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Which Employee Compensation Is Subject to 409A Valuation?

by / ⠀Finance Investment / November 9, 2022

The 409A valuation refers to determining the fair market value of a private company’s stock in order to determine the exercise price for stock options. 409A of the Internal Revenue Code regulates the method for valuing the company stock for purposes of awarding option holders with a market-based exercise price. The purpose of the 409A valuation is to establish a reasonable exercise price for various employee compensations such as stock options, performance shares, employee stock options plan (ESOP), stock purchase plan (SPP), and restricted stock units (RSU), and other stock-based compensation plans. The employee compensation is subject to 409A valuation whenever it is granted or paid out. In this article, we will brief about the 409A valuation and look at the employee compensation subject to 409A.

IRS and 409A valuation

The Internal Revenue Service (IRS) has issued a set of proposed regulations that serve as a template for valuing private company stock under 409A. Theoretically, under 409A, the company stock must be considered as trading on an established securities market with a price that may be readily and regularly ascertained. In order to apply the practical guidance in the 409A regulations, the IRS has issued a safe harbor that allows employers to determine the fair market value for stock options using the Black-Scholes option-pricing model and other similar pricing models that meet the requirements in the 409A regulations. That being said, it is essential to comply with the 409A regulations to avoid the penalties associated with the violation.

Why should companies perform a 409A valuation?

As per the 409A regulations, employee compensation is subject to 409A valuation whenever it is granted or paid out. It is a common practice for organizations to perform a 409A valuation. This is in order to avoid any penalty for violating 409A rules. From determining employee compensations to showcasing the company’s financial performance, performing a 409A valuation makes the company’s financial information more transparent and objective.

While investors consider 409A as part of their assessment of the company, other factors exist that they consider before making an investment decision. It is important for the company to perform a 409A valuation. It provides a complete picture to its investors, shareholders, and employees.

Reasons to perform 409A valuation

The stock price of private companies is not readily available as compared to publicly-listed corporations. It is important for companies to perform a 409A valuation. This is in order to achieve a fair market price for their stock. This pertains to companies that provide stock as a component of the option compensation but are not public companies. Following are some reasons for 409A valuation:

  1. A 409A valuation is required to satisfy the requirement of the Internal Revenue Service (IRS) in order to avoid the penalties for violation of 409A provisions.
  2. The 409A provisions allow employers to avoid the unintended consequences that potentially arise when employees receive stock options as part of their compensation.
  3. VCs, angel investors, and private equity investors may consider 409A valuation as a source for their investment decision.
  4. In the case of initial public offerings (IPO), the company’s shares must be valued in order to file with the Securities and Exchange Commission (SEC).
  5. Employee compensations, including performance shares, restricted stock units (RSU), stock options, and other stock-based compensation plans, are determined at the time of grant or at the time of vesting or settlement.

Employee compensation and 409A valuation

The IRS requires that the market price of a company’s stock needs established in order to determine the exercise price for stock options granted to the employees. Otherwise, the exercise price will not be considered a fair market price and will result in a penalty. This applies to all types of stock-based remuneration, such as employee stock options, performance shares, restricted stock units (RSU), and more.

In order to determine the strike price for employee compensation plans, the 409A valuation is mandatory. While subject to 409A valuation, the IRS requires that deferred compensation needs properly valued. Read on to know more!

Deferred compensation is subject to 409A valuation, why?

The 409A valuation of deferred compensation is required because the IRS views deferred compensation as the extension of current compensation. This is subject to 409A valuation. In essence, deferred compensation refers to an employee’s remuneration in a future year. Since the deferred compensation is subject to a 409A valuation, it is recommended to perform a 409A valuation to determine the stock’s fair market value at the time of compensation or deferral.

Further, if the value of deferred compensation is not established at that time and is later determined, it will be considered a void or invalid deferred compensation. This potentially results in a tax liability. The IRS 409A code for employee compensation is open and clear. Companies that fail to comply with the stipulation may be liable for penalties.

Difference between qualified and non-qualified deferred compensation

Deferred compensation in the form of qualified deferred compensation allows employees to add their money into a trust that is separate from their employer’s business operations. The deferred compensation is eligible for tax-deferred payment when the employee becomes an active participant in the plan. This form of deferred compensation is fully vested and subject to 409A valuation. Find the rules and regulations regarding deferred compensation listed under IRC Section 409A. On the other hand, non-qualified deferred compensation allows employees to add a portion of their income or pay into a permanent trust, wherein tax deferred grows. The non-qualified deferred compensation is eligible for tax-deferred payment when the employee becomes an active participant in the plan.

How can employers and employees comply with the 409A section?

Employers are required to comply with the 409A rules and regulations in order to avoid penalties for violation. 409A valuation can be determined through a third-party appraisal or an independent valuation. This ensures that 409A valuation is a credible process. Plus, it maintains an objective estimate of the value of the stock on the date of employee compensation or deferral.

On the other hand, employees are required to receive full disclosure of the terms of their deferred compensation plans. They also should be updated as per any change in the 409A valuation. We recommend working with a professional or expert experienced in performing 409A valuations. This way your company meets the IRS’ and SEC requirements. Thus, the 409A valuation is crucial in the process of planning and decision-making for employee compensation.

Restrictions of 409A section for deferred compensation

There are certain restrictions that the IRS sets forth for deferred compensation. It is important to remember these restrictions when it comes to determining the value of deferred compensation. The following are the most important restrictions that apply to

  • The deferred payments may not be distributed prior to the time they are established. Deferred compensation amounts that are earned in a previous year may be paid out in the following year. But they cannot be received until they are vested.
  • The right to receive the compensation need irrevocably established or vested prior to the time the services related to that compensation are performed. It is wise to consult with a professional before making irrevocable elections regarding deferred compensation. Otherwise, you may face a penalty.
  • The IRS disapproves the use of certain techniques to secure the payment of nonqualified deferred compensation. this includes payment into a trust not organized for charitable, scientific, educational, or religious purposes.

Risks of failure to pay deferred compensation

The IRS allows a company to pay deferred compensation at the time the employee becomes an active participant in the plan. However, if an employee does not become an active participant in the plan, then the IRS does not allow this. Failure to make a deferred compensation payment can result in tax liability or financial penalty. The IRS requires certain standards when it comes to deciding when employees can receive their vested and non-vested deferred compensation.

In some cases, deferred compensation can be subject to a substantial risk of forfeiture. This means that the company can repossess the deferred compensation for failure to meet conditions specified in the plan. It is wise to consult with a professional to avoid any unwanted circumstances regarding deferred compensation. This helps companies avoid the penalties and violations that may result from failure to pay deferred compensation timely.

How does section 409A impact private companies?

Typically, the impact and consequence of the 409A value depend on the organization. Private companies may be required to provide the 409A valuation to determine the stock eligibility and to plan the compensation amount. Additionally, the complexity of the organization and the types of compensation are factors that affect the 409A valuation. It is vital to work with a professional and experienced 409A valuation expert. They determine the value of the stock at the time of compensation. This way the plan outlines it.

Conclusion

While the primary focus of the 409A section is to determine the stock’s fair market value for compensation, it is important to note that there are several rules and regulations that must be met according to the IRS. Further, it is advisable to work with a professional or expert who is knowledgeable in the 409A valuation. This ensures that the employer can avoid any penalties as well as violations.

About The Author

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Sarath CP is a digital Strategist and growth analyst with Eqvista. He has worked for both startups & big brands, helped them to build a strong brand presence, and achieve sustainable business growth.

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