Issuing stock options to employees as a form of compensation is a great option for early-stage companies. The following are a few benefits to issuing stock options:
- Aligns the interests of your employees to your firm
- Helps attract and retain talent
- Recognized incentive/reward
- Allows you to remain competitive with peers
By giving stock options to your employees, you can share the future upside of your company’s growth. The employee will be given an option with a pre-determined strike price that can be “exercised’’ into common ownership. As the company's value increases, so does the upside of the option holders.
But before you rush out and issue options, it’s important that you comply with all legal requirements. IRC Section 409a of the U.S. tax code has a few requirements business owners should know. The following questions and answers are designed to provide greater context for business owners who are uncertain about how best to proceed in order to be compliant.
What do Business Leaders need to know about 409A?
Due to IRC Section 409a, created through the American Jobs Creation Act of 2004, employers cannot simply issue options with an exercise price that “feels right.” The code deals more broadly with deferred compensation, but typical stock options are considered to be deferred compensation and as such must be issued at fair market value to avoid tax consequences at the time of the grant. Ultimately, the U.S. Government wants its share of taxable income at the time stock options are exercised.
Why do I need a 409A valuation?
Within the United States, equity compensation plans require businesses to ensure the targeted exercise price is supported by the Fair Market Value (FMV) of a business’s common stock as of the option grant date. According to the IRS Revenue Ruling 59-60, FMV constitutes, “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” So, to issue compliant stock options, you need to have valuation documentation that supports the FMV at the time of the grant.
Simply put, businesses are required to offer deferred compensation to their employees at or above fair market value. Overall, the IRS takes rule 409a seriously. Undervaluing the company, or not having a valuation report to comply with 409a, can lead to severe penalties imposed by the IRS. Some of these penalties include, but are not limited to, an additional 20% penalty for the deferred compensation in question. In contrast, overvaluing the company means you are issuing stock options to employees that aren’t very motivating—the whole point of issuing stock options. A company issuing non-qualified stock options at a price below FMV could create a taxable event for employees. Determining the FMV is a tightrope walk for providers, but an experienced provider understands how to maneuver across and deliver reports that satisfy both parties.
Can I perform the valuation myself?
If a company desires to issue options, or any other form of deferred compensation to its employees, it is recommended that the company seek an expert advisor who will give a fair and highly-defensible assessment. If a company is young enough, small enough, and happens to have someone internal to the company with the right amount of experience (generally understood to be five years of experience with valuations), then that internal expert can produce a valuation report themselves. On the upside, you save money on a valuation report. The downside is that you generally don’t have access to the same databases, court rulings, and standard practices for producing an IRS-compliant report. So, if a company has the right person in the management team or on their board, doing it yourself is an option, but it does come with issues to consider.
Are there any circumstances when I do not need to do a 409A valuation?
There are a few, very limited sets of circumstances when performing a 409a may not be necessary. The most notable of these is when companies are not issuing deferred compensation to their employers. Additionally, a recent transaction of a company’s underlying assets may be sufficient evidence for a fair market value price. However, due to the penalties associated with non-compliance, we feel that it is best to err on the side of caution and to consult a valuation expert whenever possible.
What safe harbors are associated with this section of the tax code?
There are certain safe harbor guidelines that make a valuation more defensible. Most notably, a valuation will generally be presumed to satisfy the requirements of the tax code if it is performed by an independent, qualified third party with relevant experience. According to the IRS, a firm should have significant experience, which the IRS defines as at least five years of relevant experience in business valuations. However, it should be noted that in order for a valuation to be considered reasonable, it still must consider all facts and circumstances relevant to the valuation of the business.