Section 409A of the Internal Revenue Code regulates non-qualified deferred compensation agreements between a corporation (a “service recipient”) and its employees, contractors, board members, etc. (“service providers”). In this article, we’ll take a closer look at IRC 409, it’s history, and the importance of achieving safe-harbor 409A valuations.
The History of IRC 409A
While Section 409A of the IRC has been around since the 1980’s, it’s current iteration was developed in the wake of the Enron scandal. Before Enron went bankrupt in the early 2000’s, a number of employees accelerated payments from their deferred compensation plans. They received millions of dollars ahead before the company’s stock price plunged, leaving thousands of employees with only a small fraction of their retirement savings. With the passing of the American Jobs Creation Act in 2004, the IRS went beyond simply closing the loopholes in Section 409A. They had constructed the intimidating, nearly-airtight legislation surrounding non-qualified deferred compensation we know today.
Understanding IRC 409A
The Internal Revenue Code makes clear distinctions between service recipients (effectively, “employers”) and service providers (effectively, “employees”). The IRS also makes a point of clearing up any ambiguity regarding differences between “qualified” and “non-qualified” deferred compensation arrangements. For the purposes of establishing a broad overview of the topic, you should take non-qualified deferred compensation to mean stock options and appreciation rights. Both options and appreciation rights can serve as an effective incentive for attracting top-tier talent to your company. Deferring compensation, particularly until employees retire and are no longer receiving a salary, can mean receiving payments in a year for which they are in a lower tax bracket. The IRS outlines five requirements stock options and SARs must meet to comply with IRC 409A:
- The exercise price of options and SARs must be equal or greater to the fair market value of the company’s stock at the time they’re granted.
- Incentive stock options (ISOs) and those issued as part of an employee stock purchase plan (ESPP) are exempt—provided they meet the necessary IRS qualifications.
- Stock options and SARs are limited to the company of a service provider’s direct employer or parent companies owning 50% or more of the corporation directly employing the service provider. Under certain conditions, the parent company may have as little as 20% ownership of the service recipient. However, under no circumstances can the direct employer (or parent company) grant service providers options or SARs in subsidiary companies. In other words, businesses can grant non-qualified deferred compensation moving up the chain of ownership, but not moving down the chain.
- Options and SARs can’t be exchanged and their delivery can’t be deferred after they’ve been exercised. There is, more or less, nothing that can be done to modify a stock option or SAR after it has been granted. Upon termination, the right to extend the exercise period is allowed up to either ten years or the original exercise period; whichever is less.
- Stock options and SARs must come from the company’s common stock. Any preferences the options or SARs may provide must pertain solely to liquidation.
These requirements appear, in some sense, to naturally necessitate a 409A valuation. 409A valuations involve an appraisal of the fair market value of a company’s common stock. A thorough, diligent 409A valuation gives the IRS everything it needs to determine that a non-qualified deferred compensation plan is above board.
Requirements of a Safe-Harbor 409A Valuation
In trying to impart an overview of what IRC 409A is and how 409A valuations work, it’s not worth focusing on anything other than the requirements of a “safe-harbor” valuation. Safe-harbor 409A valuations employ a set of presumptions, as outlined in the Internal Revenue Code, for which the IRS must accept the outcomes of fair market value appraisals unless it can prove them to be “grossly unreasonable”. Failing to meet the qualifications of a safe-harbor 409A valuation exposes your company and its employees to the nightmarish risks of non-compliance penalties.
The three presumptions for achieving a safe-harbor valuation are as follows: your valuation must base itself on (a) an appraisal from an independent third-party valuation firm, (b) a generally applicable buyback or “repurchase” formula, or (c) valuations performed by a qualified individual or company at time in which neither the service recipient nor the provider anticipated an IPO or “change of control” event. The third presumption applies only to the illiquid stock of startup corporations. For those interested in learning more, it’s worth noting: the depth of information and minutiae associated with each of these presumptions is bottomless. In fear of falling down a tangential rabbithole in the middle of our overview, we’ll need to move on.
There are, in theory, three paths to achieving a safe-harbor valuation. You can submit your own appraisal with the help of DIY software. This is almost universally considered to be a bad idea. You can also simply do it yourself, provided you meet the IRS definition of a “qualified individual”. It’s not impossible to achieve a 409A valuation by going this route. It’s just substantially riskier and you’ll have no one to blame should you be slapped with non-compliance penalties. The third path to securing a safe-harbor valuation, employing the services of an independent third-party valuation firm, is widely believed to be the safest and most successful option.
Independent Valuations in IRC 409A Safe-Harbor Presumptions
The process of confirming the independence of the firm chosen to perform your 409A valuation sounds like it should be simple. It’s not. Paying for “the real deal” when it comes to independence can be costly. This isn’t necessarily to say that independent 409A valuations cost more; quality ones, sure—but rather, that you’ll be wading through a lot of muddied water when navigating the market for an independent appraisal.
It’s no secret, IRC 409A is a compliance headache (a necessary evil, all the same). For this reason, many companies are eager to bundle their valuations with cap table software services. Software providers form partnerships with thoroughly-vetted valuation firms. Your cap table software already has a majority of the information valuation firms need, significantly streamlining the appraisal process.
However, even some of the biggest names in cap table software feel comfortable rolling the dice on their clients’ 409A valuations to make an extra buck. Preserving the independence of your 409A valuation means there can be no conflicts of interest between your company, the valuation firm, and your cap table software provider. Yet, a gut-wrenching number of top-tier software companies jeopardize the independence of clients’ valuations—typically in one of three ways:
- They start their own “independent valuation firm” (read, “a legally separate entity”) with whom they’ve established deep ties financial ties.
- They acquire a valuation firm, continuing to operate it under a thin veil of independence or fully cannibalizing it; bringing valuation services in-house and pretending like it’s not a problem when clients start asking questions.
- They arrange inappropriate agreements to share ownership of your equity in some way, shape, or form.
The general rule of thumb regarding the independence of firms performing your 409A valuations is that they should be providing you with no other products or services. We’d like to introduce a new rule of thumb. Software providers should be fully transparent in laying out the structure of their relationships with valuation providers. The structures they present must be simple, presented concisely, and leave zero room for ambiguity. If it doesn’t pass your smell test, you can guarantee it’s not getting past the IRS without severe scrutiny.
IRC 409A Non-Compliance Penalties
While employers (or “service recipients”) are often the party responsible for jeopardizing 409A compliance, their employees (the “service providers”) easily bear the worst of the consequences. Each employee receiving non-qualified deferred compensation is subject to the following tax penalties:
- The employee’s taxable income is adjusted to include the entire balance of the plan for the current tax year, going back to the year options were vested (regardless of whether or not the options were exercised).
- A 20% excise tax on the amount above.
- An interest tax comprised of the federal underpayment rate (which changes quarterly) plus a 1% tax on underpayments beginning at the year in which compensation was first deferred.
There are a smattering of other taxes and fees in addition to the penalties listed above, but those are the big three. The SEC—in an effort to irrevocably pin the phrase “read it and weep” to a single, specific webpage—have constructed a hypothetical example of what these penalties might look like. All in all, that’s one bad day at work. Being deemed non-compliant is enough to throw companies into chaos, even with the saving grace of the IRC 409A document correction program.
IRC 409A exists to serve a little regulatory “tough love” to companies and executives who might otherwise take advantage of the tax system. Its penalties collectively make the strongest argument for the “measure twice, cut once” approach you’ll ever see. That’s why, when it comes to Section 409A, ensuring you achieve a safe-harbor valuation means everything. Doing so requires thorough research and due diligence into the appraisal methodology, quality standards, and (above all else) the independence of any third-parties involved in crafting your valuation. At EquityEffect, we’ve got nothing to hide. We’re not just calling out our competitors, but the cap table software market as a whole. Many of the leading cap table software solutions providers are allowing—even partaking in—irresponsible valuation practices exposing the businesses they serve to a devastating amount of risk. We support the best equity management platform on the market with simple, transparent partnership structures which offer no room for ambiguity or guided miscommunication. We do it right. It’s time for everyone else to get on board. Will you?