Stock As Deferred Compensation: Regulatory compliance
By Alex Hodgkin
The first in a series of three articles on the complexity of 409a compliance by leading valuation firm Arcstone Partners
Offering equity participation as a form of compensation is nothing new: companies have long enticed potential employees and partners with a piece of the company as a portion of their overall compensation package. That’s certainly true in this era of entrepreneurship. However, with changes made to the IRS code over the last few years, both public and privately held companies have struggled with the complexity of incorporating equity participation into their compensation plans for employees. Today, the term “409A,” which refers to the section of the IRS code that governs equity participation, is very much a part of the everyday business lexicon of most compensation professionals. It is a complex issue: debate rages and confusion abounds about just how companies achieve compliance with 409A when developing their compensation policies and practices.
Hang on, though. Let’s step back and lay a bit of groundwork: How did all this come about in the first place? With the widespread use of equity as deferred compensation, the Federal government sought to make sure that equity compensation plans adhered to appropriate rules and guidelines. To ensure compliance, the government established harsh tax consequences for the failure to do so. Thus was created Internal Revenue Code Section 409A, part of Section 885 of the Jobs Creation Act of 2004. Finalized in April 2007, 409A applies to stock options and stock appreciation rights (SARs) defined as deferred compensation. Most of the 409A text, some 397 pages in all, deals with the design and structure of compensation programs. Mostly lawyer stuff – for public company HR professionals, this is the critical piece. A few crucial pages in the middle deal with valuation. Finance stuff – to most private company CFOs, this is the critical piece. In other words, in the absence of an actively traded public market, private companies are harder to value.
So here’s the problem, particularly for private companies: under 409A, stock options that have an exercise price less than the fair market value of the underlying stock as of the grant date could result in adverse tax consequences for the option recipient. The gain is subject to taxation at the time of option vesting rather than the date of exercise, with potentially devastating penalties and interest charges. In short, the consequences for noncompliance that affect the individual who holds the options (and not the issuing company) are significant.
While it’s perhaps an uphill battle, compliance is not a lost cause. Section 409A, while lengthy and complex, does outline some reasonably clear approaches on how to develop compliant policies. These presumptive methods, known as safe harbors, shift the burden of proof of noncompliance to the IRS if implemented properly. That simply means that if a company employs a safe harbor method to value the price of its stock options, the IRS must show that the company was grossly unreasonable in calculating the fair market value of the underlying security before wrongdoing may be claimed.
Please read our next article which discusses the specific safe harbors available under 409A.
Thanks to Alex Hodgkin, one of the co-founders and managing directors of Arcstone Partners for this informative article. Alex’s is readily viewable on their website