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Stock Option Issuance: IRC 409A and ASC 718

Tax Compliance:  IRC 409A
Since January 1, 2009, Internal Revenue Code 409A (IRC 409A) has been in full effect and any new stock option must be priced at or above “fair market value” (FMV).  Pricing stock options below FMV will cause adverse tax consequences for both the issuing company and the option holder.  The combination of federal and state taxes, penalties, and interest can exceed 75%.*

To avoid potential penalties and withholding requirements for both employer and employees, companies need to establish FMV in a way that satisfies the IRS. IRC 409A provides a regulatory “safe harbor” and most companies have chosen to obtain a valuation report from an “independent appraiser.”  It has been our experience that companies commonly get an independent appraisal after obtaining the first round of outside capital and thereafter get an appraisal every 12 months or after a material change (such as a new equity financing), as required by the law.

GAAP Compliance:  ASC 718 and ASC 505-50
In addition to the tax requirements of IRC 409A, companies must consider the GAAP requirements of ASC 718 and ASC 505-50 (formerly FAS 123R).  Since 2006, GAAP has required that even private companies report the value of stock options issued as compensation to employees and non-employees.  The requirements of GAAP are more detailed than the requirements of the tax regulation; they are laid out in a more than 200 page AICPA practice aid, “Valuation of Privately-Held-Company Securities Issued As Compensation.”  Audit firms have been very thorough—some would say “demanding”—in their review of valuation reports under the provisions of Statement of Auditing Standard 73 (SAS 73), “Using the Work of a Specialist,” and look for strict compliance with the AICPA practice aid.

Why You Need a Dual-Use Report
A report prepared for the lower requirements of IRC 409A probably will not meet the higher standard of ASC 718 and can lead to difficulties during a financial audit or an acquisition.  The professionals at Teknos anticipated this issue as early as 2006 and we only provide a dual-use report that meets both the tax and GAAP standards.  Our reports have been reviewed by all of the Big Four and other major accounting firms and pass scrutiny (a SAS 73 review) without any difficulty.  Our reports also have been utilized in the preparation of S-1 and other registration materials for the SEC, and we have written “cheap stock” memos to address questions raised by the SEC.

Teknos has prepared thousands of these reports for companies in a wide range of industries.  We can rapidly prepare a dual-use IRC 409A and ASC 718 valuation report for your company at a reasonable fee and will provide support for any subsequent interaction with the financial auditors reviewing the report.  For assistance with IRC 409A and ASC 718 reporting, please contact us: .(JavaScript must be enabled to view this email address)

For a variety of articles and white papers on the subject of stock option pricing and regulatory compliance, see:
How Changes in Regulation Have Driven Stock Option Prices.
Revised Valuation Allows Completion of IPO.
Acquirer Challenges Early IRC 409A Report.
IRC 409A After Three Years:  It’s Not Just About Tax.
The Effect of Convertible Notes on IRC 409A Valuations.
Why Is Our Stock Option Price So High?.
Think That the IRS Doesn’t Care About IRC 409A?  Think Again.
Does Crowdfunding Affect IRC 409A Valuation?
Six Mistakes to Avoid When Issuing Common Stock Options
Three Types of Common Stock Transactions That May Affect Your IRC 409A Valuation
Three Best Practices in Valuation for Companies Planning an IPO

Special Note: From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services. However, nothing in this communication may be taken to represent the official position or policy of the IRS. The opinions expressed herein are those only of Teknos Associates.

*The highest marginal income tax rates are 39.6% for federal purposes and 9.3% for California purposes.  The penalty rates are 20.0% for federal purposes and 5.0% for California purposes.  In addition, payroll taxes, interest, and penalties for late payment may apply.