What is IR Code Section 409A?

Caution: The discussion below is not comprehensive.  You need to consult your own attorney as to the specifics of Section 409A and as it applies to your situation.

These days anyone involved with equity compensation will hear a reference to “Section 409A”.   It is a reference to Section 409A of the Internal Revenue Code, part of the American Jobs Creation Act of 2004.

Employees and independent contractors participating in a nonqualified deferred compensation arrangement which fails to comply with Section 409A will be subject to:

  • income tax on vesting
  • an additional excise tax equal to 20% of the amount deferred
  • interest on the underpayments if the tax on the deferred amounts is not paid when first includible in income at a rate equal to the underpayment rate at the time of vesting plus 1%.

 Incentive stock options (“ISOs”) are exempt from Section 409A.  However, one requirement of ISOs is that the exercise price at the time of grant is no higher than the market value of the common stock.   So, if it is determined that the fair market value of common stock is greater than the exercise price at the date of grant, the option will not be exempted from 409A.  Therefore, the steps necessary for valuing a nonqualified stock option are also applicable to incentive stock options.

The company may protect itself and its option recipients from the negative consequences of Section 409A by doing the following: (1) make sure that the exercise price is no less than fair market value on the date of grant, and (2) insure that the option does not include any other feature for the deferral of compensation other than deferral of recognition until the exercise or disposition of the option or, if the stock received on exercise is restricted, until the vesting of that stock.    An example of a deferred compensation feature would be an option that allowed the employee at the time of exercise to elect to take cash amount equal to the option spread as deferred compensation over time.   This would render the option subject to Section 409A. 

With respect to setting the exercise price at fair market value, it is important to keep in mind that the board’s  determination of fair market value must be defendable to the IRS (and in the event the company goes public, to the SEC, as discussed below).   A simple board resolution stating the fair market value of the company is insufficient.  The fair market value of private company stock or equity unit must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company.

The factors to be considered under a reasonable valuation method:

  • the value of tangible and intangible assets;
  • the present value of future cash-flows;
  • market value of similar entities engaged in a substantially similar business; and
  • other relevant factors such as control premiums or discounts for lack of marketability.
There is a presumption that the valuation is reasonable if it is based on (a)  an independent appraisal prepared no more than 12 months before the transaction date, or (b) a written report by a person “with significant knowledge and experience or training in performing similar valuations”.  To rebut the presumption, the IRS must show that either the valuation method, or the application of the method, was “grossly unreasonable.”

These days, boards of directors of many venture-backed companies are relying on periodic formal valuations done by financial firms.   That may not be a realistic solution for an early stage company.  In such cases, the company can minimize its risk under Section 409A if it can find an adviser, CFO, or someone else who can qualify as someone with “significant knowledge and experience or training in performing similar valuations”.  Often very early stage companies have developed some software code but have no sales, sales contracts, or significant value in their trademark.  In such cases the reasonable replacement cost of the software code is one metric that might form the primary basis for the valuation. 

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