IRC Section 409A: What startups and growth stage companies need to know

Equity-based compensation plans are a key component of incentive programs within many startups, early-stage, and growth companies, particularly those operating in the tech sector. The challenge is that issuing stock options and other share-based awards isn’t as straightforward as it can appear. This is because any stock options that a company offers must comply with the complex rules set out in Internal Revenue Code Section 409A (409A) — which governs nonqualified deferred compensation and certain equity rights.

While 409A has been around for more than a decade, it’s often overlooked by startups when they issue stock options. This oversight can lead to serious consequences — not only for companies, but for the valuable employees they want to reward.

To help CFOs and management better understand 409A, this article provides a brief overview of 409A requirements, identifies the key risks for startups and growth companies, and highlights key actions companies can undertake to enhance their compliance when offering stock options.

Overview of 409A

409A is a complex and comprehensive tax rule that applies to nonqualified deferred compensation and certain equity rights. 409A is particularly important where privately owned companies provide stock options and other equity rights to their employees. At its simplest level, as it relates to equity rights, 409A mandates that companies can’t issue stock options with an exercise price that’s lower than the current fair market value (FMV) of the stock associated with the grant. In order to meet this requirement, companies need to understand and determine the FMV of their stock — a process that isn’t as straightforward for private companies as it’s for public companies where stock prices can be obtained daily in the market.

Recognize the risks

Startups and growth stage companies that don’t comply with the provisions of 409A prior to issuing stock options could find themselves facing a wide range of unexpected consequences, including:

• Tax risks: Unlike many other tax rules, if a company unknowingly or knowingly violates 409A, their employees can face significant tax consequences. If the company issues a stock option to an employee with an exercise price below FMV, it may result in immediate taxation and an additional over 20% tax imposed on the individual. This is a serious risk given that the employees that are awarded with stock options are typically among the most essential to a startup company’s success.
• GAAP reporting: Companies that keep their books in accordance with generally accepted accounting principles (GAAP) must recognize share-based compensation expense as a part of their financial reporting. If they didn’t conduct a 409A valuation at the time they issued their options, the company will need to provide additional support the grants are valued appropriately in order to comply with GAAP requirements.
• Audit risks: Companies that don’t consider 409A compliance and GAAP requirements in advance of issuing stock options could face numerous issues as part of the audit process, including the need to make financial statement adjustments to compensation expense and equity, to ensure they are compliant with GAAP, restate their financial statements, and run the risk of having internal controls deficiencies.
• Reputational risks: Companies that fail to comply with 409A could see their reputation significantly impacted. This could reduce their ability to attract and retain essential employees. It could also affect their ability to attract funding. For startups and growth stage companies, the inability to attract funding could threaten their long-term sustainability or a successful exit.

Where to start for 409A compliance

Before issuing any stock options, CFOs and management at startup, early-stage, and growth companies should work to understand the requirements of 409A and to ensure they have the right processes in place to be compliant. This can help them avoid or better manage their risks, while also supporting board and management fiduciary requirements related to fairness. As a starting point, companies should consider the following three activities:

1. Get educated

Before issuing any stock options or other share-based compensation, CFOs and management should educate themselves with respect to 409A. Understanding key requirements in advance can ensure companies conduct the right analysis to support the issuing of any awards and that they have the processes in place to undertake related activities.

2. Conduct a 409A valuation

To support the issuance of stock options, companies should conduct a valuation that complies with the safe-harbor provisions of 409A to determine the FMV of their stock. While companies can perform this valuation themselves, it’s likely more beneficial to hire an independent third-party expert that has extensive knowledge 409A, other regulatory requirements, and a history of working with companies on valuation and compliance activities.

An independent third-party expert can make the valuation process straightforward and reduce the potential for mistakes and errors that could jeopardize compliance with 409A. When a valuation is conducted by a qualified, independent third-party, 409A provides a presumption of reasonableness — meaning that the valuation can be relied upon for 12 months and is rebuttable only where the IRS can establish that the valuation method or the application of the valuation method was grossly unreasonable, for example where there is a material change in the company’s operations or circumstances between the valuation date and the date the options are granted. Using an independent third-party expert also provides a ready defense and support in the event the valuation is ever challenged by the IRS, or is forced to respond to inquiries by auditors, investors, or due diligence in an exit.

If you’re just learning about requirements of 409A, but you have already issued stock options or other share-based awards, there are opportunities to correct any potential issues. While 409A violations can result in very stiff penalties, the IRS does have a program that allows companies to correct errors within a certain period of time following the grant of options. Depending on when the error is corrected, companies can avoid or significantly reduce potential penalties and other ancillary impacts.

3. Determine accounting and reporting implications

In addition to ensuring compliance with tax regulations, a 409A valuation can also enhance a company’s accounting and reporting processes, such as the need to report share-based compensation expenses. Taking time to understand the relevant accounting and reporting implications in advance of issuing stock options can help ensure compliance with GAAP and reduce the potential for errors or deficiencies to be reported in the audit process.

In the COVID-19 era, keep valuations top of mind

For tech startups and other companies looking to issue stock options, doing the advance work to understand 409A, conduct a 409A valuation, and determine accounting and reporting implications is essential for ensuring the incentives they provide comply with 409A. 

In our quickly evolving economic environment, startups and growth companies should keep valuations top of mind. The reality is that the COVID-19 pandemic has had a major impact on many companies, with some seeing very positive gains due to rapid increases in consumer demand and others seeing significant losses. Companies that have previously granted options that are now underwater may need to act quickly to boost their employees’ confidence and motivation. This might mean conducting a new 409A evaluation that considers the company’s current situation in order to find ways to restore the incentive that stock options provide to employees.