Overview

Section 409A of the Internal Revenue Code (IRC) applies to amounts deferred under nonqualified stock options (NQSOs) and stock appreciation rights (SARs).  On April 10, 2007, the IRS issued the long-awaited final regulations under Section 409A of the IRC, which are expected to significantly and immediately affect the manner in which private companies set the exercise prices for the options and values for stock-based compensation.  The regulations and supplementary explanation expanded on many of the core issues previously addressed in IRS Notice 2005-1 and the proposed regulations.  All affected plans and agreements require amendments to conform to the requirements of Section 409A prior to December 31, 2007.  Via Notice 2007-86 recently issued on October 22, 2007, the IRS extended transition relief from December 31, 2007, to December 31, 2008, requiring documents to be brought into compliance by January 1, 2009.  For NQSOs and SARs granted on or after January 1, 2005, the fair market value rule under Section 409A will be met if it can be shown that “reasonable valuation methods” were used. 

Based on the available guidance set forth in the regulations, it appears that companies may respond by (i) maintaining status quo, if exercise prices are believed to exceed fair market value, (ii) performing an internal valuation based on specific factors (present value of future cash flows, comparable company transactions and so on) or (iii) choosing a “presumptive” valuation method such as a third-party valuation.  Only the use of a third-party valuation will shift the burden on the IRS to prove that the option prices were below fair market value and that the presumptive valuation method used was unreasonable.  In all other cases, the burden will fall upon the company to prove that its stock valuation method was reasonable with regard to the regulations. 

The final regulations eliminate the proposed regulations consistency standard with respect to the valuation of stock rights.  Thus, one valuation method may be used to establish the exercise price of a stock option while a different valuation method may be used to value the stock upon repurchase.  However, one valuation method may not be used to change the exercise price previously determined using a different valuation method.

Furthermore, the final regulations also extend the period during which the safe harbor for a written valuation by a qualified appraiser may be used to value the illiquid stock of a start-up corporation.  The proposed regulations prohibited the use of this safe harbor method if, at the time the valuation is applied, a change in control or initial public offering could be reasonably anticipated within 12 months.  The final regulations reduce this period to a change in control reasonably anticipated within 90 days or an initial public offering reasonably anticipated within 180 days.

The application of Section 409A to deferred amounts (upon failure to meet the fair market value rule) will result in adverse tax consequences for the option recipient and tax withholding responsibility for the granting entity.  The adverse tax consequences include taxation at the time of the option vesting rather than the date of exercise, a 20% additional tax on the optionee and a potential interest charge.

Valuation Implications

Based on the guidance, companies may respond  to the regulations in one of the following ways:

Maintain Status Quo:  Retain existing option pricing practice if exercise prices are believed to exceed fair market value.  Upon an IRS audit, if exercise prices are found to be lower than fair market value, the burden will fall on the company to prove that its stock valuation method was reasonable with regard to the regulations.  If it fails to meet this burden, Section 409A and the related adverse tax consequences will apply.

Informal Valuations Based on Specified Factors:  Perform an internal stock valuation based on specified factors (e.g., values of tangible and intangible assets, present value of future cash flows, comparable company transactions, etc.).  Again, if exercise prices are found to be lower than fair market value, based on an IRS audit, the burden will fall on the company to substantiate the fair market value rule.

“Presumptive”  Valuation Methods:  Choose a “presumptive” valuation method (third-party valuation) set forth in the regulations, thereby shifting the burden on the IRS to prove that the option prices were below fair market value and that the presumptive valuation method used was unreasonable.

Expertise

If your firm needs to demonstrate compliance with the regulations under Section 409A, let CBIZ Valuation Group help you determine the fair market value of your company’s stock as of the grant date(s).  Our valuation analysis will take into consideration the regulations and utilize acceptable valuation methodologies that meet requirements under other sections of the IRC.  Accordingly, our analysis will take into account the factors enumerated in Revenue Ruling 59-60 that are considered standard in business valuation for tax matters.

CBIZ Valuation Group has developed significant expertise in assisting privately held companies meet the requirements of Section 409A.  We have both the ability and proven competence to guide your firm through the myriad issues underlying the ruling.