409A Constraints on Stock Option Grants

Hot tax code insight of the week!FN1 Section 409A of the Internal Revenue Code requires that companies issue stock options at a strike price that reasonable approximates FMV.FN2 This has one of two practical consequences:

              i) start-ups issue restricted stock instead (or an analogous exemption (any property (such as stock appreciation rights) subject to Section 83 is okay)), thereby bypassing 409A; or
              ii) start-ups go through the (somewhat expensive) process of establishing a FMV (in compliance with 409A) prior to issuing in stock options.FN3

Here's the background: under the previous regulatory framework (governing things during the early '00s), stock options could be issued fast and loose, often according to some vague formula (like 1/10 of the value of the last financing's share price). This allowed rich guys to defer huge portions of their rich guy salaries into the future.

So the IRS enacted 409A, which governs all deferred compensation plans and agreements entered into, or vesting after, January 1, 2005, and requires that i) stock options are issued at FMV and ii) the FMV must be determined using “reasonable application of a reasonable valuation method.” The IRS has provided guidance that the determination of reasonableness (an inherently circumstantial standard) will presumptively be satisfied by either of the two following approaches:

1) Independent Appraisal. An independent valuation by qualified experts using standard methods recognized under the IRS Code.

2) Illiquid Start-up Appraisal. Certain private companies (in existence less than 10 years and not anticipating an IPO in the next 6 months nor a merger in next 90 days (among other things)) can rely on valuation by a person (including an employee) with significant knowledge or training in performing such valuations. (Go here for a detailed discussion of the requirements).

The presumption of reasonableness is rebuttable only upon evidence that the method or the application of such method was "grossly unreasonable" (there's no official guidance on what this means).

Such valuations last for 12 months absent any intervening events that would materially and reasonable affect FMV. Failure to comply has a number of consequences, the most salient being that employees will be subject to taxation at each vesting milestone plus a 20 percent penalty, and potential interest.

Most companies engage in precisely the kind of appraisal required by 409A at each financing event but if such financing was more than a year in the past and the company is short on cash it is probably better off issuing restricted stock rather than stock options as incentive equity.

FN1. A character in David Foster Wallace's novel Pale King (set in an IRS office in the Midwest) describes tax compliance as "boredom beyond any boredom he’d ever felt."

FN2. More generally, 409A applies to any legally binding right to deferred compensation (any agreement, plan or arrangement that provides for a deferral of compensation, even if such compensation is subject to restrictions (such as vesting)).

FN3. The cost for valuation appraisal varies, but will probably come in between $5k and $25K.