IRS Penalties of not Performing 409a Valuation
Most startups struggle in the early days of their business when cash flow is tight. Employee salaries take up a lot of much-needed cash flow that could be used better in growing the business. Having a low salary makes keeping the best talent in the business really tough, turnover rate can be really high. Therefore, in order to keep the best talent in the business, a business owner usually does what is called equity-based compensation.
Equity-based compensation allows a business owner to utilize their best talent while not being able to pay them a growing wage. Instead, the employee is being paid by ‘future value’ or equity in the business. Thereby business owners are able to better utilize their cash flow to invest in the business to make more money.
While earning money is an essential aspect for all business owners, they will need to at some point learn how to manage their taxes. A business owner will need to know how to properly calculate the fair value of the equity-based compensation or risk having IRS penalties for not performing 409a valuation.
What is a 409a Valuation?
Privately held businesses can apply the 409A framework for granting private stock options. Equity-based awards must be awarded at or above FMV at the grant date in accordance with 409A.
The tax basis for non-qualified stock options is determined by that valuation. If the business succeeds, the shares will increase in value over time. The difference in value between the time the shares are awarded and the time the employee receives or sells them will be used to determine how much tax is owed by the employee.
A great example of how this works is that you are a business owner in need of hiring a content writer for my finance channel. In order to attract the right talent for the job, I would offer the content writer that I am hiring to have the right to purchase the option of 1,000 shares at the current value of let’s say $1. So that is $1,000 in current value.
Under a written agreement, the content writer is able to exercise those options after 2 years of employment. If the price of the shares had risen to $5 per stock, the content writer would have earned $5,000, which is 5 times what he would earn if he had taken the $1,000!
To establish that the options offered to the content writer are fairly valued at $1, having a 409A valuation is required. The business owner must not speculate or make it up in accordance with IRS requirements. It must be justifiable and defendable. In the absence of that, businesses can employ this type of equity-based pay to conceal shareholder income.
Ways to Properly Valuated your Business
Companies have the opportunity to get a “safe harbor” valuation in accordance with 409A standards. You can assume that a safe harbor valuation is accurate since you used the right framework. By obtaining safe harbor, the IRS must now demonstrate that the determined value was wildly out of line. Therefore, as a business owner, knowing how to protect oneself is really important. Here are 3 ways to make sure you have a safe harbor valuation:
Independent appraisal method
A certified independent appraiser evaluating the valuation must be done within the last 12 months. Because of the trustworthiness and guarantees offered by an impartial professional, this is the alternative that is the safest and hence typically the most preferred.
Formula-based Valuation
Due to the requirements, only a select few businesses can use this strategy. In particular, the formula must be applied consistently for compensatory and non-compensatory purposes in all transactions in which the issuer is either the buyer or the seller of the common stock. The stock must also be subject to non-lapse restrictions (buy/sell agreements), which require the holder to sell it back to the company at the formula price.
Illiquid start-up method
As the name suggests, the illiquid start-up method is commonly used by startups to create a true valuation of their business. As valuation can be considered a safe harbor for an illiquid startup (typically less than 10 years in business with not publicly traded securities) if it is completed by a “qualified” (but not necessarily independent) person who meets the IRS’s standards for experience and expertise, is supported by a written report and takes into account pertinent valuation factors like the value of a tangible and intangible object.
Why Proper Valuation by Valuer is Important?
It’s crucial that firms have appropriate valuation and governance mechanisms in place to guarantee stock options are issued at the correct strike prices given all the limits and requirements that must be followed to meet safe harbor qualifications.
The simplest and safest approach to create a safe harbor and shield your employees from future IRS fines is to hire professionals to execute a 409A value.
The IRS penalties for not reporting the correct 409a Valuation
Having a misrepresented valuation of the business stock price can cause you the business owner and the employee who is working for you to suffer greatly. That’s because the IRS will charge an instant tax on the employee for the full value of the award plus an extra 20% penalty if they deem that you gave options below fair market value.
Going back to the previous example of the content writer working for the business owner. Given that the business owner granted the content writer 5,000 shares at a strike price of just $1. However, after 3 years, if the IRS determines that the true valuation of the stock should have been $2, the content writer has to pay not only a fine but also a higher federal income tax (32% assuming a mid-range tax bracket).
Conclusion
As a business owner, checking taxes only happens once a year in April. That is why it is important to sit down and take the time to properly manage your year-end business valuation and find the fair value needed to pay taxes. It not only helps you as the business owner in paying the right amount of taxes, but it also ensures that your employee knows that they are being treated well. For any assistance on the 409a valuation reach us. Our team is built of experienced valuation analysts who have performed valuations for companies of all stages and sizes. For each valuation, a dedicated in-house analyst handles everything from getting your information to sharing updates and answering your questions throughout the process.
