409A applies to anyone subject to U.S. federal income taxation who receives non-qualified deferred compensation, including:
- US tax residents
- Non-residents who earn US source compensation
409A involves the taxation of deferred compensation such as stock options and stock appreciation rights. 409A applies to the compensation that is earned in one period and paid out in a future time period. Stock options are a classic example of deferred compensation. Companies that pay their employees using deferred compensation now have specific requirements that they need to follow. As a general rule, all stock option grants need to have an exercise price at or above the FMV of the company’s equity value on the date such grant is made. This requirement, and its many related complexities, generally comes from 409A of the IRC and the related IRS regulations
409A also contains general guidelines that apply to all valuation methodologies. For closely held corporations where equity value is not readily tradable, the taxpayer corporation has to use a “reasonable” application of a “reasonable” valuation method to value the subject stock. Whether or not a valuation method is considered “reasonable” depends on the relevant facts and circumstances surrounding the subject’s closely held corporation as of the valuation date. The following factors are considered when applying a “reasonable” valuation method for corporations:
- Value of the tangible and intangible assets
- Present value anticipated future cash-flow
- The market value of stock or other equity interests in similar corporations and the market value of other entities engaged in a trade or business substantially similar to the subject corporation
- Recent arm’s length transactions involving the sale or transfer of such stock or equity interests
According to Section 409A regulations, a valuation method is not reasonable if:
- It is more than 12 months old
- It does not take into consideration any material recent developments regarding the taxpayer corporation
Option recipients ending up being non-compliant with IRC section 409A would result in adverse tax consequences where the gain would be subject to taxation at vesting rather than exercise. Moreover, there would be additional penalties and interest charges to the company. Also, 409A compliance is part of a due diligence checklist of every investor/acquirer. Hence, if you have not done any 409A valuation your investment or M&A process will get derailed.
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