409A Compliance Checklist for 2025: How to Stay Audit-Ready

In today’s business environment, compensation structures have evolved far beyond the traditional salary and benefits packages. Organizations increasingly utilize compensation strategies to attract, retain, and incentivize key talent while managing cash flow and tax implications. 

Section 409A of the IRS regulates the treatment of non-qualified deferred compensation paid by employers to their employees and other service providers. These aim to prevent tax deferral abuses with severe penalties for noncompliance. Companies must carefully balance flexibility in payment timing with regulatory requirements while designing their compensation.

Why 409A Compliances Matters?

Section 409A of the Internal Revenue Code governs nonqualified deferred compensation, including stock options, deferred bonuses, and severance agreements. Compliance ensures employees are taxed appropriately on deferred compensation and avoids severe penalties for companies and recipients. The 409A valuation, therefore, plays an important role and companies must consider 409A compliance throughout the 409A valuation process.

409A Compliance is important because of:

• Penalties for Noncompliance: Employees face immediate taxation, a 20% additional tax, and interest penalties. Companies risk IRS audits and legal liabilities.
• Fair Market Value (FMV) Determination: A 409A valuation establishes an independent assessment of a private company’s stock price, ensuring equity grants (e.g., stock options) are issued at or above FMV.
• Investor and Employee Confidence: Compliant valuations enhance transparency, protect against IRS scrutiny, and align compensation with IRS rules.

409A Compliance Checklist with Legal Considerations

A comprehensive 409A compliance checklist helps ensure your company’s deferred compensation and equity awards are structured and valued according to IRS rules, protecting both the company and its employees from significant tax penalties.

1. Initial Setup for Valuation

Engage a qualified, independent third-party valuation firm to perform the valuation for IRS “safe harbor” protection. Prepare the necessary company documentation, including financial statements, cap table, and business plan. Schedule the initial valuation within 12 months of the first option grants.

2. Select Valuation Method

Select an IRS-approved method (Market, Income, or Asset Approach) based on the startup stage and data availability. Ensure stock option strike prices are set at or above the FMV determined in the valuation.

3. Regular Maintenance

Set calendar reminders for annual valuation renewals. Track significant events that may trigger a new valuation—document board approval for each 409A valuation report.

4. Documentation & Governance

Proper documentation isn’t just bureaucratic—it’s a legal shield against IRS disputes, investor lawsuits, and deal-breaking due diligence gaps. Obtain board approval for the valuation report and store signed copies of the report along with supporting data.

5. Employee Communication & Equity Plans

Inform employees receiving options about the valuation impacts. Include 409A compliance clauses in equity grant agreements.

6. Post-Valuation Compliance

Monitor for material changes triggering revaluation—correct errors via IRS voluntary correction programs (e.g., repricing options within 2 years).

7. Tax Filing Considerations

Track ISO vs. NSO tax treatment requirements. Prepare for annual equity compensation reporting. Monitor the $100K ISO vesting yearly limitation. Document Form 3921 issuance to employees

409A Non-Compliance Penalties

The penalties for failing to comply with Section 409A regulations are severe and affect both companies and employees/recipients of the deferred compensation. 

To illustrate the severity of 409A non-compliance penalties, consider an executive with $100,000 in deferred compensation under a non-compliant plan. They would face their regular federal income tax (approximately $37,000 assuming a 37% tax bracket), plus an additional 20% federal penalty tax ($20,000), and potentially state-specific penalties such as California’s 5% surcharge ($5,000). Combined with premium interest charges calculated from the date the compensation first vested, the total tax burden could easily exceed 60% of the original deferred amount. 

This punitive tax structure demonstrates why proper 409A compliance is critical for companies and executives.

Penalties for Recipients (Employees)

• Immediate Income Recognition: All deferred compensation under the non-compliant arrangement becomes immediately taxable, even if not yet received. This applies to all amounts deferred under the plan for the current and previous years.
• Additional 20% Federal Tax Penalty: On top of regular income tax, a 20% additional federal tax is imposed on the amount included in income
• Premium Interest Tax: Interest penalty on the tax underpayment at the federal underpayment rate plus 1% calculated from the date the deferred amount was first vested.
• State Tax Penalties: Some states impose additional penalties (e.g., California adds another 5% state tax penalty)

Corporate Implications

While the direct penalties fall on the individual recipients, companies face significant issues such as :

• Withholding and reporting obligations
• Potential lawsuits from employees facing unexpected tax burdens
• Reputation damage and difficulty attracting talent
• Possible need to provide “gross-up” payments to compensate executives for penalties

Key Tax Regulations for 409A Valuations

Let us take a closer look at tax regulations and guidelines regarding 409A valuations.

Internal Revenue Code (IRC)

As the name suggests, 409A valuations are governed by Section 409A of the Internal Revenue Code (IRC). This section applies to most nonqualified deferred compensation (NQDC) plans. Unlike qualified plans, NQDC plans do not satisfy the requirements of Section 401(a) of IRC and hence do not provide employers and employees with the same tax benefits. Common examples of qualified plans are 401 k plans and pension schemes.

Examples of NQDC plans are:

• Salary reduction arrangements
• Bonus deferral plans
• Supplemental executive retirement plans (SERPs) a.k.a. top-hat plans
• Excess benefit plans
• Phantom stock plans

Sometimes, restricted stock units (RSUs) may also come under NQDC.

Under Section 409A, there are requirements relating to distributions, accelerations of benefits, and elections. 

Penalty for non-compliance with these requirements include:

• All deferred compensation which is not subject to a substantial risk of forfeiture and has not been previously included in gross income will be immediately taxable
• 20% penalty tax on the amount defined as immediately taxable in the previous point
• Increased interest rate on the late payment of income tax due on the amount defined as immediately taxable in the first point

Tax Court Cases

In the context of stock options, an important ruling was passed in 2013. The case involved the co-founders of Marvell Technology, Dr Sehat Sutardja, and his wife, Weili Dai. They were contending for a refund of all taxes paid under Section 409A. Among all the arguments they made, the ones that are relevant to us are:

• Grants of employee stock options are not taxable events
• Stock options are not treated as deferred compensation as per Treasury Regulations

However, the US Court of Federal Claims ruled that the Section 409A applied to discounted stock options.

Treasury Regulations

The Treasury Regulations referred to by the co-founders were an interpretation of a paragraph in Chapter 1 of the IRC that applied to stock options if the exercise price was never less than the fair market value (FMV).

Since the stock options were issued at a discount, this Treasury Regulation was not applicable.

Revenue Rulings

The IRS publishes Revenue Rulings which are its interpretations of the IRC. You may refer to Revenue Rulings to understand how the IRC is applied in various cases. If the IRS changes its position on stock options, it might be expressed in its Revenue Rulings.

An example of a Revenue Ruling relevant to us is the Revenue Ruling 2008-13.

Suppose you offer performance-linked compensation to your employees. Let us also suppose that when your employees retire, are involuntarily terminated, or terminate employment for good reason, you pay them the compensation regardless of whether they met the performance goals.

Then, such ‘performance-linked’ compensation will not be treated as performance-linked by the IRS since there is no substantial risk of forfeiture.

If you issue stock options linked to performance, you must take note of this Revenue Ruling.

Accounting standards

You must adhere to the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), whichever is the applicable accounting standard in your case. GAAP is set by the Financial Accounting Standards Board (FASB) and IFRS is set by the International Accounting Standards Board (IASB). You can check their website to see if their accounting standards apply to your company.

409A Compliance Remediation Options

If your company has discovered potential 409A compliance issues, several remediation approaches are available. The appropriate strategy depends on the nature and timing of the violation.

Immediate Remediation Options

• IRS Correction Programs: The IRS has limited programs for correcting certain violations, which can reduce or eliminate penalties if completed before the IRS discovers the issue. However, not all violations are eligible for these correction programs.
• Option Repricing: Consider adjusting the undervalued options to the correct fair market value. This must be done before the options are exercised, and board approval and employee consent are required. It may also impact employee morale and retention.
• Rescission: In some cases, it is necessary to rescind non-compliant agreements within the same tax year completely. This generally must occur before the end of the calendar year the violation took place and may not be viable for long-standing issues.

Preventative Measures for Startups 

When addressing 409A compliance violations, companies have several remediation options available. For immediate corrections, consider using IRS documentary correction programs when eligible, repricing undervalued options to the correct fair market value (with board approval and employee consent), or potentially rescinding non-compliant agreements within the same tax year. 

To prevent issues in future , implement regular compliance audits, upgrade documentation procedures, educate all stakeholders and establish formal valuation protocols. Startups should be particularly careful with early-stage equity issuances, documenting founder grants thoroughly and establishing consistent practices. Regardless of approach, consulting with qualified legal counsel is essential to navigate these complex remediation strategies effectively.

Why do 409A Tax Regulations and Compliances Matter?

A fair and accurate 409A valuation is required to ensure that the company is following the rules and regulations. For those who fail to comply with the 409A valuation requirement, the IRS could impose heavy penalties. Employees, executives, or even board of directors members can be imposed a 20% penalty. Properly performing a 409A valuation could protect employees and employers from facing heavy tax penalties at a later date. That being said, follow the regulations and 409A compliance in order to avoid penalties.

Types of Equity compensation subject to 409A compliance

It is important to recognize the various types of equity compensation that require compliance with Section 409A.

Types of equity compensation subject to Section 409A compliance include preferred stock, stock options, warrants, RSUs (Restricted Stock Units), RSAs (Restricted Stock Awards), and phantom stock. Preferred stock grants shareholders priority dividends over common stock and requires a 409A valuation to determine fair market value (FMV). Stock options and warrants give holders the right to purchase stock at a set price, with the strike price based on FMV, making 409A valuation essential. 

RSUs and RSAs are equity forms often subject to vesting, where FMV must be established at grant for proper tax treatment. Phantom stock provides stock ownership benefits without actual shares, require a 409A valuation to ensure accurate compensation. Compliance with 409A ensures these equity types are fairly valued and taxed correctly.

Example of the Tax Implications of 409A Valuation

This particular example was inspired by a real life shareholder a few years back. In this case, a shareholder was issued 50,000 stock options with a strike price of $0.75, and another at a 33% lower price of $0.50. Here are the differences stacked up against each other:

Scenario 1		Scenario 2
Options Granted	50,000	Options Granted	50,000
Strike Price (409A Valuation Price 33% lower)	$0.50	Strike Price (Original 409A Valuation Price)	$0.75
Sale Price	$4	Sale Price	$4
Taxable Income per Share (Sales Price – Strike Price)	$3.50	Taxable Income per Share (Sales Price – Strike Price)	$3.25
Total Taxable Income	$175,000	Total Taxable Income	$162,500
Tax due (20%)	$35,000	Tax due (35%)	$56,875

You can see that in both scenarios, the options were liquidated at $4.00 a few years later, with their taxable gain per share, total gains, and taxes due.

Scenario 1

After 3 years, the ISO options vested. The employee exercised their options at the strike price of $0.50 and acquired the shares. Then, they sold the shares at $4 per share, so:

• Taxable Income per Share = Sales Price – Strike Price$4 – $0.50 = $3.50
• Total Taxable Income = Taxable Income per Share x Options Granted $3.50 x 50,00 = $175,000

With a lower strike price at $0.50, the shareholder was able to exercise their options and hold onto their stock for over a year, allowing their ISOs to be taxed as a qualifying disposition. So the taxes were:

• Capital Gains Tax = Total Taxable Income x Capital Gains Rate $175,000 x 20% = $35,000

Qualifying Disposition:

• Options held for at least two years from the grant date and one year from the exercise date. Under this, profits are taxed at the long-term capital gains rate.
• In this case, the gains were taxed at the long-term capital gains rate, i.e., 20% (as per US long-term capital gains rate.

Scenario 2

Under the second scenario, the shareholder had a strike price of $0.75, and didn’t have enough funds to cover the exercise to share and hold them for over a year, eventually selling these back to the Company in the same year. With this, this sale did not count as a qualifying disposition, and was taxed at Income Tax Rates, as:

• Taxable Income per Share = Sales Price – Strike Price$4 – $0.75 = $3.25
• Total Taxable Income = Taxable Income per Share x Options Granted $3.25 x 50,000 = $162,500

With the gains taxed under ordinary income tax i.e. 35% (federal (22%) + state(13%)), the total taxes due were:

• Ordinary Income Tax =Total Taxable Income x Income Tax Rate $162,500 x 35% = $56,875

Tax Savings

Comparing the two scenarios and stock option pricing, the total tax difference was:

• Tax Savings = Taxed at $0.50 strike price – Taxed at $0.75 strike price
• Difference = $35,000 – $56,875 = $21,875

Thus going back to the beginning of the example, with the drop in the 409A valuation price from $0.75 to $0.50, the option holders had a tax difference of over $20,000 on their tax returns.

This example shows why having a good understanding of the 409A valuation process and end results has on your taxes.

What is the Role of a Registered Valuer in Tax Valuation?

Registered valuers like Eqvista are professionals who assess the value of assets like stocks and bonds. Business owners like you can gain peace of mind and stay tax-compliant with Eqvista, an expert in valuing private companies and ensuring accurate 409A valuations.

Some advantages of hiring us as a registered valuer are as follows:

A registered valuer can invest in a team of taxation professionals with expertise in valuation-related laws and regulations, ensuring zero oversights that could lead to avoidable tax compliance issues. Since registered valuers are a different entity than your company, our 409A valuations can help you attain a safe harbor status as per the independent appraiser method provision.

Experienced registered valuers can produce audit-ready valuation reports that also carry actionable insights about your company. A team of qualified experts who have valued startups from various industries, stages, and regions is dependable in attaining tax compliance. Registered valuers who deal with valuations done for tax purposes can advise on tax planning and compliance matters.

As a registered valuer, Eqvista’s strength lies in our experienced team of tax professionals and NACVA-certified valuation analysts. Eqvista plays a key role in providing 409A valuations for tax compliance purposes.In just six years from inception, we have served more than 15,000 companies. 

We pride ourselves on seamlessly balancing tax compliance with our client’s needs. Eqvista’s 409A valuations are designed to comply with IRS regulations and provide safe harbor status, reducing the risk of audits and penalties for companies

Eqvista offers competitive pricing for their high-quality 409A valuation reports, making them accessible to companies at different stages and sizes.

FAQs

Here are some frequently asked questions on 409A compliance and why they are important:

Who needs 409A compliance?

Any company that offers nonqualified deferred compensation—such as stock options, RSUs, or severance plans—must ensure 409A compliance. This applies to private and public companies and affects employees, independent contractors, and directors who receive these benefits.

How often must a company perform a 409A valuation for compliance?

A 409A valuation is generally required at least once every 12 months or sooner if a material event could affect the company’s value.

Can 409A compliance errors be corrected?

Yes, the IRS offers a correction program for certain 409A compliance errors if they are identified and fixed within two calendar years. However, corrections can be costly and may not eliminate all penalties, so it’s best to get 409A compliance right from the start.

What are the key steps to maintain 409A compliance?

• Engage a qualified, independent appraiser for valuations
• Keep all documentation up-to-date and accurate
• Review and update plans after material events
• Educate HR, finance, and legal teams on 409A rules
• Consult with experienced legal or tax advisors as needed

Why Choose Eqvista to Maintain Your 409A Valuation Compliance?

Achieving 409A compliance is crucial for any company issuing stock options as it protects the business and its employees from severe tax penalties and ensures regulatory integrity. Eqvista simplifies this process by providing comprehensive, independent 409A valuation reports that establish the fair market value of your company’s common stock, deliver safe harbor protection, and support you through potential IRS audits. 

By partnering with Eqvista, you minimize compliance risks and give your employees confidence in the fairness of their compensation. Ready to secure your company’s future? Contact Eqvista today to schedule your 409A valuation and ensure your equity compensation plans are fully compliant.