Employee stock options and 409a valuations

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.

Let’s explain employee stock options with an example: Let’s say a company grants an employee 1,000 stock options with an exercise price of $25 per share. That means the employee has the right (not the obligation) to purchase the 1,000 shares of a company at the $25 per share price.

In this scenario, if the employee’s options vest according to the vesting schedule, perhaps 25% per year over 4 years. After 1 year, the employee has 250 vested options. If the company’s stock price rises to $55 per share, the employee can confidently exercise their 250 vested options. They would pay the company $25 per share, for a total of $6,250 (i.e. 250 options x $25 share price), and receive company stock of 250 shares.

The employee can immediately sell those 250 shares on the open market for $55 per share, netting a profit of $7,500 (250 shares x $30 difference market price(25) and the exercise price (55). This allows the employee to benefit financially from the increase in the company’s stock price, providing them an incentive to help grow the business.

ESO 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).

Tax differences for employee stock options

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.

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.

Comparing Differences Between ISO and NSO

Example of ISO vs. NSO taxation based on 409a price

BLUESKY Inc. is a fast-rising cloud storage startup known for its AI-powered data security solutions.  The company plans to grant stock options (ISO and NSO) to its employees as part of a new incentive compensation plan.

SCENARIO – 1

An employee is granted 50,000 ISO stock options with a strike price of $0.05 (the 409A valuation price) per share. After four years, they sold vested shares at $4 per share.

• For ISOs, the difference between the sale price and the strike price (bargain element or spread) is considered.  The difference between the strike price ($0.05) and the sales price ($4), is $3.95 per share for the 50,000 options received. This would give the total amount of $197,000, even if the employee has exercised the options.
• In this case, the gains will be taxed at the long-term capital gains rate i.e.15% (as per US long-term capital gains rate) since the options were held for at least two years from the grant date and more than a  year from the exercise date. The capital gains tax will be $29,550. 

SCENARIO – 2

A contractor is granted 50,000 NSO stock options with a strike price of $0.05 (the 409A valuation price) per share. Since the strike price is higher, the contractor exercised and sold the options in one transaction at $4 per share.

• Similarly, the difference between the sale price and the strike price (bargain element or spread) is considered.  The difference between the strike price ($0.05) and the sales price ($4), is $3.95 per share for the 50,000 options received. This would give the total amount of $197,000, even if the employee has exercised the options.
• In this case, the gains will be taxed ordinary income tax i.e. 35% (federal (22%) + state (13%)) since the options were exercised and sold in one transaction. The ordinary income tax will be $69,125. 

TAX DIFFERENCE

• The tax difference would be the difference in tax liability between the two scenarios, assuming the respective tax rate applies.
• In this case, the difference between the capital gains tax ($29,550) and ordinary income tax ($69,125), is ($39,575).

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

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.

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.

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.

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.

Possible ways to get 409a valuation for Stock Options

This is something that early-stage companies and founders must keep in mind if they want to avoid having to pay tax fines to the IRS. Find a credible 409A valuation source if you’re an early-stage company issuing options and want to take advantage of the safe harbor. Before you can issue your first common stock option, you must complete your 409A valuation.

Here is a basic summary of what a 409a valuation looks like for stock options:

Independent Appraisal Method

The easiest option to get a 409a value is to use Eqvista’s “Independent Estimate” process, which involves an independent, expert appraisal of the company’s FMV. This method allows the law to establish a rebuttable presumption of reasonableness for a professional appraisal of a company’s stock’s FMV. This means that if the firm is ever audited by the IRS, the IRS, not the company, would bear the burden of proving that the technique utilized was not a “reasonable valuation approach”. This significantly minimizes the chances of an IRS FMV challenge being successful.

Common Valuation Methods

There are a few common valuation methods that come under the independent appraisal method which are as follows:

• Market Approach – The OPM backsolve approach is commonly used by valuation providers when your firm raises a financing round. New investors are likely to have paid fair market value for the shares, but preferred stock is given to them. As a result, modifications must be made when calculating the FMV of common stock. Other market-based methodologies evaluate a company’s equity worth using financial data from comparable public companies, such as revenue, net income, and EBITDA.
  
• Income Approach – The straightforward income approach is frequently used by valuation providers for organizations with significant sales and positive cash flow. In using this method, the FMV of your company is calculated as total assets minus liabilities.
• Asset Approach – The asset approach is frequently utilized for early-stage enterprises that have not yet raised funds and are not yet profitable. To determine a proper valuation, this process evaluates a company’s net asset value.

Prepare necessary data and information to perform 409a valuation

Essentially, the 409A regulations apply whenever there is a deferral of remuneration (where an employee has a legal claim to compensation that will be paid in a later taxable year during the current taxable year). A 409A valuation is an appraisal of your company’s common stock and it’s essential if you want to give your staff stock options. It’s best if your 409A valuation is done by an independent third party. When you maintain your cap tables and keep them up-to-date, and take the time to acquire all of the necessary data and documentation for the valuation, the process is more likely to go well.

Get your 409a valuation done every 12 months

Valuations under IRC 409A are valid for a maximum of 12 months after the effective date, or until a “material event” occurs. A material event is something that potentially has an impact on the stock price of a corporation. Qualifying funding is the most typical significant event for the majority of early-stage firms, and consists of a negotiated sale of common stock, preferred stock, or convertible debt to independent, institutional investors.

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.

Here is an example for 409A Violation and resulting penalties:

Leeway, a pharmaceutical company, is facing a significant issue with an NQDC plan. A research manager, with a $500,000 aggregate plan account balance, received a $50,000 payment from one of the NDQC accounts a year earlier than they elected. This premature payment is a grave 409A violation, as it does not comply with the strict rules around payment timing and distribution triggers under section 409A.

Tax penalties, in this case, is:

• Immediate Income Recognition – Managermust report the full $500,000 plan balance as taxable income for the year of the violation, despite receiving only $50,000 in advance.
• 20% Additional Tax Penalty – The research manager would owe a 20% penalty, which in this case would be $100,000 (20% of $500,000)
• Premium Interest Tax – From the vesting date forward, the research manager would also have to pay a premium interest tax of 1% above the federal underpayment rate on the $50,000 early distribution.
• Potential State Penalties – The research manager may also owe additional state-level penalties depending on the state.
• Amended Tax Filings – The research manager and the company must amend previous tax returns (e.g., Form W-2, 1099, 1040) to account for the 409A violation.

The penalties can be severe, as the entire $500,000 plan balance becomes immediately taxable, even though only $50,000 was distributed early. This highlights the importance of strict 409A compliance for NQDC plans.

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Frequently Asked Questions on 409A Valuation and Employee Stock Options

Many companies use stock options as a way to compensate their employees, but did you know that issuing stock options can affect your 409A valuation? Here is a list of the commonly asked questions on 409A valuations and their effects on stock options and your company.

Does 409A apply to employee stock options?

Companies issue stock options to employees as a part of their compensation package. Hence, as per the IRS, before a company issues a stock option, it must comply with the applicable 409A valuation procedures. This is because the strike price or exercise price of stock options is derived from the fair market value of the common stocks of a startup.

WHAT ARE THE BENEFITS OF GRANTING EMPLOYEE STOCK OPTIONS?

Granting employee stock options helps to align employee and shareholder interests, attract and retain talent, Provide equity-based compensation, Increase employee engagement and productivity, and provide a Flexible compensation structure.

HOW IS EMPLOYEE STOCK OPTIONS’ FAIR MARKET VALUE (FMV) DETERMINED?

Employee stock option of FMV is established through a 409A valuation process, which sets the exercise price and has major tax implications if done improperly by an independent expert.

HOW DO EMPLOYEE STOCK OPTIONS AFFECT A COMPANY’S STOCK PRICE?

Employee stock options do not directly determine a company’s stock price, and they can indirectly influence it by aligning employee and shareholder interests, attracting and retaining talent, and having accounting and tax implications for the company.

Are stock options exempt from 409A?

In general, stock options that fall under incentive stock options (ISOs) must comply with the 409A valuation procedures. However, if the company decides to use non-qualified stock options (NSOs), then it is excludable from section 409A until certain conditions are met. Be sure to connect with Eqvista’s expert to find out which option scheme you should comply with.

Critical Aspects of Employee Stock Options and 409A Valuations

• 409A valuation is a critical factor in determining the tax implications of employee stock options at private companies.
• 409A valuation ensures compliance with IRS regulations and helps employees understand the potential tax consequences of exercising their options.
• Companies must obtain a new 409A valuation at least annually or whenever a significant event occurs that could impact their value.

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.