IRC 409A: It’s Not Just About Tax

IRC 409A became part of the tax code on January 1, 2009.  So, what have we learned in recent years*?

One of the biggest surprises to most people is that the issue – proper pricing of stock options—is not just about tax law.  Despite the fact that the name which everyone uses, “409A,” references the tax code and despite the fact that people go to the trouble of obtaining an independent valuation because of the fear of tax penalties, it’s not just about tax.

And this lack of understanding – that it’s not just about tax – can create downstream problems for companies and option recipients.

No Sign of IRS Enforcement – Yet

No one has seen any sign of the IRS moving to enforce the few provisions of IRC 409A which apply to issuing stock options (the sections pertaining to stock options fill only 6 of 138 pages in the final regulations).  Why have we not heard anything about IRS enforcement?  Because, like any new tax regulation, enforcement takes time.  And it takes even more time for enforcement results to become visible to the community.

The IRS is going to choose its first few cases very carefully.  It wants to win them and it wants to send a message.  Once it chooses its cases, it has to pursue them through a couple of layers of internal appeals and then into Tax Court.  Only after all of that will there be a published decision.  The process could take several years.

But we know that the IRS is pursuing IRC 409A enforcement; representatives of the IRS have said so at various accounting and valuation conferences and in private meetings.  We even know the three main issues on which the IRS is concentrating as it looks at companies and valuation reports.

The “red flag” issues are: (1) valuation reports which are not prepared in conformity with an accepted standard (most credible valuation organizations use the American Institute of Certified Public Accountants (AICPA) valuation guide (AICPA Valuation Guide)); (2) valuation reports which are not prepared by qualified valuation personnel (most credible valuation organizations are staffed with people who have earned valuation credentials such as ASA, AVA, CFA, or CPA/ABV); and (3) companies which record “cheap stock” charges (because of a difference between the value determined for tax purposes under IRC 409A and for GAAP purposes under ASC 718).

Audit Firms Moving Aggressively – Now

Even while the IRS is slowly pursuing its own enforcement strategy out of sight from the general public, there has been a much more rapid enforcement program underway in plain view.  For the last several years, audit firms have been aggressively examining the valuation reports used to support option issuance.  They are required to do this under the provisions of SAS 73, which dictates the sort of review they must perform to rely on the work of a specialist (the valuation firm) during an audit.

It is reasonable to think that the standards of the audit firms are tougher than the standards of the IRS, because there is much more written in ASC 718 and the AICPA Valuation Guide, than in IRC 409A.

Risk – Early Valuation Reports Are Rejected

Almost all early stage companies understand the requirements of IRC 409A and obtain a valuation report at least every 12 months.  But many of these same early stage companies do not understand that an audit firm also will be reviewing these valuation reports.  In fact, most of these valuation reports are not reviewed by an auditor for several years, because it does not make sense to hire an audit firm until the company has grown and looks like it will be successful—and some companies will be acquired before they ever are audited.

Because the standard for a tax-compliant report (under IRC 409A) is fairly low, most valuation reports pass it.  However, because the standard for a GAAP-compliant report (under the AICPA Practice Aid) is much tougher, many valuation reports do not pass it.  And, because of the lag in getting auditor scrutiny, many companies will not find out until late in the process—sometimes too late.

Whether an early valuation report is rejected during a routine audit or during an acquisition, the consequences can be severe.

If the problem comes up during a routine audit, the options issued at the early, low valuation will need to be cancelled and reissued – reissued not at the fair value on the original date of issuance, but at the fair value at the time of reissuance.  For example, if options were issued under the mistaken assumption that fair value was $0.05 per share – when fair value really was $0.10 per share – and the error was not discovered until an audit two years later – when current fair value is $0.50 per share – then all of the options issued at $0.05 per share will have to be reissued at $0.50 per share, not $0.10 per share.  That will not be pleasant to explain to employees.

If the problem comes up during an acquisition, the problem is potentially even worse.  Acquirers routinely use a Big Four accounting firm for part of the due diligence review; experts scrutinize early valuation reports for any weakness that could leave the acquiring company exposed on tax or accounting issues.  If any issue is found, it will be used to attempt to negotiate a reduction in purchase price (or at least an increase escrow amount).  Read our earlier whitepaper on the subject.

Some lawyers have mentioned that they think employees who are damaged by these sorts of mistakes in option pricing will have grounds to sue the issuing company and its board of directors.

Best Advice?

The best advice is to assume that any valuation report obtained to support stock option issuance (IRC 409A / ASC 718) will be scrutinized someday.  There is only a small probability that scrutiny will come from the IRS.  But there is a near certainty that scrutiny will come from an audit firm.

So, a company obtaining a valuation report should do three things.  Ensure that the valuation firm represents (in both the engagement letter and in the valuation report itself) that the report will follow the AICPA Valuation Guide.  Ask who will prepare the valuation report and whether that valuation provider is experienced, qualified, and accredited (beware firms which outsource work offshore to nameless individuals who will never have any contact with your company).  And check to see how well the valuation firm handles auditor review questions (ask auditors and lawyers about the valuation firm’s reputation – someone inside each audit or law firm will know).

Valuation reports are like a company’s formation or financing documents – they must be done correctly from the beginning and cannot be changed later without great difficulty or expense.  So, choosing a valuation firm is a lot like choosing a law firm – it’s worthwhile to select a firm with a reputation for quality and experience to avoid difficulties later.

* Although parts of IRC 409A have been in effect since January 1, 2005, the full provisions of IRC 409A did not go into effect until January 1, 2009.

Teknos Associates provides valuation and advisory services for emerging growth companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards to deliver relevant and timely valuation reports and fairness opinions.

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.

IRS Circular 230 Disclaimer:  Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.

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