IRC §409A
IRC §409A applies to a wide variety of deferred compensation plans and techniques, including employee options to purchase common stock. The following comments are limited to the aspects of §409A that pertain to stock options.
Basic principles.
If a company grants an option to an employee or other service provider to purchase the company’s common stock and the option exercise price is lower than the fair market value of the underlying common stock when the option is granted (a "discounted option"), that option is subject to unfavorable income tax treatment. It doesn’t matter whether the discounted option was intentional or inadvertent – consequences are the same. This creates an awkward situation for private companies because there is no active market to serve as a point of reference for determining the value of private company equity securities on a regular basis.
Tax consequences.
Unlike other options, discounted options are subject to the following tax treatment:
- Discounted options are taxable as they vest (unlike other options which are not taxable until they are exercised at the earliest);
- In addition to the normal income tax applicable to stock option profits, a 20% “penalty” tax is added for discounted options (at the Federal level; some states impose additional penalties);
- The company that granted the discounted option is also obligated to withhold income taxes from the holders of discounted options as they vest and the income is subject to other employment taxes such as FICA.
Avoiding §409A tax consequences.
The §409A regulations offer the following solutions for private companies that want to avoid the adverse tax consequences that arise from discounted options:
- For companies that are less than 10 years old and are not expecting a liquidity event in the near future, the fair market value of their common stock can be determined by preparing and documenting an internal valuation analysis. The individual preparing this analysis need not be independent from the company but must have at least five years of relevant experience in business valuation, financial accounting, investment banking, private equity, secured lending, or other comparable experience.
- For any company, the fair market value of the common stock can be determined by a qualified independent appraiser.
A safe harbor is created for stock options that are granted with exercise prices that equal or exceed the fair market value determined in the specified manner. To continue the safe harbor for future option grants, the fair market value of the common stock must be determined at least annually (more frequently if something material to value changes in less than a year).
FAS 123(R)
FAS 123(R) (Statement of Financial Accounting Standards No. 123 (revised 2004) Share-Based Payment) specifies the accounting treatment under U.S. GAAP for stock options and other stock rights issued in exchange for goods or services.
Basic principles.
If a company grants a stock option to an employee or contractor, the stock option is an element of compensation for the services being rendered by the employee or contractor and therefore needs to be treated as compensation expense in the company’s financial statements.
Quantifying compensation expense.
In order to calculate the amount of compensation expense to be recognized in each period, the fair value of each stock option must be determined. In addition, the expected life of each option and the forfeiture rate for all options must be estimated. The fair value of each option is amortized (i.e., recognized as compensation expense) over the option’s expected life.
Determining the fair value of a stock option.
The fair value of a stock option is calculated using a Black-Scholes option model (or similar financial models). The Black-Scholes model calculates the value of the option based on the value of the underlying stock, the exercise price and time to expiration of the option, the estimated future volatility of the company’s stock and the risk free interest rate. Because it usually isn’t possible to estimate the actual volatility of private company stock, the historical volatility of an appropriate industry sector is often substituted as a measure of volatility when valuing private company stock options.
Similarities and differences
The same general valuation methods and principles are applied to estimate the value of private company stock for purposes of FAS 123(R) and IRC §409A. However, there are also some notable differences that need to be considered in addressing valuations for each of the requirement:
- § 409A is a federal income tax requirement which means the valuation is subject to scrutiny by the IRS. FAS 123(R) relates to US GAAP which means the valuation is subject to scrutiny by the company’s independent audit firm in connection with the company’s annual financial audit.
- Technically, the standard of value for FAS 123(R) is “fair value” while the standard of value for §409A is “fair market value”. These standards appear to be very similar, but there are differences that should be considered and reconciled in the valuation process.
- The independent audit firm places a great deal of emphasis on the guidance provided by the AICPA Practice Aid regarding Valuation of Privately-Held-Company Equity Securities and other GAAP fair value principles. The §409A regulations focus on generally accepted valuation methods and make no reference to the AICPA Practice Aid.
- For IRC 409A, if a valuation is conducted by a qualified appraiser and then challenged by the IRS, it is the IRS that must show that the results were grossly unreasonable: If you do not agree with the IRS’ conclusions on that subject, you have the right to have the issue decided by an independent party (a judge). For FAS 123(R), the standard is more subjective and the audit partner and audit firm are the court of last resort. If they do not agree with the conclusions reached in the valuation report, they may insist upon changes before finalizing the audit.
It is usually advisable to obtain a valuation that is suitable for purposes of both IRC §409A and FAS 123(R). To do so, care must be taken to select a valuation consultant that has been successful preparing and defending valuations for both purposes.