Section 409A of the Internal Revenue Code

Section 409A applies to non-qualified deferred compensation (NQDC) plans. Deferred compensation plans which do not meet the specific requirements of 409A are treated as “current income” and subject to significant excise taxes plus penalties.

Section 909A of the Internal Revenue Code applies to employees, directors, and “other service providers.” It contains very specific rules governing the timing of deferrals, timing of distribution, funding methods, and various other aspects of deferred compensation.

409A Penalties for Non-Compliance

If there is a violation, affected service providers will owe current tax on deferrals for the current year and all prior years (to the extent not subject to a substantial risk of forfeiture).

All service providers will have to pay interest at underpayment rate + 1% from the original deferral date. Additionally, service providers will owe tax on 20% of all taxable compensation. If you do not draft the plan correctly, all participants could be “affected,” and all post-2004 deferrals taxable.

Exceptions to 409A Coverage

Section 409A defines deferred compensation broadly to include the following equity compensation instruments, such as non-discounted stock options, restricted stock, and stock appreciation rights (SARs).

Similar treatment now extends to all SARs, which include private and public companies and cash and stock-settled arrangements. To fall into the 409A exception, however, the equity compensation instrument MUST be valued at “fair market value” at the time of grant.

How to Value a Private Company Under 409A

Value is determined “by the reasonable application of a reasonable valuation method.” What does this mean?

First, to explain, it is easier to define reasonable by defining what unreasonable means. For example, it’s unreasonable to use a previously calculated value that fails to reflect all material information. That is, a fair market calculation should probably be more than twelve months old.

There are two primary safe ways businesses can go about obtaining a reasonable evaluation:

1. Get a written valuation report for the illiquid stock by a person with significant knowledge and experience
2. Have an independent appraisal done, which can cost a cash-strapped startup between $5,000 and $7,000

IRS Guidelines for 409A Valuations

According to IRS guidelines, 409A evaluations should include the following:

• The value of tangible and intangible assets
• The present value of future cash-flows
• The market value of stock or equity interests in similar companies and other entities engaged in businesses
• Recent arm’s length transaction involving the safe transfer of the stock
• Other relevant factors, such as control premiums or lack of marketability