If you are trying to start or run a small business or startup and offering your employees and contractors stock as part of their compensation you need to know what a 409A valuation is.
Often, this aspect of the tax code is overlooked or forgotten, but this piece of the code is vital for small businesses and startups to understand. Don’t get caught unawares. Learn the ins and outs of 409A valuations with our easy to understand guide.
- 1 What does 409A Mean?
- 2 What is 409A Valuation?
- 3 Why Is a 409A Valuation Important?
- 4 What is a 409A Valuation Report?
- 5 Which Aspects of a Business are Considered for a 409A Valuation?
- 6 What is Fair Market Value?
- 7 How does a 409A Valuation Affect Stock Options?
- 8 What is the Difference between a 409A Valuation and Other Kinds of Business Valuations?
- 9 How Much does a 409A Valuation Cost?
- 10 How Long Does It Take?
- 11 Why Should you Hire a Business Valuation Company to Do Your 409A Valuation?
- 12 Where Do I Get a Formal 409A Valuation?
- 13 Guide to 409A Valuations for Startups
- 14 When Do You Need a 409A Valuation?
- 15 When should you get your first 409A valuation?
- 16 Reasons to Not Use a 409A Valuation
- 17 Reasons to Use a 409A Valuation
- 18 Deadlines for a 409A Valuation
- 19 Common Mistakes with 409A Valuation
- 20 Frequently Asked Questions
- 21 Definition: What is a Key Employee?
- 22 What are the Consequences of 409A Non-Compliance
- 23 History of 409A Valuations and Cases of IRS Enforcement
What does 409A Mean?
Section 409A of the IRS tax code refers specifically to “nonqualified deferred compensation.” This refers to several types of compensation you might be offering your employees and contractors. The IRS defines it this way:
Section 409A applies to compensation that workers earn in one year, but that is paid in a future year. This is referred to as nonqualified deferred compensation. This is different from deferred compensation in the form of elective deferrals to qualified plans (such as a 401(k) plan) or to a 403(b) or 457(b) plan.
What does this mean for your startup or small business? Basically if you pay your employees or contractors partly with 401(k) plans or stocks then you need to file under section 409A.
What is 409A Valuation?
If the above description applies to your startup or small business then you may need a 409A valuation. But just what is a 409A valuation?
In a 409A valuation, an expert appraises the fair market value of the company or business’s common stock.
The complexity of this valuation varies broadly depending on whether the stock in question is publicly traded or private company stock. With publicly traded stock, it’s possible to simply look at the prices of the stock on the public exchanges and markets. However, when it comes to private company stock, an independent valuation is required in order to assess the value of the stock.
Put simply, a 409A valuation is just a way to determine the value of the stock you compensate your employees and contractors with. This includes:
- 401(k) plans
- Stock options
- Stock awards
- Stock appreciation rights
Why Is a 409A Valuation Important?
409A valuations are crucial to get if you need one. They will help you avoid tax issues when it comes to the IRS. Not only you, but also your employees could be on the hook with the IRS for a lot of money if you don’t get a 409A valuation when you need one.
If, for example, you gave your employees and contractors an option to buy 500 shares at $1 per share, you need a 409A valuation. Without that valuation, the IRS could later tell you that the stocks were worth $2 a share on that date. Your employee would have to pay the difference PLUS a penalty of 20% of the price difference. In the example here, that would mean more than $1000 in sudden fines. And don’t forget that the IRS will change interest on any fines or fees.
The cost of NOT getting a 409A valuation can be very steep for you and your employees.
What is a 409A Valuation Report?
A 409A valuation report is what an expert will produce when you get a 409A valuation from them. The report should tell you the fair market value of all deferred compensation you gave to your employees and contractors.
This report will help keep you in compliance with IRS guidelines and rules in regard to the deferred compensation you give your workers. This includes stocks as well as things like 401(k) plans.
Which Aspects of a Business are Considered for a 409A Valuation?
A 409A valuation doesn’t look at the entire business, only the parts that are relevant to section 409A of the IRS tax code. These parts include:
- Value of tangible and intangible assets
- Present value of future cash flows
- Fair market value of your business compared to similar public and private businesses
- Control premiums
- Lack of marketability
- How this method of valuation is applied in other scenarios
There may be other aspects that apply. It will change depending on the specific business getting the valuation and what it needs. The goal in deciding which factors to consider is to make sure all the deferred compensation you have to report is thoroughly accounted for in the valuation.
What is Fair Market Value?
A big consideration in a valuation is figuring out the “fair market value” of various types of deferred compensation.
Fair market value basically means the price a reasonable person would pay for something. This is a very simple way of defining it, but it is essentially true. Fair market value assumes that the buyers and sellers of an asset are both knowledgeable enough to behave in their own best interest.
When it comes to taxes, fair market value is used for more than just 409A valuations. STocks, property and insurance claims all also rely on fair market value to come up with fair parameters. In regard to your 409A valuation, fair market value will determine the worth of deferred compensation such as stocks and 401(k) plans that you compensate workers with. Fair market value is a crucial concept that will ultimately determine your tax liability in regard to these assets.
How does a 409A Valuation Affect Stock Options?
With stock options being one of the major areas that a 409A valuation looks at, it is important to understand how your valuation may impact stock options.
Sometimes, a 409A valuation will not affect stock options at all. If stock options or stock appreciation rights are at or above fair market value, then you don’t need to worry about 409A when doing your taxes. Of course, you may not know just at a glance if your stock options are at fair market value. It is often better to err on the side of caution and get a valuation to ensure you do not need to file under section 409A.
A 409A filing is definitely needed when stock options are not at or above fair market value. The valuation may determine that the value of those stocks is different than you or the recipient initially thought or assumed. There are many circumstances that could lead to this. For example, someone who inherits stock options may get them at a much lower value than what they are really worth. A 409A valuation would likely lead to these stock options being valued much higher.
What is the Difference between a 409A Valuation and Other Kinds of Business Valuations?
A 409A valuation is not the only type of business valuation that is available. There are also:
- Asset-Based Valuations
- Income Valuations
- Benefit Valuations
- Market Valuations
These difference from 409A valuations in the ways described below:
- Asset-Based Valuations: This focuses on tangible assets, usually, rather than the intangible assets that are the focus of a 409A valuation. An asset-based valuation is usually appropriate for retail and manufacturing companies with substantial tangible assets. This valuation assesses fair market value for things like improvements to the business, inventory and fixed assets.
- Income Valuations: While 409A valuations are all about deferred compensation, income valuations are focused on the company’s income potential. That is not the payments doled out to employees and contractors, but the actual income the business is accruing. Businesses who get this type of valuation usually do not have many tangible assets. The focus is cash flow and potential future profits.
- Benefit Valuations: 409A valuations look at compensation for everyone; benefit valuations focus on compensation for the business owner alone. Like income valuations, benefit valuations are future-focused, trying to estimate future earnings for the business owner.
- Market Valuations: This type of valuation focuses on sales figures. The goal is to figure out what a business would be worth if it were sold, which is not a concern of 409A valuations. A market valuation is a simple determination of what a business is currently worth on the open market.
How Much does a 409A Valuation Cost?
The answer to how much a 409A valuation costs depends on how you go about doing it.
It is possible to do your own 409A valuation, but we do not recommend going this route unless your business is very small and your deferred payments are obvious and easy to calculate. The penalty for doing your 409A valuation wrong or having an error on it is quite high, so you should be very confident about all the assets in question if you plan to save money by doing your valuation yourself.
You can also use software and programs to help you do your 409A valuation on your own. This is ok for early startups, but can be risky. It still depends on you getting everything exactly right. If you miss anything you can be in for IRS penalities.
Another option is to get a company like Redwood Valuations to handle your valuation. Our experts have decades of experience with hundreds of clients. If you choose us to do your 409A valuation you can be sure you will get a result that the IRS will accept. Don’t save money in the short term if it will cost you later in IRS fees and interest payments. Get your 409A valuation done right through Redwood.
How Long Does It Take?
There is some variation in the amount of time a full 409A valuation can take depending on the complexity of your business’s finances and payments. We can offer an estimate of a typical valuation, however:
- 1-3 days: Hand over your data to a professional valuator, including financial projections, past 409A reports (if you have any), articles of incorporation and term sheets
- 10-20 days: Run the actual 409A report
- 1 day: Review the first draft of the report with the valuator (this is typically a short appointment of 30 minutes – 1 hour)
- 1-2 days: Make any needed revisions to the report
- 1-10: Apply the revisions to get your final report
As you can see, there are a lot of variable factors involved in getting a time estimate for a 409A valuation. These time estimates are approximate. We can work with you to give you a more precise time estimate as we proceed through the valuation process, but our valuations generally take 2-3 weeks for a draft report (4-6 weeks for more complex engagements).
Why Should you Hire a Business Valuation Company to Do Your 409A Valuation?
While it’s possible to do your own 409A valuation, we recommend going with a business valuation company like Redwood Valuation Partners to do your 409A valuation.
There are several benefits to having an expert handle your valuation for you. For one, you won’t have to deal with the stress and pressure of getting your valuation perfect in order to avoid fees and penalties from the IRS.
For another, our valuators are experts in their field who have decades of experience. You can trust they will do your valuation right the first time, saving you time and money over less experienced valutors. Plus, they can handle your business no matter what its particulars involve. Redwood has a diverse range of clients, from high pressure startups to rapidly growing companies.
Where Do I Get a Formal 409A Valuation?
Business valuators can provide you with a 409A valuation. Redwood Valuation Partners is one such valuation company. We would be happy to work with your on your 409A valuation. Here are just a few of the benefits of working with us for your 409A valuation:
- We have more than 500 clients who have come to trust our work
- We have expert knowledge in the fields of finance, tax, venture capital and the audit process
- We understand the pressures of running a startup or small business
- Our team includes experienced associates and analysts with decades of knowledge
- We will defend your valuation at any point
- We will do your valuation without unreasonable fees
- We have existed for as long as the 409A IRS code has existed
Guide to 409A Valuations for Startups
Redwood specializes in working with early-stage and high growth companies like startups. We can help startups looking for help with their 409A valuations.
The first step for a 409A valuation will be turning over all relevant company information. Once we have this information, we can run the report needed for the valuation.
With this report in hand, the next step is to review it with you and make sure we haven’t missed anything. We’ll make revisions together and then our experienced valuators will produce a final report.
When Do You Need a 409A Valuation?
You need a 409A valuation as soon as you issue your first employee stock options. After that point, you will need to get a 409A valuation every 12 months. They are only good for the current tax year, so make sure you stay on top of redoing the valuation every months.
Also take note of any time your company experiences big changes. You may need to get another 409A valuation depending on what type of major change occurs.
When should you get your first 409A valuation?
Your first 409A valuation may coincide with the start of your company. However, you may not need a 409A valuation until later. As soon as you start issuing employee stock options or other deferred compensation you will need a 409A valuation.
Reasons to Not Use a 409A Valuation
Don’t jump the gun on 409A valuations when you may not actually need one. Here are some scenarios where you don’t actually need a 409A valuation:
- If you run a public company you can issue stock options in such a way that you don’t actually need to get a 409A valuation
- If you don’t issue any stock to your employees you do not need to get a 409A valuation
Reasons to Use a 409A Valuation
Of course, the flip side is the many companies who do actually require a 409A valuation. Here are some scenarios where you do need a 409A valuation:
- When you want to ensure you’re following all applicable tax laws to avoid an IRS audit
- When you do issue stock to your employees
- When you want to ensure your employees will not run into tax trouble
Deadlines for a 409A Valuation
The deadline for a 409A valuation depends on when and why it was initiated. The deadline for a valuation may be immediate if you have just issued stock options to your employees.
You also need to make sure you have a new valuation done if it has been 12 months since the first valuation was performed.
A third deadline approaches if you have recently made big changes at your company. Once you do this, you may need to get a valuation quickly (as in the first scenario) to ensure you are still in compliance with section 409A of the tax code.
Common Mistakes with 409A Valuation
Don’t get caught by any of the common pitfalls involved with doing a 409A valuation. Here are some common mistakes to avoid when it comes to your 409A valuation:
- Trying to haggle with the valuator. The information the valuator comes back with might not be exactly what you were hoping for, but trust that they have the experience and knowledge to do an accurate valuation.
- Speaking of valuators: Hiring the wrong valuator. Inexperienced valuators may not understand 409A or your business as well as you need them to. Don’t take chances when you can know you’re getting the best valuators from Redwood Valuations.
- Overlooking your own accountants. True, you are hiring an expert to do your valuation, but there’s no reason not to also consult your in-house talent. If the IRS does an audit, it will be your own accountants who will need to come to the rescue.
Frequently Asked Questions
We know the common pitfalls and confusions that come with trying to do your first 409A valuation, or even renewing your valuation. We have an extensive FAQ to help answer some of the questions that are likely at the top of your mind. Our FAQ covers:
- Do I need a 409A valuation?
- How often is a 409A valuation needed and how long is it good for?
- What kind of clients do you work with?
- What is your turn around time?
- What does the process and deliverable look like?
- Do you defend your work from regulators and auditors?
- Is there a rule of thumb regarding common as a percent of preferred?
Definition: What is a Key Employee?
IRS Tax Code Defines “Key Employee”
(1) Key employee
(A) In general
The term “key employee” means an employee who, at any time during the plan year, is—
(i) an officer of the employer having an annual compensation greater than $130,000,
(ii) a 5-percent owner of the employer, or
(iii) a 1-percent owner of the employer having an annual compensation from the employer of more than $150,000.
For purposes of clause (i), no more than 50 employees (or, if lesser, the greater of 3 or 10 percent of the employees) shall be treated as officers. In the case of plan years beginning after December 31, 2002, the $130,000 amount in clause (i) shall be adjusted at the same time and in the same manner as under section 415(d), except that the base period shall be the calendar quarter beginning July 1, 2001, and any increase under this sentence which is not a multiple of $5,000 shall be rounded to the next lower multiple of $5,000. Such term shall not include any officer or employee of an entity referred to in section 414(d) (relating to governmental plans). For purposes of determining the number of officers taken into account under clause (i), employees described in section 414(q)(5) shall be excluded.
(B) Percentage owners
(i) 5-percent ownerFor purposes of this paragraph, the term “5-percent owner” means—
(I) if the employer is a corporation, any person who owns (or is considered as owning within the meaning of section 318) more than 5 percent of the outstanding stock of the corporation or stock possessing more than 5 percent of the total combined voting power of all stock of the corporation, or
(II) if the employer is not a corporation, any person who owns more than 5 percent of the capital or profits interest in the employer.
(ii) 1-percent owner
For purposes of this paragraph, the term “1-percent owner” means any person who would be described in clause (i) if “1 percent” were substituted for “5 percent” each place it appears in clause (i).
(iii) Constructive ownership rulesFor purposes of this subparagraph—
(I) subparagraph (C) of section 318(a)(2) shall be applied by substituting “5 percent” for “50 percent”, and
(II) in the case of any employer which is not a corporation, ownership in such employer shall be determined in accordance with regulations prescribed by the Secretary which shall be based on principles similar to the principles of section 318 (as modified by subclause (I)).
(C) Aggregation rules do not apply for purposes of determining ownership in the employer
The rules of subsections (b), (c), and (m) of section 414 shall not apply for purposes of determining ownership in the employer.
For purposes of this paragraph, the term “compensation” has the meaning given such term by section 414(q)(4).
What are the Consequences of 409A Non-Compliance
If you are not compliant with section 409A then you can be audited by the IRS. Audits are not only expensive, they are also time consuming. Plus, you are likely to face taxes and penalties.
History of 409A Valuations and Cases of IRS Enforcement
Section 409A came about on January 1, 2005, as part of the American Jobs Creation Act of 2004. It was added to the IRS tax code in order to broadly address all forms of deferred compensation and ensure businesses are in compliance.
Part of the impetus for creating section 409A was questionable business practices at Enron. Enron executives used deferred payments to access money shortly before the company went bankrupt. This allowed them to escape certain loses they may have suffered otherwise.
Another reason for the creation of 409A was the IRS’ concern over historical tax-timing abuse.
The IRS was initially slow to enforce 409A, then started to examine select large employers for compliance. This indicates that the IRS is moving to refine the standards of 409A and will start evaluating more and more businesses for compliance. In 2014, the IRS conducted a limited audit initiative to see how well businesses were complying with section 409A. This may produce a nasty surprise for businesses who aren’t prepared for a section 409A audit.
Self-auditing is recommended for all businesses trying to stay in compliance with section 409A. You may be able to find problems before you have to deal with a much scarier, costlier and more time-consuming IRS audit.
- Wikipedia 409a Page https://en.wikipedia.org/wiki/Internal_Revenue_Code_section_409A
- IRS Comments on 409a https://www.irs.gov/irb/2007-19_IRB
- Taxes and Business Organizational Choice: Deja Vu All Over Again? http://citeseerx.ist.psu.edu/viewdoc/download;jsessionid=D53B644260219D6556C5506BC9932F28?doi=10.1.1.385.7162&rep=rep1&type=pdf