Thursday, March 21, 2013

Stock Option Valuation...When and Why?

What does §409A say and how are the IRS applying the rules?

This section of the Code was enacted in October 2004 and final regulations were issued on April 10, 2007. §409A applies to compensation that workers earn in one year but that is paid in a future year. The Code defines this as "nonqualified deferred compensation." It is important to note that this is different from deferred compensation in the form of elective deferrals to qualified plans. Stock options, stock appreciation rights, or similar instruments can qualify as nonqualified deferred compensation.

§409A sets forth certain extensive requirements that the deferred compensation must meet. If the deferred compensation does not meet these requirements, the compensation is includable in gross income. For example, if a stock option has an exercise price that is less than the fair market value of the common stock as of the issuance date, this will result in adverse tax consequences for the option recipient and the company. Overall, the compensation is subject to certain additional taxes, including a penalty of an additional 20% income tax. Furthermore, the company will be required to withhold income and employment taxes as the time of the option vesting. Thus, every time stock options are issued, a sound valuation of the common stock is necessary. Put simply, the exercise price of the option must be equal or greater than the fair market value of the common stock as of the option's issue date. In order to abide by §409A and avoid early income recognition and additional taxes by the option holder, §409A's valuation rules must be followed.

In 2010, the Internal Revenue Service released Notice 2010-6  that puts into effect a correction program for non-compliant deferred compensation documents. If the deferred compensation documents do not comply with §409A, there is a slight opportunity to escape or mitigate the consequences. The correction program does not allow the correction of all errors. However, the Notice does permit most inadvertent and unintentional document failures to be corrected. The Notice sets forth the specific correction procedure that must be followed to obtain relief.

What are §409A's valuation rules for private company stock?
According to §409A, "in the case of service recipient stock that is not readily tradable on an established securities market, the fair market value of the stock as of a valuation date means a value determined by the reasonable application of a reasonable valuation method." To be considered reasonable, a valuation method must take into consideration all available information, facts, and circumstances as of the valuation date. 

The Code goes on to list specific factors that must be considered under a reasonable valuation method. Factors that must be considered under a reasonable valuation method include:
The value of tangible and intangible assets of the corporation;
The present value of anticipated future cash-flows of the corporation;
The market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation of the stock of which is to be valued, the value of which can be readily determined through nondiscretionary, objective means;
Recent arm's length transactions involving the sale or transfer of such stock or equity interests; and
Other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders, or its creditors.

It is important to select a valuation expert who is knowledgeable about the requirements of §409A so that the valuation is valid.

How often are fair market valuations necessary?

To be considered a reasonable valuation, the valuation of a private company stock must provide a value "as of a date that is no more than 12 months before the relevant transaction to which the valuation is applied." For example, if a stock option is issued on December 1, 2011, a valuation date on or after December 1, 2010 must be used.

Additionally, the valuation is invalid if it does not reflect information available after the valuation date that materially affects the value of a private company... 

...If the valuation does not meet the requirements of the Code, both the recipient and the issuer are subject to unfavorable income tax consequences.