What is Section 409A?
January 19, 2008
Background
On April 10, 2007, the Internal Revenue Service (IRS) issued final regulations under Section 409A of the Internal Revenue Code. Section 409A was added to the Internal Revenue Code in October 2004 by the American Jobs Creation Act.
Under Section 409A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan (as defined in the regulations) currently are includible in gross income unless such amounts are subject to a substantial risk of forfeiture. In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties. Certain states also have adopted similar tax provisions. (For example, California imposes an additional 20 percent state tax, interest, and penalties.)
Implications for discount stock options
Under Section 409A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The tax consequences include taxation at the time of option vesting rather than the date of exercise or sale of the common stock, a 20% additional federal tax on the optionee in addition to regular income and employment taxes, potential state taxes (such as the California 20% tax) and a potential interest charge. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time.
I will write a future post on “How do you set the exercise price of stock options?”
Additional information
Below are links to all of WSGR’s client alerts on 409A.
You can assess the applicability of Section 409A by reviewing WSGR’s client alerts covering various aspects of Section 409A and the final Section 409A regulations in detail, including highlights, stock rights, separation pay arrangements, traditional deferred compensation arrangements, action items for compliance and transition relief.
Comments
10 Responses to “What is Section 409A?”
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I would really love to read your as-of-yet-to-be-written “How to set the exercise price of stock options” article. We are struggling with this right now with. We want to properly motivate our people (currently 1099 contractors), but we worry that too low of a strike price might signal low valuation to a future investor.
Generally speaking, the price of common stock issued to founders, early employees (via options or otherwise) and other “cheap” common stock is not a factor considered by investors in capital-raising (meaning VC) transactions.
Yokum,
Suppose deferred compensation comes in the form of convertible notes, convertible into a series B preferred stock to be issued.
1. Does the fact that, until the series B closes, the risk of forfeiture is very high put the compensation outside the realm of 409A?
2. If the notes are converted to the series B preferred, does the fact that the compensation is no longer a legal obligation to pay put the deferral outside the realm of 409A?
I don’t understand the fact pattern and the questions. If it’s a convertible note, then it’s an obligation to pay money. I don’t see why there is a risk of forfeiture. If the person receives the convertible note for free, then it strikes me that there probably is a taxable event at that point in time. If the person pays real money for the convertible note, then I don’t see how it is compensation.
Yokum,
In a cash sale of a private company, what is the typical disposition of unvested options? (Non Qualified).
@Ijm - If the options are not assumed by the acquiror, unvested options fully vest and the option holder can either exercise and receive merger proceeds or receive net cash equal to the price per share to the common minus the exercise price per share.
Is 409A Valuation is MUST do item for a start-up? Or does the Board of Directors have the right to wave that requirement and take the risk?
@Ames,
It’s a matter of risk. If the company has received venture financing or has revenues, then I think it is a must do item from a risk perspective. Paying $5K and up for a 409A valuation is a small price to pay for insurance in the event that the IRS challenges the option exercise price in the future. The 409A valuation report shifts the burden of proof to the IRS to show that the exercise price was wrong.
If a company has not received venture financing and has no revenues, then most companies don’t seem to get a 409A valuation. However, the company should prepare a valuation analysis on fair market value of the common stock to support the board conclusion on fair market value. If the company has a CFO/financial expert that prepares a valuation report, this will also suffice to shift the burden of proof.
Yokum,
Our startup is struggling with the strike price on our first grants of options under our employee stock incentive plan. We did a Series A preferred at $1 a share, but aren’t particularly sure if that’s relevant. I’d obviously like to grant the common shares at a fair price, but share the concerns in a prior question related to future valuations. Do you have any tips on a valuation analysis my board could use? We are pre-revenue, so any process at this point seems arbitrary. Thx.
@Burt - if the company did a Series A with institutional venture capital investors, then the company should get a 409A valuation. The “old school” 10 to 1 preferred to common price ratio would not be an unusual result for a pre-revenue company. Of course, any rules of thumb like this are not proper accounting.