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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.

Please also see the post on “How do you set the exercise price of stock options to avoid Section 409A issues?“

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 of the Final Section 409A Regulations (published April 16, 2007)

Stock Rights Under Final Section 409A Regulations (April 19, 2007)

Separation Pay Arrangements under the Final Section 409A Regulations (April 27, 2007)

A Road Map for Traditional Nonqualified Deferred Compensation Plans under the Final Section 409A Regulations (May 17, 2007)

Action Items for Compliance with Section 409A Final Regulations (June 12, 2007)

IRS Provides Transition Relief until December 31, 2008, for Section 409A Compliance (October 24, 2007)

Compliance Required with Section 409A before December 31, 2008 (June 12, 2008)

Written by Yokum · Filed Under Stock options 

Comments

  • David
    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.
  • ljm
    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.
  • Ames
    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.
  • Burt Ti
    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.
  • re:my query of July 10: The note is only convertible into class B preferred shares...no cash. The note was given in lieu of cash compensation. The company is pre-revenue and needs to raise funds thru the class B offering. An outside investor is buying 60% of the B shares for $1.61/share. At that time, the notes will convert to B shares at the same price ($1.61). Until the B actually closes there is a high probability of bankruptcy and default. Does the fact that the company does not have to pay cash to redeem the note put the deferred comp. outside the realms of 409A?
  • Ginny Coles
    Yokum: I would appreciate your advice on how to handle the situation of the 409A valuation being lower than the FAS123R valuation. Thank you!
  • @Ginny - I defer to my tax and benefits specialists on these issues and you should consult with appropriate auditors and tax/employee benefits experts. Please read the disclaimers.

    I have heard of many situations where the auditors are rejecting 409A valuations. At the end of the day, I think that the company needs to appease the auditors with an acceptable FAS 123R valuation for accounting purposes, but that does not necessarily create an issue with the IRS as long as a 409A-compliant valuation backs up the option exercise price. Companies used to take cheap stock charges in connection with IPOs, which tacitly admits that the option price was too low. However, as far as I know, the IRS has not taken the position that these option grants with exercise prices that were too low are no longer ISOs (which need to be granted at FMV).
  • Bill Mc
    Hi Yokum,

    When a consultant (or a law firm) agrees to work in exchange for options in a client, how do you determine the number of options you receive as a fee? For example, if you provide $100K in legal or other advice, what are the typical option terms assuming the company is worth say $5MM post-money after the last round? Duration? Any good option agreements online?

    Thanks much.
  • @Bill Mc - There are probably a few different ways to think about it. One is to simply express the number of shares as a percentage of the company. For example, options for an employee/director/advisor will typically be benchmarked as a percentage of fully-diluted ownership. These options will vest over 4 years for employees and typically 2 to 4 years for directors/consultants.

    Another way to think about it is in terms of value provided (somewhat like warrant coverage). See the post " What should the terms of bridge loan warrant coverage be?"

    Perhaps even a different way to benchmark the size of option grant is to look at assumed in the money value and grant enough shares to provide the implied value. For most companies, there will be a difference between preferred stock FMV and common FMV. If there Series A is $1.00/share and the common FMV is $0.10/share, then each share has an implied $0.90/share spread. If the company wanted to provide $9000 of value, it would grant options to purchase 10,000 shares.

    Generally, consultant options will be exercisable for a period between 5 and 10 years. They might be fully-vested upon grant (upon completion of services) and not dependent on continuous status as a service provider in order to be exercised. However, some may be subject to continued services in order to be exercisable.

    An option grant is not a do it yourself exercise. There are various things that can be screwed up ranging from 409A compliance, securities law issues, failure to obtain valid approvals which may result in option backdating, etc.
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