Equity-based compensation is a common tool for growing companies, but it comes with a level of tax complexity easy to overlook. Section 409A of the Internal Revenue Code imposes strict rules on how deferred compensation arrangements must be structured, particularly with respect to valuation. Stock options are one of the most common examples, and when those rules are not followed, the resulting tax consequences can be significant, often falling on employees rather than the company.  

About Section 409A 

Section 409A was enacted as part of the American Jobs Creation Act of 2004 to prevent tax avoidance through deferred compensation. It broadly governs deferred compensation arrangements, including items such as stock options or stock appreciation rights (SARs), among others. 

The core principle behind Section 409A is tax on compensation cannot be deferred or timed at the employee's discretion, once the compensation is no longer subject to substantial risk of forfeiture or its value is effectively secured. Issuing common stock options to employees is a common transaction subject of Section 409A. If options are issued with a strike price below the fair market value (FMV) of the underlying common stock, they are subject to Section 409A's strict rules. 

Purpose of a 409A Valuation 

Stock options are a common form of deferred compensation, and a 409A valuation exists to establish the FMV of the company’s stock for that purpose. To avoid being subject to Section 409A's rules, options must be issued at or above fair market value. If this condition is met, the recipient of the stock option is taxed upon exercise. If not, they will be taxed upon vesting (before they have received any proceeds with which to pay the tax). 

An important aspect of using a 409A valuation to support stock option awards is that a valuation provides safe harbor protection, meaning the IRS presumes the stated strike price is reasonable. Additionally, it shifts the burden of proving that it is not reasonable onto the IRS. 

When to Get a 409A Valuation and What to Expect 

Any company issuing equity compensation should obtain a 409A valuation in advance of the grant, regardless of stage. Once equity compensation has been issued, a 409A valuation must be completed annually or whenever a material event occurs, whichever is sooner. A material event is any event that could materially impact the value of the company's stock. Common examples of material events are new funding rounds, significant bank financing, significant changes in revenue and M&A activity. 

Obtaining a 409A valuation can feel intimidating for many business owners, but the process is usually more straightforward than expected. Most companies can complete it using information they already maintain for financial reporting and tax compliance. The valuation firm will typically request several years of financial statements, tax returns, shareholder agreements and other operational details. Using this information, the valuator analyzes the company’s performance and structure to arrive at a defensible estimate of value. While the specific steps may vary based on the company’s complexity, the objective remains consistent. Determining the fair market value of a single share of stock underlying the options being granted.  

Implications of Not Securing a 409A Valuation 

If a deferred compensation arrangement violates Section 409A, there are serious penalties. Unfortunately, they primarily fall on the employee rather than the employer. These penalties can create significant employee relations issues and may surface during transactional due diligence.  

Let's walk through a simplified example that illustrates the impact of these penalties:  

Assume an employee has been granted 1,000 options at a strike price of $5, which vests immediately. An independent valuation determines the FMV as of the date of grant is $10. The IRS would assess ordinary income tax on the spread between the FMV and the strike price, as well as a 20% 409A penalty. In this case, the employee would owe a total of $2,500 in taxes and penalties. Keep in mind, this is upon vesting, not upon sale, meaning the employee owes this amount before receiving any proceeds or having any liquidity to pay the tax. Had the options been granted at or above FMV, the tax is deferred until exercise and no penalty is assessed. 

Even if the employee ultimately benefits from future appreciation, the tax burden remains significantly higher. If we assume the employee holds the options for a year before exercising and selling the underlying shares, and the FMV has increased to $12, the tax burden grows. The IRS would assess capital gains tax on the additional $2 per share of appreciation. Using a capital gains tax rate of 20%, this amounts to $400 in capital gains tax. Had the options been issued at FMV, the IRS would assess ordinary income tax on the gain, which would amount to $600. 

In both scenarios, the employee receives total proceeds of $12,000. In the discounted grant scenario, the employee ends up paying a total of $2,900 in taxes and penalties. In the FMV grant scenario, taxes amount to just $600. Despite receiving the same $12,000 of proceeds, the employee in the discounted grant scenario pays nearly five times more in taxes and penalties than the employee does in the fair market value grant scenario. When structured properly, equity compensation remains an effective and widely used tool for aligning employee incentives with company growth. 

How We Can Help 

While Section 409A adds complexity to equity compensation, the core message is simple: valuation matters. Granting options below FMV can trigger significant tax penalties and create unintended consequences for employees. A timely, defensible 409A valuation, updated as the company evolves, helps avoid these risks and ensures equity compensation remains an effective tool for attracting and retaining talent. 

Companies planning to issue equity should build the 409A process into their early planning to ensure grants are structured correctly from the start. If you’re preparing to issue options or want confidence that your valuation is compliant, our valuation team can guide you through the process and deliver a reliable 409A valuation.