Section 409A Safe Harbor Rules for Startups
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What is Section 409A and how does it affect my company?
In most situations, Section 409A deals with deferred compensation. Deferred compensation is compensation that is unreported or underreported, and therefore on which people don’t pay income taxes. From the IRS’ perspective, this is problematic because they want people to pay income tax on all of the income they receive.
How deferred compensation impacts most companies is when companies are issuing stock and stock options to employees and other key service providers in exchange for services. The IRS considers the stock or the stock options that somebody receives as compensation. If a company gives an employee stock, for example, and the employee has not paid for that stock (or is receiving an artificially low strike price), then the employee and company could be penalized for under-reporting taxable income. The company has an obligation to withhold payroll taxes on the amount of the stock, and the employee has the obligation to pay income tax on that amount. In a company that’s rapidly scaling and increasing in value, the fair market value of the options strike price and the actual restricted stock that’s given to employees becomes important.
Section 409A outlines some of the things that companies can do to protect themselves and their employees. For example, it establishes a safe harbor which says that if the company employs one of these methods, it can have a presumption that it’s given the stock options or the stock a fair market value price when it’s compiling it’s reporting and giving stock to employees.
There are two main safe harbors that companies tend to use when they’re in their private growth stage. The first is utilizing an internal report by what’s called a “qualified individual”. A qualified individual in this safe harbor rule is someone who has experience in private equity, lending, business valuations or business approvals, investment banking, or some other kind of financial service. That person does an internal valuation report justifying his or her findings. The internal report gives the company a safe harbor that the strike price they picked for their options or the value they’re attributing to their stock is actually a fair market value.
The second more common method that companies use is hiring an independent valuation firm. Many cap table management software companies, as well as independent appraisal firms, offer these services. If the appraisers are independent and qualified, the company can get a valuation report. The reports range in price from a couple $100 to a couple $1000. The independent report should give the board of directors’ confidence that its options strike price is set at fair market value, thereby avoiding a taxable impact to the employees and withholding obligation on behalf of the company.
These safe harbor options do not necessarily mean that the reporting is full proof and the IRS can never question it, but if the company is audited, it means that the IRS would have the burden of showing that such a report, either internal or an external independent valuation is grossly unreasonable under the circumstances, which is a very hard burden to prove and can be very valuable to the company.
Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal