How does a 409A Valuation Ensure Tax Compliance?

In the pursuit of hiring talented executives and conserving cash, stock options can lead to win-win situations for everyone involved. However, hefty penalties are involved when you do not comply with tax laws.

With stock options, the tax liability depends primarily on the purchase price. You must derive this price by conducting a 409A valuation to establish the fair market value (FMV) of your company’s stock. Non-compliance with the requirements of 409A valuations might be seen as an attempt to misreport income and evade taxes. This can expose your employees to serious tax penalties.

Also, legal disputes between you and your employees may arise out of 409A valuations due to a lack of transparency and disagreements regarding accuracy, timing, and methodology. If your employee believes you failed to comply with the regulations, they might seek legal recourse.

So, you must understand how to ensure tax compliance of your stock options with 409A valuations.

409A Valuation and Tax Compliance

Through a 409A valuation, your company can secure a safe harbor status. If you attain a safe harbor status, in case of an IRS audit, the onus would be on the IRS to prove that your valuation was ‘grossly unreasonable’ and not on you to prove that your valuation was reasonable. 

The IRS presumes that your valuation was reasonable. Once you attain the safe harbor status, you can utilize stock options in your hiring plans with peace of mind.

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

Needless to say, 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.

First, you must comply with the IRC when granting stock options. Then, you must report these compensation arrangements in your financial statements as per the relevant accounting standards. Ensuring compliance with the relevant accounting standards is the first step towards transparency. Transparency ensures that your audits go smoothly without arousing suspicion and leading to adverse tax consequences.

How can you make sure your valuation stays compliant with tax legislation?

Following are some measures you can take to ensure the tax compliance of your valuations:

Understand Tax Regulations

Employers must understand the relevant sections of the IRC before granting stock options. To ensure that you are interpreting the IRC correctly, you can rely on Treasury Regulations and Revenue Rulings. Misinterpretations can lead to penalties and legal disputes as in the case we discussed earlier.

There are various exceptions to Section 409A that you must make a note of. For instance, suppose you defer an employee’s compensation but pay it within 2 ½ months after the taxable year in which you deferred the compensation. Then, section 409A will not be applicable.

Understanding such exceptions will enable you to structure compensations to maximize tax savings.

Selecting Appropriate Valuation Methods

You can choose one of three valuation methods for tax purposes. The IRS prescribed these methods to establish the fair market value (FMV) of your common stock. By adhering to these methods, you can attain a safe harbor status. Then, the onus will be on the IRS to prove that your valuations were ‘grossly unreasonable.’ Then, you can use stock options in your hiring plan with peace of mind.

You can use the following valuation methods to attain a safe harbor status

• Independent appraisal presumption: The IRS will presume a qualified independent appraiser’s valuation as reasonable if 12 months have not passed and no material events occurred from the date of valuation to the date of granting stock options.
• Binding formula presumption: If a single formula is applied consistently in the valuation and all binding agreements (agreements to buy or sell stocks), then the valuation is presumed reasonable. 
• Illiquid startup presumption: Private companies, with less than 10 years of vintage, not anticipating an IPO or a change of control event within 180 days can use this method. However, you must have significant knowledge and experience in performing such valuations. You must perform such a valuation in written form 12 months before issuing a stock option. Only then there is a chance of the IRS presuming such a valuation as reasonable.

Engaging Qualified Professionals

The independent appraiser presumption method is the cheapest and most convenient way to attain safe harbor status. At a very low cost, you can get a qualified valuer to perform the valuation for you. They can also advise you on the frequency of valuations to ensure tax compliance of your valuations. 

If your company is at a stage where 409A valuations are frequently needed, consider signing up for Eqvista’s annual plans that offer unlimited 409A valuations.

Documentation and Record-Keeping

In all aspects of tax compliance, accurate and detailed documentation and record-keeping is key and valuations done to grant stock options are no exception. When you hire a qualified valuation provider, make sure you receive a written report from them. 

By simply maintaining a timeline of material events and 409A valuations, you can avoid granting stock options in a non-compliant manner.

Staying Up-to-Date with Tax Regulations

As businesses evolve, so do tax regulations. At times, the IRS might revise its position on certain sections of the IRC. You must not miss such details as they can have devastating tax consequences.

Proactive Communication with Tax Authorities

If you have any doubts about the interpretation of any sections of the IRC, you can seek clarification from the IRS. The fee for opinion and advisory letters is nominal when compared to the tax consequences. If your company satisfies certain conditions, you may be exempted from the fees.

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.

Ensure tax compliance with Eqvista’s reliable 409A valuations!

Due to the complexity and breadth of tax laws, even a taxation expert will prefer to specialize in a specific type of tax. It can be a nightmare to keep up with all the changes and updates to all sections of the IRC. At the same time, hiring a 409A taxation expert as a full-time employee can be expensive.

Additionally, internal valuations are subject to higher levels of scrutiny from the IRS. To solve all these pain points, Eqvista offers reliable 409A valuations for all stages of a startup’s lifecycle.If you would like to know more about Eqvista’s 409A valuations, get in touch with us on this page.