IRS Section 409A

Section 409A is a part of the Internal Revenue Code and governs the non-qualified deferred compensation paid to a service provider of the company.

While many company founders may be unaware of IRS Section 409A, it’s an important tax law that governs the rules for valuing a company’s share price. The law outlines the requirements for 409a valuations as well, hence the name. These would determine how an independent appraiser assesses the value of your company to determine the share price, and ultimately the amount of tax to pay on these.

Despite this, not every company may have a 409a valuation done, especially for those without an Employee Share Ownership Plan (ESOP) or compensation to their shareholders. But if you are about to give shares or options to your employees, then you should know all about IRS Section 409a and the valuation methods. At the end of this article, you will have a better grasp on this.

Let us begin with what the IRS Section 409A is all about.

What is the IRS Section 409A?

Section 409A is a part of the Internal Revenue Code and governs the non-qualified deferred compensation paid to a service provider of the company. It also imposes a 20% excise tax when the section’s operational and certain design rules are violated. The service providers include the board members, some independent contractors, general employees, and executives. The service providers also include those executives that offer services. For instance, a corporation or an LLC can be a service provider for another company.

Basic of the IRS Section 409A

On January 1st, 2005, Section 409A was added to the IRC (Internal Revenue Code) under Section 885 of the American Jobs Creation Act of 2004. The overall effect of Section 409A is comprehensive due to the broad definition of “deferral of compensation.” In fact, this section was passed based on the practices of the Enron executives who accelerated their payments under their deferred compensation plans to access the company’s funds before it went bankrupt. It was also enacted partly in response to a history of perceived tax-timing abuses due to the limited enforcement of the constructive receipt tax doctrine.

According to IRS section 409A, the “non-qualified deferred compensation” has to comply with other rules concerning the distributions and timing of deferrals. So, as per the regulations put up by the IRS, Section 409A is applied when there is a “deferral of compensation.” This normally takes place when an employee of a company has a legally binding right during a taxable year to the compensation that would be payable in another tax year or is payable in the current tax year.

There are many exceptions to this, which includes welfare benefits such as death benefit plans, disability pay, sick leave, and vacation leave, along with qualified plans such as 401(k) plans and pensions. Some of the other exceptions include ones for “short-term deferrals,” which are the payments made within two and a half months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture. Additionally, it also includes particular stock appreciation rights (SARs), specific stock options and certain separation pay plans.

Parts of the IRS Section 409A

Even though we all aren’t lawyers, its good for business owners to have at least a basic understanding of the law for their company operations.

A general summary of Section 409A is as below: U.S. Code § 409A.Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans

(a)Rules relating to constructive receipt
1) Plan Failures
2) Distributions
3) Acceleration of Benefits
4) Elections

(b)Rules relating to Funding
1) Offshore property in a trust
2) Employer’s financial health
3) Treatment of Employer’s defined benefit plan during restricted period
4) Income inclusion for offshore trusts and employer’s financial health
5) Interest on tax liability payable with respect to transferred property

(c) No inference on earlier income inclusion or requirement of later inclusion

(d) Other Definitions and Special rules
1) Nonqualified deferred compensation plan
2) Qualified employer plan
3) Plan includes arrangements, etc.
4) Substantial risk of forfeiture
5) Treatment of Earnings
6) Aggregation rules
7) Treatment of Qualified Stock

(e) Regulations

You can refer to the Cornell Law School for more details on the law at https://www.law.cornell.edu/uscode/text/26/409A.

Why do you need 409a Valuation?

Now that you are clear about what Section 409A is about, how do you know if you need a 409A valuation or not? Well, the IRS usually requires companies that are planning to issue or that have issued option grants to get a 409A valuation done. This is important so that the company can calculate their price per share while maintaining a safe harbor status. Another reason is for startups and their founders to be aware of this rule so that the beneficiaries (shareholders) could avoid violating any of the 409A rules and paying large penalty fees.

Therefore, it’s better to spend time to find a suitable 409A provider to help you with your company valuation. In fact, for you to get the safe harbor status, you will need to have the 409A valuation performed by an independent third-party company.

When do I need a 409a Valuation?

As mentioned above, you need to get a 409A valuation before you issue your first share option. Also the 409A valuation has a 12-month validity, so one needs to be done every year to update your company’s share price.

A 409A valuation might also be needed in case of a material event that takes place before the 12-month validity period. A material event is something that could significantly affect the stock price of the company. The most common kind of material event that companies encounter is a qualified financing round.

Qualified financing round could be a significant sale of preferred equity, common shares, or convertible debt to institutional and independent investors at a negotiated price. Other important events to trigger a 409a valuation could also include a large secondary sale of common stock, divestitures, acquisitions, strategic pivots of business models, and largely missing or exceeding previous 409A financial projections.

To summarize, the times for a 409a valuation include:

  • You need your first 409A valuation when you are about to issue your first common stock options.
  • When your company grows, you should get a valuation done every twelve months or after any material event.
  • In case you are approaching an acquisition, merger or IPO, you might need to get the 409A valuation done for any external audits.

By having your 409A valuation performed on time, you can secure a safe harbor status for your company.

But, how much does a 409A cost?

The cost of getting a 409A valuation can vary from $1,000 to $7,000 based on your company’s history, the 409A valuation methods used, and the person/agency doing the valuation. Regardless of the reason, it is important that you select an independent and reputable provider. There are also providers who offer a subscription model instead of the one-time fee.

What is 409a Safe Harbor?

The safe harbor status of a 409A valuation means that you have some protection during an IRS audit. If you have a 409A valuation done for your company, the IRS would generally accept the stated company value unless they are able to prove that the valuation is “grossly unreasonable.” There are three kinds of safe harbor methods set by the IRS for getting the FMV of the private company’s common shares. These include:

  • Binding Formula Presumption
  • Illiquid Startup Presumption
  • Independent Appraisal Assumption

Out of these safe harbor methods, the most common one is the Independent Appraisal Presumption. In fact, this method is used by 99% of private companies. By using this method, an independent appraiser uses the traditional methodologies and performs the 409A valuation for your company. The independent appraiser also needs to be a third-party and not someone who works in the company or is a close friend of the founders or board members.

How do you get a 409A Valuation?

Now that you know what a 409a valuation is and why you need it, let’s move on to understand how you can get one done. There are three options for how you can get a 409A valuation for your company. These include:

  • Do it yourself. The first option is to perform the 409A valuation yourself for your company. The advantage of this is it saves you money rather than paying a business valuer to do it. However, its riskier as the valuation won’t have safe harbour status, and it’s more prone to mistakes. You also increase your risk of an IRS audit and possible penalties for your shareholders.
  • Use software. This option is just like the one above, except the valuation is done using software to calculate the FMV of the company. However, it still has its own risk, as there is no safe harbour status for software generated valuations.
  • Hire a firm. The last option is to hire a firm to perform the 409a valuation. As this option comes with a cost, it also offers you more protection as it has safe harbour status. This reduces the risk of an audit and the burden of proof is on the IRS. The valuer would also have more experience with assessing the value of your firm.

In short, choose the right option and hire a firm to get your IRS Section 409A valuation done properly.

What are the documents needed for the 409A valuation?

If you have selected an independent appraiser for your 409A valuation, you will need to begin collecting all the relevant information for the valuation firm. Although the list of documents will be similar for most valuation firms, a few things will be different.

To prepare for this, here is a list of the documents you need to gather:

#1 Company details

  • Name of your CEO
  • Updated Articles of Incorporation
  • Name of your legal counsel
  • Name of your external audit firm, if applicable

#2 Fundraising and options

  • Your company presentation, executive summary, or business plan
  • The number of options you expect to issue in the next twelve months
  • The most probable timing of a future liquidity event

#3 Industry information

  • Your industry
  • Relevant public comparable companies. Many 409A valuations rely on some form of comparison to any publicly traded company when determining the FMV of a private company.

#4 Company financials

  • Last 3 years of financial statements
  • Non-convertible debt amount
  • Cash burn and runway
  • Forecasted EBITDA for the next 12 months (from the Valuation Date) & the next 2 calendar years
  • Forecasted revenue for the next 12 months (from the Valuation Date) & the next 2 calendar years

#5 Additional details

  • If there has been any material event that has taken place before the 409A valuation, or if any has taken place in the history of the company, you will have to share the details of this for your 409A valuation.

In short, you will have to share the above documents with your 409A valuation provider. That is when they will begin to perform the valuation for your company.

What are the 409A valuation methods?

Once everything is in place, it is time for the valuation provider to start with the 409A valuation. There are three main 409A valuation methods used for getting the FMV of the shares of a company. Using one of these three methods, the valuation provider tries to offer the lowest strike price for your company’s shares. This is to reduce the tax burden on the shareholders when receiving the company’s equity.

In fact, there are many methods in the market used for 409A valuations, but these three are the most commonly used by business appraisers:

1. Market Approach

Out of all the three methods, this is the most common method used for larger corporations or those looking to raise new seed funding. This method takes similar public companies or data available from private companies, and compares their financial information to derive the company’s valuation.

2. Income Approach

In case the company has a good amount of revenue and a positive cash flow, that is when the income approach is used by the valuation provider.

3. Asset Approach

The asset approach is used mostly for the early stage companies that have not yet raised money and do not generate revenue. As per this approach, the total asset value of the company is determined to get the value of the company.

Find out more information on the 3 methods of company valuation here.

Penalties

Most 409a valuations that follow the common valuation methods would not be subject to penalties by the IRD. But if it doesn’t follow the rules as per IRS Section 409A, then the company may be subject to penalties. These penalties would be levied on the option holders, be it the employees, investors or shareholders.

In short, the mistake would be from the company and the penalties would be paid by those getting the options. To avoid such issues, you need to find a reputable third-party firm that can offer you with the right 409A valuation. If not, the penalties can be strict including an immediate tax on the vesting, an additional tax of 20%, and penalty interest.

Although many companies do not have to face an audit, the IRS still reviews company valuations to ensure enforcement of the law. If your company becomes successful and you are close to an exit (IPO or M&A), you may face an audit in the future. Hence, it is better to have a reputable firm helping you with this. Eqvista is one such firm that can help you.

How can Eqvista help you?

After reading this article, you now know that a 409A valuation is very important for your company, especially if you are giving out options or taking up new investments. And with all the information provided, you can now make an informed decision about your 409A provider. In fact, Eqvista offers 409A valuation services. We have an expert team ready to help you learn more about the value of your company.

Get in touch with our team and schedule a consultation with our valuation experts. We can discuss about your company and how to go about getting a 409a valuation done in no time! You can also easily share the details of your company’s cap table on the Eqvista platform.

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