What is IRS Section 409A?
Section 409A was added to the Internal Revenue Code on January 1, 2005, and issued final regulations in 2009. In most private company cases, the main concern is the IRS assessing penalties if option strike prices are not at least at fair market value ("FMV") of the common stock.
The IRS provides three "safe harbor" methodologies for setting the FMV of the common shares of private companies.
- Independent Appraisal Presumption: A valuation is performed by a qualified independent appraiser, using traditional appraisal methodologies. The valuation is presumed reasonable if it values the stock as of a date that is no more than 12 months before the applicable stock option grant date and if there is no material change from the date of valuation to the grant date. If these requirements are met, the burden is on the IRS to prove the valuation was "grossly unreasonable."
- Illiquid Start-up Presumption: The illiquid start-up presumption is applicable to private companies less than 10 years old, not anticipating sale, IPO or change of control within the next 12 months, and the stock is not subject to a put or call right. If the CEO cannot be absolutely sure the company satisfies all these requirements, the company must use other valuation methodologies. The valuation will be considered reasonable by the IRS, if it is in written form, performed within 12 months of an option grant and performed by a person with significant knowledge and experience or training in performing similar valuations.
- Binding Formula Presumption: This valuation method must be based on the consistent application of a single formula and used for a binding agreement, i.e. buy-sell agreement, both for grant of stock and options, purchases or sales of stock to third parties, conversion of loans in to stock, etc. This method is as a multiple of some tangible benchmark, such as Sales, EBITDA, or Net Income.
If the valuation is performed outside of “safe harbor” the burden of proof falls on a taxpayer. The penalties for Section 409A violations are severe and include immediate tax on vesting, additional tax of 20% and penalty interest. Of the three “safe harbor” methods the most practical and advisable is independent appraisal methodology. The majority of VC or angel-backed startups use the independent appraisal method.