409A Valuations have been targeted in recent years by big box cap table software providers and have been used as a marketing ploy by these venture-backed behemoths to capture clients. The market has been flooded with ultra-low cost “automated” 409A offerings in an aggressive effort to try and consolidate the valuation market and reduce the competitive options for clients. The fundamental issue with these “automated” 409A valuations is that they often fail to deliver a defensible, well prepared analysis and you truly get what you pay for… or less if you include the cost of repricing options and potential tax penalties that you may face in the likely event that the “automated” valuation does not survive an audit! Here are some of the biggest risk factors when using big box “automated” providers:

  1. They often misprice options as they fail to properly understand a client’s business and related risks due to the minimal amount of time spent on each engagement. Through our experience in audit review, we have seen these “automated” providers make a wide array of grossly incompetent errors ranging from delivering analyses with material calculation errors to inappropriately estimating double the concluded stock price in 6 months when nothing had changed with the business.
  2. These providers are frequently venture-backed and are primarily focused on maintaining investor returns and searching for an exit. As is the nature with venture backed businesses, there is a good chance they either will go out of business or be forced by investors to drop an unprofitable business line which can leave you holding the bag in the event of an audit. In contrast, Redwood is owned and operated by dedicated appraisers whose only focus is to deliver defensible analyses and will support your valuations for decades to come.
  3. Due to the “automated” nature of their valuation process, these big box providers have virtually non-existent customer service, which can leave clients feeling unimportant. These providers care more about the statistical impact of your engagement to their sales pitch and pivots to “secondary markets” than spending the requisite time to deliver a high quality valuation. As such, they will not spend the time to understand your priorities as a client to help your company reach its goals.
  4. Their team of “experts” often do not have a background or significant experience from a qualified financial services firm and the bulk of their work is outsourced to low cost labor overseas in order to maintain their aggressive pricing strategy. In contrast, Redwood employs a team of appraisal specialists with over 100 combined years of valuation experience from industry leading financial services and consulting firms, and proudly maintains a close and personalized workflow with clients.

The key takeaway is that you absolutely should consider getting a 409A valuation if you plan on issuing options in a private company, but if appraisal and accounting services aren’t the core competency of a valuation service provider (i.e. a cap table management company is providing valuations), then you should not use them as they will likely oversimplify your valuation which can lead to a wide array of problems. A qualified valuation provider like Redwood Valuation will collaborate with you to make sure your valuation is performed properly and defended.

What Is IRC 409/Section 409A?

409a valuation IRS taxInternal Revenue Code Section (“IRC”) 409A is a complex regulatory framework that was introduced in 2005. It specifies that private companies are required to issue stock option awards with strike prices either at or over the fair market value. Section 409A places different types of qualified deferred compensation into five categories: qualified employer plans, foreign plans, section 457 plans, welfare benefits, and stock options. It also outlines timing restrictions, such as when qualified and unqualified plans can be payable, and the penalties for violating these rules.

IRC 409A also outlines which aspects of a business are relevant to its valuation. This includes things like the value of assets, cash flow, control premiums, and marketability. Understanding these regulations and considering all elements that the IRS weighs is key to avoiding financial consequences, which is why help from a valuation professional is so essential. Complying with IRC 409A also ensures that new startups get off on the right foot, both in terms of complying with federal and state law (where applicable) and laying the groundwork to incentivize or reward employees and attract new hires using deferred compensation.

The IRS implemented IRC 409A shortly after the Enron scandal, where the company’s executives were accelerating payments under deferred compensation plans. This allowed them to access that money before the company declared bankruptcy. Employees and shareholders may now be penalized and fined if a company does not adhere to the regulations outlined in IRC 409A. However, safe harbor status helps avoid these penalties.

Safe harbor effectively means that your company will be protected from IRS audits, as the IRS must accept the valuation unless they can prove that it meets a standard of being “grossly unreasonable.” If a company does not have safe harbor status and fails an IRS audit, they may be exposed to additional taxation, tax penalties, and a full refunding of employee contributions to qualified retirement plans. Further, based on some of the “grossly unreasonable” work we have seen from big box “automated” providers, it would not be surprising to see more employees/companies left exposed to IRS penalties after receiving poor quality valuations from such providers (i.e. providers that focus on cap tables or secondary markets).

What Is 409A Valuation?

accounting for business valuationsCompanies often want to grant options to employees as part of an equity-based compensation package. Federal laws require a valuation before doing this to ensure that the exercise price reflects the fair market value. Per Internal Revenue Code Section 409A, a grant with an exercise price below the fair market value triggers a tax penalty.

IRC 409A valuations are uniquely relevant to private companies since public companies have traded market prices that determine the fair market value of the stock used to set the option exercise price. 409A valuations determine the fair market value of common stock in order to price options on common stock and should come from qualified and independent appraisers. Fair market value is defined by the IRS as the price at which a willing buyer and a willing seller, both under no compulsion to buy or sell, each with sufficient knowledge enter into a transaction to buy or sell an asset. As a company reaches its milestones, the periodic nature of these valuations ensure that the business’s fair market value is accurate and up to date.

The IRS regulates 409A valuation standards, and audits are possible. Scrutiny from financial statement auditors or the SEC in accordance with ASC 718 are more likely and also carry significant risks.  As such, reputable valuation providers often include or offer audit defense as a service for this reason. Failure to complete regular 409A valuations and adhere to IRS guidelines can lead to tax penalties and other financial consequences including but not limited to a 20% penalty tax and additional interest rate charges based on the date of value.

Note that 409A valuations are only valid for limited periods of time. They expire after twelve months or after a material event occurs that could impact the business’s fair market value. For example, a startup completing a funding round is considered a material event and requires a new 409A valuation to receive safe harbor under IRC 409A .

Generally speaking, a material event is any occurrence that will change the company’s financial condition, business strategy, or mission. Other than closing a funding round, material events include such things as:

  • A major merger or acquisition.
  • A significant pivot in business or operational strategy.
  • Substantially surpassing the forecasted progress associated with an earlier valuation.
  • Forging or ending a major strategic partnership with another company.
  • Changing the company’s legal status (ex. LLC to Inc.)
  • Engaging in the sale of company assets, business units, etc.

If any of these events occurs, you need a new 409A valuation regardless of whether you are within twelve months of the previous one.

Valuation for a private business is determined by an expert who estimates your company’s fair market value. In the event of an audit, the IRS will conduct its own review of your organization’s accounts and information to ensure that its value was accurately reported.

In order to estimate the fair market value of your company, an appraiser will typically rely on one or more of the following approaches:

  • Market approach: This approach uses various financial statement metrics of similar enterprises’ equity securities, assets, or investments to estimate the fair value of the Company’s equity securities, assets, or investments. The best determinate for ascertaining fair market value of equity securities of a company is the quoted market price of an active market for the equity securities. By definition, illiquid stock (stock that is not traded on an active market) has no quoted market price. In some instances, a company may enter into arms-length transactions for the sale of its equity securities. These transactions may qualify as a quoted market price and be considered the best measure of fair value provided that the equities sold in the transaction are the same securities for which fair market value is being determined, and the transaction is a current transaction between willing parties (not forced or in a liquidation sale).
  • Income approach: This approach derives value by estimating reasonable future cash flows to the firm and/or equity holders and discounting them to present value using a risk-adjusted discount rate or capitalization rate consistent with the riskiness of the forecasts. Limitations under this approach rest on the validity of the forecasts and the underlying assumptions. The income approach is more effective for later-stage companies due to there being an established operating and financial history on which forecasts are predicated. We did not weight the concluded value derived from this approach as discussed below.
  • Asset approach: This approach focuses on the fair market value of the Company’s net assets. The approach is most appropriate for earlier stage companies that are in early-stages of development, have small or modest intangibles and goodwill, a relatively small amount of cash has been invested, and where the market or income approaches have no or limited basis.

In selecting a methodology to apply, a qualified valuation firm should consider relevant factors of the business to deliver a meaningful and defensible value estimate. There are no “cookie-cutter” valuations as each analysis must be uniquely tailored to a company’s individual circumstances (hence why using big box “automated” providers can be very problematic). Working with a firm that has sufficient experience and qualifications can ensure that you not only have an updated report in compliance with IRS requirements but also that the methods relied upon are most appropriate for the risk profile of the company being valued.

How Startup Valuation Works

company business valuations for 409a compensationEven if your business is only a small startup, if you offer stock options, you should consider a 409A valuation to receive safe harbor. However, 409A valuations for startups don’t always look the same as those for other types of businesses. In fact, startups present some unique challenges when it comes to valuations.

For example, many startups have limited to no income. This means that it may be difficult to apply a traditional income approach to gauge the enterprise value. Additionally, a startup may not compete in a universally defined industry, and as such, it may make traditional market comparisons within the market approach problematic. In these situations, valuation firms will often employ methods for startups that specifically address these challenges. A couple examples include:

  • Backsolve: The Backsolve method (or OPM Backsolve method) calculates an implied fair market value for the company and its stock based upon the company’s most recent round of funding, capital structure, and any other potential financial instruments that the company may hold.
  • Cost-to-recreate: This method estimates the cost of building a comparable company from the ground up, including opportunity costs and reasonable profit margins, as appropriate. Popular among investors, this approach assumes that a savvy investor wouldn’t pay more than the standard cost to recreate the assets from scratch to invest in a startup.

While it may be possible for some startup or small-business owners to complete 409A valuations on their own, the risk is generally too high and the methods too complex. Additionally, startups often experience rapid growth or progress through several material events in a relatively short span of time, which further intensifies the need and regularity of audit ready valuations. Given the unique challenges and business circumstances that startups face, coupled with the serious consequences that come with not complying with IRS regulation and guidelines, it is often better to work with a firm experienced in the special valuation techniques that are ideal for earlier stage and rapid growth companies.

The cost of a valuation varies based on circumstances such as the size of the company, complexity of its capital structure, and scope of work. Similarly, the length of time needed to complete a valuation also varies; generally, between two and four weeks. Regardless of time and cost, the most important consideration is that you choose to work with a firm that will help ensure the best possible outcome for your business.

409A Valuation Conclusion

Valuation of your enterprise can be complex, regardless of it you are launching a new startup, growing a closely-held business, or playing a key role in a large, international corporation. There are a lot of valuation charlatans out there, particularly the big box “automated” providers, so it is critical to get valuations from reputable experts with significant valuation experience. If it has been a year since your last valuation or your enterprise has undergone a material event, connect with Redwood Valuation so that we can help guide you through the 409A valuation process.

What does 409A Mean?

Section 409A of the IRS tax code refers specifically to “nonqualified deferred compensationaccountant nonqualified deferred compensation for 409a.” 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?

specialist business valuation expert services

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?

cashflow and assets importance for 409a valuationA 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?

409a valuations for equity and stock options employee compensation

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

Do I need a 409A valuation?

If your company is private and plans to issue compensation in the form of equity (most commonly, stock options), then a 409A valuation is the best and easiest way to receive safe harbor from the IRS scrutiny under IRC 409A. Additionally, there are numerous other, and perhaps more important, reasons to get a 409A valuation for your company.

How often is a 409A valuation needed and how long is it good for?

A 409A valuation is good for 12 months or until a material event occurs. When evaluating whether a material event has occurred, you should consider outside investments, recent rounds of financing, M&A activity, major changes in the management team, financial performance different than forecasts, changes to the business model, and similar events. We are happy to help you navigate this issue with a free consultation.

What kind of clients do you work with?

While we specialize in early-stage and high growth companies, our clients have ranged from pre-revenue startups to mature companies with over $1 billion revenue. Although we perform hundreds of valuations for life science, medical device, and early-stage tech companies, we have experience valuing a wide-array of industries from architecture to food manufacturing and distribution to vehicle leasing and much more.

What is your turn around time?

A basic 409A or business valuation generally takes 2 to 3 weeks to complete a draft report. More complex engagements, such as purchase price allocations, may take 4 to 6 weeks. We try to work with our clients to meet your needs and may be able to expedite our deliverables upon request.

What does the process and deliverable look like?

To start, we have a kick-off call to better understand your needs and your business. We provide a straightforward request list and incorporate as much of it into our model as possible. We may have follow-up questions or calls, but we keep the process as efficient as possible. The final deliverable is a robust, written report. You may ask us questions throughout the process and we value your feedback.

Do you defend your work from regulators and auditors?

The founders of Redwood have been around since IRC 409A came into existence and have built a loyal team that will be familiar with your business from year-to-year and defend your valuation at any point. Unlike venture-backed, online-based valuation providers that may run out of cash and large consulting firms that inevitably have high turnover, we are guaranteed to be around in 5 years and will have our core team in tact.  Additionally, we will defend your valuation without unreasonable fees.

Is there a rule of thumb regarding common as a percent of preferred?

No rules of thumb exist regarding common as a percent of preferred. The value of common is impacted by the rights and privileges of the various share classes. However, in our experience management often has a good sense of what the final value should be. Our valuation conclusions are considered to be very reasonable by both management and regulators.

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.

(D) Compensation
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.