IRC Section 409A & Valuation of Equity Incentives

Internal Revenue Code Section 409A ("Section 409A"), which was enacted in October 2004 as part of the American Jobs Creation Act of 2004 and generally became effective on January 1, 2005, dramatically changed the rules governing “non-qualified deferred compensation arrangements” and impacted a wide range of plans and arrangements, including bonus arrangements (annual, performance-based, multi-year, and contingent signing bonuses); severance plans and arrangements; individual employment agreements; discounted stock option plans and stock options with additional deferral features; and stock appreciation rights, phantom stock, and restricted stock unit plans.  Section 409A imposes significant restrictions on distributions, deferrals and changes in the timing of election and in the form and timing of benefit payments and calls for a 20% additional tax on the recipient (as well as penalties similar to interest) unless specific requirements set out in Section 409A and the related regulations are satisfied. As a result, companies have been required to undertake substantial reviews of their covered equity compensation plans and arrangements and consider the need to make changes in their policies and procedures including ensuring that the material terms of all non-qualified deferred compensation arrangements are set forth in writing.

One area of concern for private companies has been the impact of Section 409A on stock options since, if such options are identified as having been granted at below “fair market value,” they would be treated as non-qualified deferred compensation and thus subject the grantee to taxation when the options vest as well as triggering the additional 20% penalty. With respect to non-statutory stock options, companies must verify that they have been granted at an exercise price at (or above) fair market value. With respect to options that are intended to qualify as incentive stock options (“ISOs”), companies must double-check to confirm that the stock that will be issued upon exercise of the ISO was properly valued at the time the option was granted to conform to the ISO requirements and thus fall outside of the restrictions that might otherwise apply under Section 409A.

In response, such companies must be prepared to clearly and carefully document the steps taken to value employee stock options including the factors taken into account by the board of directors in determining the fair market value of the underlying common stock at the time the decision was made to grant the option. The Regulations relating to Section 409A require employers or other service recipients to use a “reasonable valuation method” to determine the value of stock underlying compensatory option grants. While, in general, reasonableness will be based on the relevant facts and circumstances as of a specified valuation date, the IRS has announced that it intends to consider the following factors to test the reasonableness of a proposed valuation method: the value of the company's tangible and intangible assets; the present value of the company's future cash flows; the market value of stock or equity interests in substantially similar businesses that can be determined readily by objective means; the effects of any control premiums and/or marketability discounts; and/or whether the proposed valuation method is used for other material purposes by the company, its stockholders, or creditors; and other relevant factors.

Private companies are not be required to incur the expense of obtaining an independent valuation from an outside expert; however, they nonetheless should be prepared to demonstrate that input has been received from persons with significant knowledge and experience in valuing illiquid securities (e.g., a board member affiliated with a venture capital company or senior in-house finance or accounting personnel with valuation experience).  Such companies may, of course, obtain a “Section 409A” valuation report from an outside expert and incorporate that report into the minutes and related resolutions for meetings of the board of directors and/or audit or compensation committees at which option grants were considered and approved.  See Specialty Form appearing at § 171:337 in Business Transactions Solutions on Westlaw Next.

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