Stock options in a startup company can be a valuable form of compensation for employees. Many early startup employees have become wealthy by getting in on the ground floor with stock options that may have been worth little at the time they were granted. However, before issuing stock options, your startup may need a 409A valuation, as provided by the tax code.

Section 409A of the Internal Revenue Code applies to the treatment of federal income tax for nonqualified deferred compensation paid to a “service provider” by a “service recipient." This generally applies to stock options given to employees, executives, independent contractors, or other businesses that provide a service to the recipient.

The 409A regulation was added to the tax code in 2004, partly in response to the Enron scandal. Enron executives were accelerating payments as part of their deferred compensation plan to take money out of the company before it went bankrupt. The new rule was also meant to address other areas of perceived tax system abuse.

Whenever an employee has a right to compensation during a taxable year that may be payable in a later taxable year, this is considered deferred compensation and may be subject to Section 409A. Other forms of deferred compensation may be exempt, including 401(k) plans, pension plans, or benefits like vacation time.

One of the primary complaints from startup companies is the costs associated with paying for an independent valuation. Illiquid startups may find it hard to justify paying thousands of dollars for a valuation that will likely show the value of the stock is minimal.

Valuation of stock options is necessary to determine the fair market value of an option. The value is based on the fair market value of the security on the date it is issued. Many startups do not have a clear idea of the value of stock options at the time they are issued, and many may be worth very little on the open market, or the stocks may not be available on established securities markets.

The tax code provides for safe-harbor valuation of stocks, and the IRS is to accept the valuation unless they can demonstrate the valuation is “grossly unreasonable.” This allows a startup to provide stock options without fear of penalties for a stock that may be difficult to value in the early days of the company. A company can obtain safe-harbor valuation by using an independent appraiser, or using a standard repurchase formula.

Illiquid startup companies can also seek a safe-harbor valuation by obtaining a qualified valuation when the company does not anticipate a public offering of the stock. An illiquid startup is defined as a corporation less than 10 years old, has no publicly traded securities, stock granted is not subject to a put or call, and the company and stock recipient could not reasonably anticipate the company would go public within the next 180 days, or be acquired within 90 days.

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.