409A compliance made easy: 3 tips to avoid penalties
If your company offers stock options to your employees, then Section 409A might sound familiar. Part of the Internal Revenue Code (IRC), Section 409A contains guidelines on deferred compensation and is a critical document for any private company.
Complying with 409A requirements is a must for any startup, especially if you offer non-qualified deferred compensation plans such as stock options and stock appreciation rights.
Non-compliance comes with severe penalties — which is why it’s always advised to seek professional help for a 409A valuation. In this article, we’ll walk you through what it means to be 409A compliant and the possible penalties you might face.
What does it mean to be 409A compliant?
Unlike public companies that can refer to public stock exchanges for their equity value, private companies must determine the fair market value of their own stock.
Section 409A was added to the IRC in 2005 after the Enron scandal drove increased regulation and oversight into employee compensation. It’s essentially a framework for companies to follow and requires private companies to specify an exercise price or the price at which employees can purchase shares of their common stock once they have vested them. It also regulates the timing of deferrals and distributions.
To ensure 409A compliance, companies must undergo valuations to ensure their exercise price is of fair market value. When an independent third-party carries out the valuation, it establishes a “safe harbor,” recognized by the IRS as a reasonable method of determining fair market value at the time of grant.
A company may do its own valuation. But doing so will not grant safe harbor and instead, increases the risk that the stock price may be incorrectly priced.
What are the penalties for non-compliance?
Broadly speaking, failure to comply with the 409A valuation requirement can result in heavy penalties from the IRS — penalties that will come down the hardest on employees and shareholders.
As per Section 409A, penalties for non-compliance in deferred compensation fall upon the recipient of the compensation and not the company that offers it, including:
- All deferred compensation (including those from bonuses, salaries, and stock options) from the year of error and previous years will become taxable. The amount will be added to the employee’s gross income even if the payment occurs in subsequent years.
- An additional 20% penalty excise tax on all deferred vested amounts.
- Restating and refiling previous years’ tax forms for both employees and companies.
- Additional penalties stemming from the understatement of income and any late payments due to the inclusion.
- Possible state-imposed penalties such as fines.
While the burden falls on the employee to pay excise taxes under Section 409A, the company must properly report and withhold the compensation paid. Should the company fail to do so, it will also be subject to penalties from withholding taxes on the vested deferred compensation amount.
That said, it doesn’t look good for companies to have the IRS come knocking on their door with charges. Failing to comply with Section 409A will discourage many potential investors and top talent who prefer companies with a solid track record and good reputation. After all, the way a company approaches the 409A is insightful; if the founders refuse to follow the steps required to establish a safe harbor, they open the door to a potentially massive liability for the company, its employees, and their shareholders.
How can I avoid 409A penalties?
The IRS has a correction program that can minimize or even eliminate Section 409A penalties if they are identified and corrected within two calendar years following the error. Companies can generally correct a stock option if issued at a discount by resetting the stock price to the appropriate amount. Each correction will come at a price.
Don’t rely on the correction program. Instead, work to get it right the first time.
Here are some tips on how to avoid 409A penalties:
- Constantly maintain complete and accurate documentation. One of the biggest mistakes leading to non-compliance is miscalculating plan deferrals and distributions. Avoid this by ensuring all your plans and key company documentation, such as financial statements, are always up-to-date and accurate.
It’s also a good practice to regularly review your compensation plans. Not only does it reduce the risk of missing something on your valuation, but it’ll also help you maintain compliance. Look out for changes in payment timing, acceleration, and re-deferral.
- Conduct frequent 409A valuations. Each 409A valuation is valid for 12 months. But if there are developments that could change the valuation materially, you should seek a new valuation to ensure that your stock value accurately reflects these changes.
Look for events that will impact the company’s future, such as material changes in the business plan, new funding rounds or a new acquisition or merger.
- Consider hiring a valuation provider. It’s possible to complete an accurate 409A valuation on your own. While it may save you some money, it is always safer if an expert does the valuation. Qualified valuers will ensure the valuation is done to the IRS’s reasonable methods to guarantee a safe harbor and are great sources for advice and knowledge.
Need help finding a reputable valuation partner? Here are five questions you’ll need when assessing potential valuers.
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