What is IRS Section 409A and how does it apply to me?

Why should you care about IRS 409A?

As an employer, when you give your employees any compensation (e.g. payroll) both you and the employee pay taxes. Usually, your payroll provider takes care of these relevant taxes (we use JustWorks and they're great). However, if you compensate your employees and contractors with something that is not cash, the IRS requires you to figure out the cash equivalent value of the consideration paid so any tax implications can be calculated.

For example, if you give your employee 10,000 shares of stock, you have to figure out what is the cash-equivalent value (referred to as the “Fair Market Value” or “FMV” in IRS language) and have your employee pay taxes on the value received. Let’s say the FMV of your share is $1.00. Your employee will owe 10,000 * $1.00 * their tax rate.

However, there is a workaround: if you offer your employees the option to buy your shares at $1.00 when the underlying share is worth $1.00 (i.e. if you offer options with a Strike price equal to the FMV), then the IRS effectively says “you are not transferring anything of value today, so no one owes taxes at the time of grant”). If, however, you state that your shares are worth $0.2 when they are really worth $1.00, then your employee will be subject to the Section 409A of the Internal Revenue Code section as they have received a form of compensation.

How can I figure out the FMV of my common shares?

The common stock of publicly traded companies, with analyst coverage, audited financial statements, and large number of market participants are still subject to constant change. It would be infinitely more difficult to determine the exact value of a common share of a private company at every single point in time without undue burden. Given this practical issue, the IRS provides certain “safe harbor” methodologies for estimating the FMV of the common shares:

  • Independent Appraisal Presumption: A valuation that is prepared by a qualified independent appraiser. An independent appraiser’s compensation is fixed and not dependent on the result of the appraisal. The valuation is presumed to be reasonable if the values the stock no earlier than 12 months prior to the applicable stock option grant date, and if there has been no material changes since the valuation date. Under this approach, and assuming all requirements are met, the burden of proof is on the IRS to show that the valuation was “grossly unreasonable.”
  • Illiquid Startup Presumption: Instead of engaging an external, qualified, independent appraiser, the company may choose to perform the valuation in-house if:
    • The company is private and less than 10 years old,
      • Is not anticipating a sale, IPO or change of control within the next 12 months, and
      • The stock is not subject to call or put rights, and
      • The person performing the valuation has significant knowledge and experience or training in performing similar valuations.
  • Binding Formula Presumptions: Usage of a single formula that is marked to a tangible benchmark, such as Sales, EBITDA, or Net Income, applicable across all binding agreements (buy-sell agreement, grant of stock or options, loan conversions into stock, etc).

If, however, the valuation approach is outside of the above noted “Safe harbor”, then the burden of proof is on the taxpayer. Once section 409A applies, they include but are not limited to an immediate tax on vesting, an additional tax of 20%, and penalty interest.

Given the complexity and nuances in following the IRS guidelines for estimating FMV, most private companies use the independent appraisal method. The team at Preferred Return has delivered over 3,500 409A valuations, and we can deliver your draft report within 3-5 business days. If you want to talk more, just schedule a time using the link here and we'll give you a call shortly.

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