If you have equity as part of your retirement or executive compensation plans, you likely need a 409A valuation. The need for a valuation also applies if you are preparing to issue equity (equity grants or stock options) or synthetic equity (stock appreciation rights or phantom equity). In all of those cases, an independent 409A valuation of the company should be obtained to ensure the price meets the IRS’ requirements.
Unlike a valuation for a sale or potential investment, 409A valuations focus on the current fair market value (“FMV”) of a company’s equity. This type of valuation does not factor in a company’s future potential performance. The independent appraisers review the financial performance of the company to determine what it is worth per share for this specific moment in time. A 409A valuation determines a private company’s FMV which is then used to set the strike price for employee stock options or the baseline value of synthetic equity awards.
Section 409A of the Tax Code contains the requirements that must be followed when valuing private stock. Section 409A is designed to restrict the ability of taxpayers to choose when to recognize income. Requiring the FMV be set according to specific guidelines helps with this restriction by setting the valuation floor for both options and synthetic equity grants. Failure to follow the 409A rules can result in a failure to price equity correctly, which, in turn, can lead to IRS penalties.
Independent valuation firms all approach a 409A valuation slightly differently but in general it is a multi-step process. First, they must determine the value of the company. Then determine how that value is allocated across the equity issued by the company to arrive at a per share price. Finally, valuation firms will generally apply a marketability discount to the shares to account for the restricted nature of privately held equity. Within each of these steps there are several accepted methodologies that may be used. A company should discuss how and why a valuation methodology may or may not be used with their valuation firm.
Use of the 409A valuation further helps companies and recipients defend themselves against IRS scrutiny. By using the 409A valuation methodology correctly, the FMV of equity-based compensation is deemed reasonable and defensible under IRS regulations. Under the 409A rules, a valuation is presumed reasonable if the stock was valued within 12 months of the grant date and no material change has occurred between the valuation date and the grant date. If these requirements are met, the burden is on the IRS to prove the valuation is “grossly unreasonable.”
When the valuation does not meet the 409A requirements, it can cause the equity-based compensation to fall outside of 409A and subject the taxpayer to penalties. These penalties include (a) immediate taxation of all deferred compensation for all years; (b) accrued interest being due on the amounts; and (c) an additional 20% tax on the deferred amounts.
If you have any questions about valuing your equity-based compensation plans or employee benefits in general, please contact any of Bricker Graydon’s employee benefits team.
