After asking whether you need a 409A valuation before issuing stock options for your startup, the answer was likely: yes. Still, it is not uncommon for entrepreneurs to reconsider seeking a valuation even after they know that they should. Before foregoing compliance with the tax code, executives and employees can face penalties for IRC 409A violations.
As we explained in an earlier blog post, section 409A of the Internal Revenue Code applies to the treatment of federal income tax for non-qualified deferred compensation paid to a “service provider” by a “service recipient.” For many startups, this includes stock options given to employees, executives, independent contractors, or other businesses.
Stock value in illiquid companies is difficult to quantify. However, in order to meet safe harbor requirements under 409A, a company generally requires an independent valuation. Unfortunately, the startup may not have the cash available to pay for an independent appraisal, which could run tens of thousands of dollars. Instead, the business owners or board may make their own assessment of the value of the stock and hope to avoid 409A penalties.
Unfortunately, most of the risks of 409A non-compliance fall directly on the recipient of the compensation. Executives, employees, contractors and other businesses are penalized when a stock option is not properly valued or does not meet safe harbor provisions. Specifically, penalties include:
- Deferred compensation for the taxable year and prior taxable years becomes includible in gross income for the taxable year;
- Accrued interest is assessed on the taxable amount; and
- A federal penalty of 20% of the deferred compensation to be included in gross income is assessed.
- In addition, a 409A violation may trigger state-level penalties by assessing additional California taxes and a further 20% penalty.
As an example, an executive gets 100,000 stock options at $5 a share; however, if the fair value of the shares is $8 a share, they would be receiving a $300,000 benefit as far as the IRS is concerned. The executive would be taxed in that tax year on $300,000, as well as accrued interest. In addition, they may face a penalty of $60,000 to the federal government and another $60,000 to California.
The penalties may be assessed whether or not the employee or executive actually cashes out their options. In the worst case scenario, if the value of the stock is less than option price at the time the company goes public, they may have to pay the tax and penalties without receiving any financial benefit from the stock options.
Violations do not need to be intentional, even a minor violation or failure to gain safe harbor status can lead to serious 409A penalties. Given these possible scenarios, paying a few thousand dollars for a 409A valuation can eliminate the risk of penalties for recipients of non-qualified deferred compensation.
Butterfield Schechter LLP is San Diego County's largest firm focusing its law practice on business counseling, tax law, and benefits. Our firm can help your startup grow while staying in compliance with the latest regulations and filing requirements. Contact our office today with any questions on how we can help you and your business succeed.