What Is a 409A Valuation?

When employees or contractors are paid in stock options, their compensation is considered to be deferred until a later time. IRC 409A, a section of the US tax law, governs the way in which such compensation is taxed.

IRC 409A imposes an excise tax on companies that violate various rules contained within it. If your firm is able to follow those rules, you may avoid paying penalties. One way to ensure your compliance is by properly valuing your stock options as compared to a fair market value (FMV).

The value of your options should match or exceed the FMV. “Pricing stock options below FMV will cause adverse tax consequences for both the issuing company and the option holder.” Hiring an independent expert firm to determine that value can help you comply with IRC 409A.

The Safe Harbor Methods of 409A Valuation

What is a 409A valuation? It’s a way to protect your firm by following IRS methods for valuing your stock options. Such a valuation must take into account any information that was available and pertinent to the valuation of the company during the process, and it must use consistent methods.

The process can involve forecasting the future cash flow of the corporation, evaluating the company’s assets (both intangible and tangible), researching the market value of stock shares at similar companies, and other factors.

Even when all these methods are used, the IRS can still at times disagree with the results and penalize your company. The IRS is able to state that the method of valuing the stock was “unreasonable.” Then, the company is responsible for showing that it was reasonable.

There are what are called “Safe Harbor” valuation methods, which can generally protect you from these challenges from the IRS, as long as the methods are used in fairly reasonable ways.

What “Safe Harbor” methods are there? First, certain companies in restricted situations are able to use a valuation method that is based on a set formula. Second, startup companies can use one of several methods that are designed just for startups.

However, the most common “Safe Harbor” method for many companies is to get an independent appraisal by a specialized expert firm. If the valuation was performed by a qualified appraiser within a year before the options were granted, it is assumed to be reasonable and valid.

Purchasing a Dual-Purpose Valuation Report

The price of an independent valuation can be very high for some companies if they purchase a generalized company valuation. Fortunately, some firms specialize in IRC 409A valuations, which can be performed at a fraction of that price.

It’s important to know that your company may also need to comply with the more detailed requirements of ASC 718 and ASC 505-50 of Generally Accepted Accounting Principles (GAAP), which govern payments made in company shares.

A 409A valuation alone may not cover the GAAP requirements. However, your company can order a dual-purpose report that gives you the IRC 409A valuation and prepares you for the ASC 718 standards.

In the end, what is a 409A valuation? It’s a way to possibly save money in the long run. Because the cost of the 409A excise tax can be high, if your firm is able to afford a professional 409A valuation, you can protect yourself from penalties later by paying an upfront fee today.

Startups with low cash flow may sometimes risk skipping this process to save money in the short term. However, can you afford to expose your business to possible IRS penalties? Many smart companies choose to avoid the risk.

Melissa Thompson writes about a wide range of topics, revealing interesting things we didn’t know before. She is a freelance USA Today producer, and a Technorati contributor.