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Focus on Life Sciences & Technology: Staying Safe - The Ins & Outs of IRC 409A Safe Harbor Provisions

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Equity based deferred compensation can be a great tool for companies looking to attract, retain and incentivize talent. It is especially potent for early stage companies who may not have the funding or cash flow to pay its employees at a market rate. Use of deferred equity compensation, such as stock options and stock appreciation rights (SARs) does carry some risk.
December 19, 2016

Equity based deferred compensation can be a great tool for companies looking to attract, retain and incentivize talent. It is especially potent for early stage companies who may not have the funding or cash flow to pay its employees at a market rate. Use of deferred equity compensation, such as stock options and stock appreciation rights (SARs) does carry some risk. One such risk is non-compliance with Internal Revenue Code section 409A (409A). 409A covers non-qualified deferred compensation plans such as non-statutory (or non-qualified) stock options and SARs (collectively “stock rights”).

Under 409A, recipients of stock rights are taxed on the full value of the compensation award as soon as it vests; but that is not all, a 20% tax penalty can also be imposed on the full value of the stock right at the same time if certain requirements are not met. These tax implications faced by recipients of stock rights can significantly reduce the value and desirability of such compensation plans. However, if structured and implemented properly, awards of stock rights can avoid 409A penalties and be effective in helping companies attract, retain and incentivize top talent.

Among other requirements beyond the scope of this article, 409A provides that stock rights can be excluded from the taxes and penalties if certain valuation requirements are met. If the exercise price of the stock right is greater than or equal to the fair market value of the underlying stock on the date granted there will be NO penalties under 409A (assuming other basic requirements are also met). The exercise price for an option is simply the price at which the recipient can purchase a share of the underlying stock at some point in the future. The exercise price of a SAR is the base stock value from which the appreciation in value is measured. Therefore, all you need to do is establish and support a measurement of fair market value on the stock underlying the stock right. If you’re a publicly traded company with observable stock prices this seems easy enough, but what if you are a privately held company?

For privately held companies, the measurement of fair market value of the underlying stock associated with the grant of stock rights needs to be established through a valuation. The Internal Revenue Service (IRS) has three basic requirements for the valuation:

  1. The valuation must be within twelve months of the grant date (The valuation date for the valuation must either be on the grant date or within the preceding twelve months)
  2. The valuation must be in the form of a written report
  3. The valuation must be performed by a qualified individual

If these requirements are satisfied the IRS will accept the valuation as reflecting the fair market value of the stock, “rebuttable only by showing that the valuation is grossly unreasonable.”1 There are some “safe harbor” options that privately held companies can take advantage of to help ensure that valuation requirements are met. Safe harbor presumption applies when the valuation is based upon:

  1. A generally applicable repurchase formula
  2. The opinion of a qualified individual within the corporation, or
  3. The valuation is based upon an independent appraisal

A repurchase formula can be used to value the underlying stock if it would result in an estimate of fair market value under IRC Section 83. However, there are some other restrictions and considerations that limit the ability to use this safe harbor. These restrictions include:

  1. The requirement that if the employee receiving the stock right wants to sell the underlying stock they must offer to sell at the formula value
  2. The entity buying the stock from the employee must also offer to sell at the formula value
  3. Most other stockholders are also required to offer stock for sale at the formula value in many instances. There are few exceptions to this requirement.

A qualified individual within the corporation can also perform the valuation IF the corporation is less than 10 years old and is not planning on experiencing a change in control in the next 90 days or having an IPO within the next 180 days. However, the individual performing the valuation must be qualified to perform the valuation based on significant knowledge, experience, education or training. This “generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the [company] operates.”1

Finally, a corporation can retain an independent appraiser to perform and provide the valuation. So long as qualified appraiser is engaged, there are few other considerations, concerns or restrictions that apply under this safe harbor. Using an independent appraiser may be the safest of the safe harbors.

Noncompliance with IRC section 409A can be costly. In addition to taxation on the value of the award, the recipient will also be penalized by 20% of the value of the reward. These taxes and penalties can significantly diminish, if not completely eliminate, any of the perceived value received in the form of stock rights. By ensuring that the grant of the stock right is at an exercise price or base appreciation level equal to or greater than the current value of underlying stock you can avoid the taxes and penalties associated with deferred equity based compensation.

Rely on one of the safe harbor provisions such as retaining an independent appraiser and update the valuation annually. If you adhere to these valuation guidelines you can avoid some of the potential 409A pitfalls and effectively utilize deferred equity compensation for attracting, retaining and incentivizing talent.

RubinBrown has a dedicated Life Sciences & Technology specializing in serving life sciences and technology based companies, including advising startup and early stage companies. Solutions include, valuation services for financing and transactional purposes, 409A compliance, portfolio company valuations and fair value for financial reporting. Business advisory and consulting services include consulting on intellectual property (IP) value, management and strategy.

 

Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.

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1 Internal Revenue Bulletin: 2007-19. May 7, 2007

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