Section 409A Requires An Independent Valuation

In late 2004, Section 409A was added to the IRS Code, creating new restrictions on deferred compensation agreements. In Fall 2005, the IRS issued proposed regulations concerning the new code. Section 409A targets “non-qualified deferral compensation plans,” placing restrictions on such plans, including distribution and acceleration limitations, and non-compliance penalties. IRS Code Section 409A applies to all compensation deferred after January 1, 2005 and the first audits began in 2007. 

The following types of plans are vulnerable to 409A: 

• Nonqualified stock options (NQSOs)

• Employee stock purchase plans

• Stock Appreciation Rights (SARs)

If plans do not comply with 409A, the following penalties apply:

• All amounts deferred for the participant (including earnings) are included in gross income and taxed immediately.

• Interest, at the underpayment rate plus 1%, is imposed on the underpayments measured from the date of deferral.

• A 20% additional tax is imposed upon the amount of compensation.

One of the important features of 409A is the provision that non-qualified stock option grants and stock appreciation rights that meet a fair market value requirement can be exempt from taxes and penalties when: the exercise price must not be less than the fair market value of the underlying stock on the date of the grant. 

The company issuing the NQSOs or SARs needs to ensure that deferred compensation is not being granted at a “discount” to fair market value, which would expose the grantee employees to unexpected taxes, penalties, and interest on the deferred compensation. The penalties under Section 409A place considerable importance on establishing that deferred compensation (NQSOs and SARs) has been issued at fair market value.

A business valuation by an independent valuation expert can help companies avoid the restrictions and penalties incurred under 409A. An independent appraisal removes the burden on the company and option holders and places it on the IRS to prove that the valuation is “grossly unreasonable.” It also creates a compliance solution for the company and minimizes significant exposure to the business’ board of directors and executives by providing qualified opinions of value.

 Moreover, it behooves the company’s executives and board of directors to ensure that the methodology and procedures for determining fair market value will withstand third-party scrutiny by the IRS. For private companies and investors in privately held firms, an independent appraisal by a qualified valuation expert can assist in avoiding adverse consequences of Section 409A.