Startup and growing companies often use deferred compensation as an effective way to attract and retain important employees.  Unfortunately, this process has been complicated by a recent tax change that significantly penalizes a broad range of “non-qualified” deferred compensation plans.  Under Section 409A, deferred compensation which does not meet certain requirements is immediately taxable to the recipient and is subject to significant penalties.  In order to avoid the penalties associated with this provision, startup companies should ensure that any deferred compensation meets IRS requirements.

Although Section 409A applies to many types of deferred compensation, stock option compensation is the most commonly implicated.  Deferred stock option compensation is not subject to Section 409A penalties if the strike price (or exercise price) is greater than, or equal to, the fair market value of the shares on the grant date.  Failure to set an appropriate strike price will subject the stock option recipient (employee) to the penalty provisions of 409A.  The penalty provisions provide that the recipient of non-compliant stock options will: (1) be taxed at ordinary income tax rates for the value of the deferred compensation, (2) pay an additional twenty percent penalty, and (3) be subject to significant late payment penalties.  Employees will, understandably, not be very happy about paying all of these extra taxes.  Furthermore, the company may be subject to employee lawsuits for failing to set an appropriate option price.

Since the consequences of setting the strike price below fair market value are severe, you may be wondering how fair market value is calculated for your company’s stock.  The IRS has provided several methods for complying with the strict requirements of Section 409A.  Although compliance can be achieved through other means, there are three valuation methods that, if followed, create a presumption that the calculated fair market value is reasonable.

Independent Appraisal Presumption

The requirements under the Independent Appraisal Presumption are fairly straightforward.  To fall within this presumption, the company must hire a qualified independent appraiser to value the company’s shares.  The valuation provided by the independent appraiser is valid for a period of 12 months unless a subsequent event occurs which has a material effect on the company’s stock value.  Examples of significant events might include a proposed merger or new equity financing.  One downside to this method is the potential cost of hiring an independent appraiser.  The upside is that an independent appraisal serves as an insurance policy against a subsequent IRS challenge.  When selecting an independent appraiser it is important to ascertain that they are “qualified”.   The surest way to do that is to select a professional that has certification credentials from one or more of the four national organizations that provide education and certification credentials for business valuation professionals.  They are the National Association of Certified Valuation Analysts (NACVA), the American Institute of Certified Public Accountants (AICPA), the Institute of Business Appraisers (IBI) and the American Association of Appraisers (ASA).  Selecting a professional that specializes in 409A valuations is also a good idea and may help keep fees to a minimum.

Formula Valuation Presumption

The Formula Valuation Presumption is only applicable for a narrow range of companies.  To use this presumption, the company must already have in place a binding formula for determining the sale price of stock to other parties.  For example, if a company’s stock had a permanent limitation which required the holder to sell or offer the stock according to a specific formula (e.g. a buy-sell agreement between the shareholders), that formula could be used to create a presumption of fair market value.  These formulas are often based on a multiple of book value or earnings (or a combination of the two).  However, if the shares may be sold or transferred in any way other than according to the formula, then this presumption is not available.

Illiquid Startup Presumption

Since startup companies are often difficult to value, the IRS has provided a special presumption for the stock of these illiquid companies.  As long as certain requirements are met, the IRS will consider a valuation of startup company stock to be reasonable.  However, if the company has any public stock or has been in business for more than 10 years, this presumption is not available.  Furthermore, the valuation must be performed by a person with significant experience performing similar valuations and must be evidenced by a written report.  But, unlike the Independent Appraisal method, the startup company does not need to hire a third party to perform the valuation (the startup may use in-house personnel as long as the relevant requirements are met).  Since in-house personnel may conduct the valuation as long as they are qualified, this method is often cheaper than hiring an independent appraiser.  For a full understanding of the requirements pertaining to this presumption, you should consult an attorney.

Deferred compensation in the form of stock option grants can be a powerful and effective tool for motivating and retaining startup employees.  However, you must ensure that the strike price is set at, or above, fair market value to avoid significant penalties under Section 409A.  By using one of the three presumptive methods for calculating fair market value, you place the burden on the IRS to prove that your valuation is unreasonable.  Conversely, if you do not follow one of the above methods, you bear the burden of proving to the IRS that your valuation is reasonable.

An attorney experienced in this area can help you determining the best approach for your company by advising you of the myriad of practical and legal considerations as well as the associated costs and the risks.