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Why Does My Business Need An IRC Section 409A Valuation?

(Hint: It Saves You Time, Money, and IRS Troubles)

If you are issuing options or any other form of deferred compensation to your employees, you must seek an expert adviser who will give you an assessment of the fair market value of your business. Business owners often believe they know the value of their own company. However, a business owner (public or private) is required to go beyond his own best guess of the company’s value and consult with a valuation expert in order to satisfy the Internal Revenue Code (IRC) section 409A. Private company valuation requirements derived from section 409A apply to businesses issuing their employees traditional or non-traditional deferred compensation including stock options (most common), bonus plans, employment agreements and offer letters, salary deferral arrangements, restricted stock units, and severance agreements.

A good valuation expert should employ the asset, income and market approaches to reach an enterprise value. Then the expert should use the option-pricing method, the current value method, and the probability-weighted return method to allocate this enterprise value to the equity of the company thus determing the value of the equity and derivative options.


Origin of 409A requirements?


409A valuation requirements for a company’s fair market value stem from the American Jobs Creation Act of 2004. The rationale behind the 409A provision was Congress' desire to control stock option reporting, based in part on the Enron and Worldcom scandals, and as a mechanism to increase reportable taxable income which had been avoided via undervaluation of employee deferred compensation.

Given these regulations, when issuing stock options or other deferred compensation arrangements to employees, you make sure that the stock conforms to IRC regulations; specifically that the targeted exercise price is compared with an accurate fair market value of your business’s common stock as of the option grant date or compensation agreement date. If you underestimate the fair market value of your company, the penalties and charges can be severe including:

• a 20% federal penalty;
• The IRS tax underpayment penalty and an additional 1% - the premium underpayment penalty;
• Certain state penalties and taxes such as in California a 20% state tax, interest, and penalties;
• Any employees will be subject to regular income tax as soon as the option vests, and if the employee doesn’t pay the tax in a timely manner, an additional underpayment penalty of 1% is levied;

Yet the penalties to overestimating valuation can be just as severe - if you overestimate the fair market value, options are taxed at more than their true value so your employees receive less income hurting company loyalty.


Does it matter performs my 409A valuation services?


YES! Private company valuation services are generally complex and choosing a 409A valuation service that undervalues or overvalues your company introduces the risks mentioned above.


An Illustrative Example


Suppose your company’s stock is illiquid (i.e. closely-held, non-marketable, minority interest) and the fair market value of your company was $0.10 per share on the grant date. Further, assume the company ends up being sold for $1 per share. Assume you issue 1 million shares to a key employee at $0.05 per share because of an adviser’s recommendation that your company was worth $0.05 per share on the grant date.

When/if the IRS finds out, because the valuation adviser undervalued your business, perhaps due to incorrect market comparisons, spreadsheet errors, or poor valuation methodologies, your employee will be subject to the previously mentioned penalties, as well as an additional $50,000 in taxable income ($0.05 multiplied by 1 million shares). In the end, as much as 85 percent of the $50,000 could end up in the government’s hands (shown graphically below).


In a second scenario, suppose you issue 1 million shares to a key employee at $0.20 per share – again, due to your adviser’s fair market value assessment. When the shares are sold at $1, the employee is missing out on $100,000 in income. Don’t think your employee won’t notice.



















Overall, when issuing most types of deferred compensation agreements (including stock options), a company is required to have a 409A valuation performed to determine its fair market value. Getting this valuation wrong by undervaluing the company, or not having it performed can lead to severe penalties imposed by the IRS. Getting it wrong by overvaluing the company and the employees receiving the deferred compensation (i.e. options) receive less income than they otherwise would have.


Morning Investments Consulting


At Morning Investments Consulting, we employ the approved valuation methods using our expert appraisers’ experience to ensure you get the right valuation for your company. We work hard to make the process easy on you so you can spend more time doing what you do best, and we have industry leading prices.


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