A 409A valuation is a report of the total value of all the stock options of a company. IRC 409A is the section of the US tax code containing the tax rules for deferred compensation, which includes stock options. IRC 409A requires you price your stock options accurately compared to fair market value (FMV) or face tax penalties.
When discussing IRC 409A with our clients, we often give this warning: “Pricing stock options below FMV will cause adverse tax consequences for both the issuing company and the option holder.”
The prices of your stock options should at least match, if not exceed, FMV in order to avoid excise taxes under 409A. To be sure your option prices are in a safe range, you may need a 409A valuation report from an experienced outside firm.
The Most Common 409A “Safe Harbor” Valuation Method
The IRS defines what it calls “Safe Harbor” valuation methods for stock options. If you use one of these valuation methods, it can protect you from penalties during an audit.
If a company creates its own 409A valuation report, the IRS can challenge it, requiring the company to prove its valuation methods conform to certain guidelines. However, if a company uses a “Safe Harbor” valuation method in a reasonable way, the IRS generally won’t challenge its valuation.
The simplest and most widely used “Safe Harbor” valuation method is to get an objective 409A valuation from a qualified, expert firm. If you get such a valuation up to a year before issuing stock options, the IRS will assume that it is accurate, saving you from the additional hassle of an audit.
Comprehensive, Low-Cost 409A Valuations
For a basic 409A valuation, the IRS requires an analysis of all the relevant information on the valuation of your company which was available at the time of the report. The IRS also requires the use of a consistent, standardized process.
A 409A valuation may also require an accurate tally of all your tangible and intangible assets, a forecast of your future cash flow, comparisons to the value of similar companies’ options, and more. So, you can understand that many companies choose to hand off this complex task to specialist firms, and the IRS encourages that.
Besides satisfying IRC 409A, your organization might also need to follow the guidelines of ASC 505-50 and ASC 718, part of Generally Accepted Accounting Principles (GAAP). Fortunately, some corporate advisory firms offer a comprehensive, dual-purpose report that satisfies both IRC 409A and the GAAP guidelines.
Although a more general valuation of your entire company can be expensive, prices drop dramatically when you purchase a specialized 409A valuation from an experienced firm. Even a dual-purpose report that adds the GAAP requirements can cost much less than a full corporate valuation.
The IRS can take an expensive percentage of your stock option value through the 409A excise tax. So, using the “Safe Harbor” method of purchasing an objective 409A valuation can actually save you money by protecting you from IRS penalties.