rules, unless they are considered as “stock rights” excludable from the Section 409A provided they meet each of the following conditions:
- The stock option is a right to purchase “service recipient stock”, which is the common stock of the corporation for which the owner performs direct services or defined eligible parent entities that possess at least 50% of the voting power or value of the service recipient corporation’s ownership. Options on preferred stock aren’t section 409A-excludable stock rights even if all of the other conditions identified below are satisfied.
- The exercise price of the stocks can never be lower than the FMV of the underlying stock on the date that the option is granted. Using section 409A, you can get the value of the stock that would be readily tradable on an established market with certain safe harbor valuation approaches.
- The number of shares subject to the stock option has to be fixed on the initial granting date. And this date can be no earlier than the date when the corporation completes the corporate action required to formulate a legally limiting right to the options for the service provider.
- The option does not hold any feature for the deferral of compensation beyond the later of the exercise or disposition of the option or the time the stock acquired pursuant to the option becomes substantially vested. The taxable income resulting from the exercise or disposition of the option must be fully includable as income at the time of exercise/disposition of the option.
- The exercise or transfer of the option is subject to taxation under section 83 and Reg. section 1.83-7.
In case the stock options don’t satisfy any of these mentioned conditions and are still subject to section 409A, what does it mean? Well, options that are subjected to the section 409A has to either:
- Be designed to conform to section 409A requirements and rules, or
- Suffer the potential adverse tax consequences of failing to conform to the rules.
Are stock options considered deferred compensation under section 409a?
Section 409A offers that some compensation you defer is however currently taxed. The amounts that are deferred under a nonqualified deferred compensation plan are currently taxed if not subject to a “substantial risk of forfeiture”. A nonqualified deferred compensation plan includes virtually any agreement, program, method, or other arrangements that offer for deferral, where the compensation is not paid until a later year.
This includes plans like compensation agreements, bonuses, or employment agreements where the cash is paid later. It also includes supplemental executive retirement plans, also called SERPs, and other nonqualified retirement plans. This also includes performance share plans, phantom stock, restricted stock plans, stock appreciation rights, and long-term or multi-year commission or bonus programs.
Restricted Stock Units and 409a
It may be a good idea for your company to change your plan from offering NSOs to offering RSUs to the employees to avoid the 409A valuation procedure. This is because restricted stock units (RSU) are not subject to section 409A. Additionally, the recipients can also benefit from tax treatment offered for the RSUs. They can file an election under the Section 83(b) of the Code to be taxed in the year the election is made on the difference between the purchase price and the FMV of the shares on the date of grant, rather than being taxed on the difference between the purchase price and the FMV as the stock vests.
409a Violation & Penalties
Let us say you still decide to give out stock options to your employees, and in this case, you have to get a 409A valuation done. If you don’t conduct a proper company valuation when issuing these options, you would not be eligible for 409a safe harbor protection. As mentioned above as well, if penalties are handed out, the employees and shareholders would have to pay them, which include:
- All deferred compensation from the current and preceding years becomes taxable immediately
- Accrued interest on the revised taxable amount
- An additional tax of 20 percent on all deferred compensation
Many owners tend to ignore the need to get a 409A valuation due to the high price. But just to be clear, a startup would have to pay a minimum of $1,000 to $3,000 for a 409A valuation. Even though this may be a high amount in the beginning, it is a worthwhile investment to avoid any penalties later on.
Let us take an example to understand this better by assuming you did not spend money on a valuation as you found it too expensive. And you end up granting 2,000 stock options at $3 per share (as per your valuation) without getting a 409A valuation done.
In the future, the IRS can investigate this option grating price and evaluate your business via an audit. Let’s say they determine the actual stock price on the grant date to be $5 per share. From then on, the share price may have increased a further $5 when the audit of the IRS started, and with the employees having vested their options, the employees would have to do two things:
- Immediately clear the income tax payments on the difference between the incorrect strike price ($3) and the current value ($10), which is $7 per share for the 2,000 shares they received. This would give the total amount of $14,000, even if the employee has exercised the option or not. Additionally, if the employee comes under the tax bracket of the 33% income tax rate, they would have to pay a $4,620 income tax bill too.
- Pay the penalty which is equal to 20% of the price difference. In this case, it is 20% of $14,000 which is a $2,800 penalty which has to be paid to the IRS as well.
Along with this, the IRS would add interest and raise the total bill of $7,240 for one person to something higher. But in case the company gets the 409A valuation before all this happens, the real value of the shares would be $5 per share, and the employee would be able to delay the payment of the tax until they exercise the stock option and purchase the stock. And this delay could be many years after the audit is performed by the IRS.
For instance, the employee purchases the shares when it has a value of $10. The tax owed by the employee would be based on $7 per year, and with the tax bracket of 33%, the total tax bill will be just $4,620 for $14,000. In short, it’s better to have a proper 409a valuation done to avoid these headaches later on for both the company and employees.
Start your 409a Valuation process with Eqvista
From everything we have covered, it is understood that you should have a 409A valuation done on time and by the right firm. This means that you do not just have to find a firm that can do your valuation, but the firm that will offer you the safe harbor status through a 409a valuation.
To guarantee that the safe harbor is provided and that you do not spend a lot on a 409A valuation, Eqvista is a great choice. We offer 409A valuations keeping in mind the IRS regulations without creating a hole in your pocket. In fact, our 409A valuation services start at $990 based on the stage that your company is in. Why so low? Eqvista aims to help companies find an affordable solution for managing their equity compensation, and work to grow with your company.
Additionally, we also offer a great cap table application. So, you can easily have all the shares of your company managed and even get your 409a valuation, all in one place.