409A Valuation: A must consideration before implementing deferred compensation plan including issuing stock options



There are many ways in which management is given a portion of the appreciation in value of the organization in which they work. The various forms include stock options, stock appreciation rights, and similar instruments. One of the more common forms is common stock options under an equity incentive plan.

Section 409A of the Internal Revenue Code applies to the compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation and is different from deferred compensation in the form of elective deferrals to qualified plans such as a 401(k) plan or to a 403(b) or 457(b) plan. 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 and a potential interest charges. 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. In simple words, to avoid adverse tax consequences referred to above, it is indeed very significant to value the stock options correctly at the fair market value complying with 409A valuation rules.

The valuation task for public companies is quite straight forward. The regulations generally require that the valuation of such stock be based upon the contemporaneous prices established in the securities market, subject to the certain modifications. Also, consideration is given to each stock option agreement’s particular restrictions and features.

The valuation could be complicated for private companies. The fair market value of private company stock must be determined, based on the private company’s own facts and circumstances, by the application of a reasonable valuation method. A method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the private company. The factors to be considered under a reasonable valuation method include, as applicable, the value of the tangible and intangible assets of the corporation; the present value of anticipated future cash flows of the corporation; the market value of stock or equity interests in similar corporations and entities engaged in trades or businesses substantially similar to those engaged in by the subject corporation; recent arm’s length transactions involving the sale or transfer of such stock or equity interests, and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes.

The regulations provide safe harbor protection for valuation of stocks of private companies and describe circumstances under which a valuation is considered reasonable as outlined below:

  • A valuation that is not more than 12 months old and is prepared by an independent appraiser.
  • A valuation based on a formula which is used consistently by the company and by all of its 10% plus shareholders for all restricted stock transactions (except for a sale of control).
  • For start-up companies (non-public and in business less than 10 years), a written valuation report prepared by a person that the corporation reasonably determines is “qualified” to perform the valuation, based on the person’s significant knowledge, experience, education or training.

The presumption of reasonableness will not apply to the valuation if the company or the option holder may reasonably anticipate, as of the time the valuation is applied, that the company will undergo a change of control event within 90 days, or make a public offering within 180 days.

The fair market value calculated previously is not considered reasonable if it does not reflect the information available after the initial date of the valuation that materially affects the value of a private company; or the value was calculated as of a date that is more than 12 months earlier than the date for which the valuation is being used. It is significant that material events which could trigger the need for a re-valuation are kept in mind. Some of these events could be:

  • Changes in the economy at large, or industry
  • New product launch or completion of product development milestones
  • Material changes to company capital structure like financing events, or recapitalization
  • New major customers
  • Resolving material litigation
  • Receiving material patent

Though the valuation could be performed internally as far as it meets the requirements of the regulations, the one performed by outside appraiser is more reliable due to the complexity of valuation techniques and their application. Further, an appraisal performed by an outside appraiser is regarded more independent than one done internally. Employers thinking about implementing an equity compensation plan should obtain defensible appraisal considering the adverse tax consequences the employee and company can have.

Write to Baljeet Singh at baljeetsinghcpa@gmail.com


20 Year-Round Tax Tips for Businesses

Among many challenges faced by business owners, tax compliance is one of the most significant one. Here are the important tax tips that you don’t want to miss out.



Being a business owner is a great thing; however it comes with many responsibilities and challenges. Tax compliance is one of the main challenges that business owners have to face. It is significant to know that tax compliance or planning is not limited to once in a year meetings with your tax accountant, year-end tax planning or filing annual income tax returns. All business transactions should be analyzed from a tax prospective on an ongoing basis. Here are a few year-round tax tips for business owners that could help them to comply with tax laws and save on taxes, potential interest and penalties.

  •  When you start a new business, consider different choices of business structures like sole proprietorships, LLC, C-corporation, S corporation etc. Choose the one that is more tax efficient and is best suited to your other business objectives. There are numerous factors that should be considered while making a choice of entity that you should review with your CPA. Once set up, keep reviewing the business structure on an ongoing basis and make the appropriate change if some different business structure is considered to be more tax favorable due to change in circumstances, your business objectives etc.
  • Give a careful consideration to the state where you would like your business to be incorporated. There are various factors that should be considered while making this decision. Some of the significant factors, that vary from state to state, include income taxes, sales taxes, franchise taxes, tax filing fees, business friendly laws and statutes. Of course, if some specific state otherwise makes more sense for you from a business prospective, you should go for that state.
  • Know the state income tax compliance requirements of any state where you carry out or intend to carry out business activities. Though the rules vary from state to state but in general, you need to register your business with a state and comply with tax filing requirements if you carry out major economic activity, generate revenue, have employees, rent or own office or property in the State. Be sure to get this evaluated before you indulge in business activities in any particular state and if required, get the registration done, obtain certificate of authority and comply with tax filing requirements.
  • Know the sales tax rules of the state where you carry out or intend to conduct business. The sales tax rules vary from state to state. Generally the sales tax is imposed on products, however many states now have sales tax on software services. Currently, there are many states that already require the sales tax on software services are Connecticut, Hawaii, Mississippi, Nebraska, New Mexico, South Dakota, South Carolina, Tennessee, West Virginia, Wyoming and Massachusetts.
  • Be aware of recordkeeping requirements by law. Have good systems in place to maintain books of accounts, supporting documentary evidences and additional details in a diary or log book or some other way. Maintain records for sufficient number of years generally for at least the period covered by the statute of limitation which is 3 years after the due date of the tax return or 2 years after the date the tax was paid whichever is later. (also read “Tax Records That Businesses Must Maintain” at https://baljeetsinghcpa.wordpress.com/2014/01/07/tax-records-that-businesses-must-maintain/)
  • Always keep separate bank accounts, credit cards, and other documents to keep track of business expenses separately.
  • Know the difference between employees and independent contractors, and classify them correctly. If an employee is wrongly classified as a contractor and IRS learns about the incorrect classification, it could result in back payroll taxes and penalties.
  • If any payment is made to stockholders/owners, be sure to classify it correctly as payroll or management fee or distribution depending on various factors like what role the stockholder is playing in the business? Are there other officers who are performing the actual operation of the corporation for which it was started? If an amount paid to the stockholder that is wrongly classified as a management fee instead of payroll, it could result in back payroll taxes and penalties.
  • Before an amount is distributed to an S-corporation stockholder, be sure that the stockholder is otherwise compensated by way of a payroll for services performed for the S-Corporation. If the stockholder is not sufficiently compensated for the services performed, then IRS could take a stand that distribution is made to stockholder instead of payroll as an attempt to avoid payroll taxes and could impose penalties on S-Corporation.
  • If a business give or take loans from shareholders, be sure to have a formal agreement to include the interest terms, repayment terms. If business financials reflect loan to or from stockholder, there should be corresponding interest income or expenses in the business’ financials and hence on the tax returns.
  • Be aware of requirements of issuing form 1099. Broadly form 1099 should be issued if any payment exceeding $600 is made during the course of your business to contractors either individual or partnership; payment of professional fee to an attorney, doctor, or other professional; payment to an individual or partnership, for rent for office space, machines, equipment. Payments include commissions, fees, interest, rents, royalties, annuities and any other type of compensation or income to a single recipient. Please note that form 1099 is required to be issued for payments to corporations only if they are for medical, health care, legal or fishing activities. Individuals are not required to send 1099-MISC for personal payments.
  • Be sure to timely deposit payroll taxes withheld from employee’s payroll. Do no use the taxes so withheld for the purposes of business operations. Using the payroll taxes for the purposes of business operation could attract criminal and civil penalties, and fines.
  • If you/your CPA decide to claim home office deduction on your income tax returns, be sure that the office must be used regularly and exclusively for conducting business. Further you can claim expenses including real estate taxes, mortgage interest, utilities and insurance for the portion the home is used for business.
  • If you receive some insurance proceeds for some causality loss, reduce the amount of causality loss by the insurance proceed before claiming the deduction for the same on the income tax return.
  • Be aware of passive loss limitation rules if you are an owner of pass through entities (e.g. S-Corporation, partnership etc.) and have losses in business. To deduct the losses, you should have sufficient level of participation in the business and should have sufficient records to evidence the participation. Also know the basis rules if you are an owner of pass through entity. The owners can deduct the losses to the extent of their basis in the business.
  • If you are considering issuing stock options, stock appreciation rights or other instruments to employees; you must consider getting a 409A valuation done to arrive at fair market price of the common stock of the corporation. Under Section 409A of Internal Revenue Code, 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. It is indeed very significant to value the stock options correctly at the fair market value complying with 409A valuation rules to avoid such adverse tax consequences.
  • Be aware of transfer pricing regulations while entering in to any transactions with related parties. In general, the U.S. transfer pricing regulations require that transactions between related parties take place at the same prices that would be expected had the same transactions taken place between unrelated parties. Regulations describe a set of specified methods that may be used to determine whether the prices charged in controlled transactions are consistent with those that would be expected at arm’s length. Unspecified methods may also be used if they are likely to yield a more accurate result than the specified methods.
  • Know the reporting requirements related to signature authority, control, or ownership in foreign financial assets or other business entities in any foreign country. There are various forms that could be applicable based on facts and circumstances of each case such as form TD F 90-22.1, form 8938, form 5471, form 5472, form 8865, form 926, form 3520 and form 3521. Be sure to get the applicability of foreign reporting evaluated in your particular case and comply if applicable.
  • Plan to file your tax returns in time. If due to some reasons the filing of tax returns is extended, be sure to pay the taxes along with the extension. Know that extension of filing the tax return does not extend the date of payment of taxes. Else, you could end up paying interest on late payments.
  • Keep in mind important tax deadlines for your business; some most common tax deadlines are:
    • Due date for filing Income tax returns for most businesses following calendar year as their fiscal year is March 15, if incorporated business and April 15, if unincorporated business.
    • Estimated taxes for income earned or received during the year are paid on quarterly basis and due dates for payment are April 15, June 15, September 15, and January 15.
    • Due date for sales tax payment is either monthly or quarterly depending on state where you are subject to sales tax.
    • Payment of payroll taxes are due either weekly, monthly or quarterly depending on size of payroll. Form W2’s to employees should be issued by January 31. Quarterly federal payroll returns should be filed by the end of subsequent month of the quarter. Annual federal payroll return should be filed by January 31. Also be aware of state payroll forms and returns filing requirements.
    • Deadline to furnish form 1099 to payee is January 31. Form 1099 & 1096 should be mailed to IRS by February 28 if filed by paper, and by April 1 if filed electronically.

Write to Baljeet Singh at baljeetsinghcpa@gmail.com