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 in all aspects of a private company. To avoid significant penalties, companies must consider 409A compliance throughout the 409A valuation process. Companies that do not maintain compliance with the 409A valuation requirement may be held liable for negligence.

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

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.

• Preferred Stock – It is a commonly used type of equity grant wherein the company issues shares with a preference over the common stock. Shareholders are paid with a specified dividend that has priority over common stock for receiving dividends. 409A valuation is a must to determine the fair market value of a preferred stock.
• Stock Options – Stock option grant employee the right to buy or sell the underlying security for a specified price within a given time period. In this regard, the strike price refers to the price at which an employee can buy or sell the shares. Therefore, a 409A valuation is critical to understanding the fair market value of a stock option due to the fact that the strike price is derived from the current market value of the stock.
• Warrants – Warrants are similar to options, giving holders the right (but not the obligation) to purchase company stock at a set price. Like options, warrants must be priced at or above FMV to comply with 409A, and a proper valuation is required.
• RSUs and RSAs – Restricted stock units and Restricted Stock Awards are forms of equity compensation granted to employees, often subject to vesting conditions. RSUs represent a promise to deliver shares in the future, while RSAs are actual shares subject to restrictions. For both, 409A compliance requires that the FMV of the stock be determined at the time of grant to ensure proper tax treatment.
• Phantom Stock – Phantom stock refers to an equity grant where selected employees, mostly senior management, receive the benefits of stock ownership without actually giving them any company stock. Hence, a 409A valuation is required to ensure that the employees are properly compensated.

What to Consider for 409A Compliance While Issuing Common Stock

The Internal Revenue Code 409A defines the specific requirements for companies when issuing common stock. Basically, the stock of private companies is not traded in an open market, and it is not possible to determine the actual fair market value. As a result, 409A compliance requires a few assumptions, projections and calculations to determine the fair market value of the stock.

409A IRS regulations and compliances

The Internal Revenue Code 409A works in a systematic manner to determine the fair market value of a specific type of equity grant. Basically, this is to make sure that the company is properly issuing equity grants by following the rules and regulations of the government. Following are a few of the general rules and regulations that are incorporated in 409A.

• The right to a benefit that is excluded from income shall not be treated as a deferral of compensation for purposes of section 409A.
• When the stock option is extended, the modification as per the 409A shall be considered if the period is not extended further than the earlier of the maximum term of the option or 10 years from the original date.
• There is a legally binding right to receive a non-taxable benefit which does not provide for a deferral of compensation under the purposes of section 409A.

Companies must carefully follow 409A regulations when issuing common stock to ensure proper valuation and avoid significant tax penalties for the company and its employees.

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.