Stock Options, Taxes, and IRS Section 409A

I find that just mentioning the IRS and the word “taxes” can cause people’s eyes glaze over and their attention to wander.

It’s understandable. Talking about tax considerations isn’t fun for anyone.

There is a tendency by many of us to want to avoid taxes until tax season comes around, but in the case of stock options, that would be a mistake.

Both the issuer (the company) and receiver (employees, board members, founders, etc.) of stock options need to understand that there is the possibility of immediate tax consequences depending on the value of the options and how that value was determined.

Two Types of Stock Options

 For many years now, founders of technology start-ups have successfully used different forms of deferred compensation to attract talented people they need to help develop and commercialize their products.

Deferred compensation generally refers to compensation that is earned in one year and paid in some future year(s). Although deferred compensation can take many forms, in technology-based startup companies, it most often takes the form of stock options.

A stock option is the right to buy stock in the future at a fixed price. The tax code generally recognizes two forms of stock options: qualified (or statutory) and nonqualified options.

Qualified options include Incentive Stock Options (or ISOs), which are issued under a qualified plan with an exercise price equal to or greater than the fair market value (FMV) of the underlying shares. ISOs usually do not create an immediate tax concern for the company or employee.

 Non-qualified stock options (NQOs) are often issued by early stage startup companies to attract key employees. NQOs are flexible and can be issued with an exercise price that is below FMV of the underlying shares. It is this possibility (an exercise price of the options that is below fair market value on the date of the grant) that can create a taxable event.

The IRS treats ISOs and NQOs quite differently for tax purposes. NQOs are subject to IRS Section 409A; ISOs are not.

Fair Market Value and IRS Section 409A

It’s up to the issuing company to provide evidence that non-qualified options (NQOs) are issued at fair market value. The IRS has provided guidance on how to accomplish this.

Under Section 409A of the regulations, the IRS provides IRS–approved valuation methods for private companies.

When a private company complies with these regulations, the company shifts the burden to the IRS to prove the fair market value is unreasonable.  This effectively reduces the likelihood of a successful challenge.

Following the IRS-approved valuation methods (and documenting same) should reduce the risk that the IRS will succeed should the agency challenge the fair market value of the options in question. 

IRS 409A Valuation Methods

 In privately held startups, Section 409A valuations can be obtained by engaging qualified independent professionals to determine fair market value. External professionals for these engagements can provide the greatest amount of risk protection.

Although venture-backed companies use external professionals to perform these valuations, the cost associated with a valuation by an independent valuation professional can be prohibitive to startup companies that wish to grant options before they raise their first significant round of capital.

For these companies, the IRS has provided a more cost-effective alternative, provided the company meets certain requirements (e.g. being in existence for less than ten years and others).

When using the valuation methods outlined in Section 409A, these companies can rely on a valuation performed by a person close to the company (i.e., an employee, advisor, or board member) who has significant knowledge and experience in performing similar valuations.

Consult Your Tax Advisor

We are not tax advisors and aren’t offering tax advice. We do recommend that entrepreneurs and startup companies always consult their tax advisor about the specifics of the company’s situation before setting the fair market value of any options.

In addition to our CFO-in-Residence, attorneys and CPAs with experience in working with startups and entrepreneurs participate in Rev1’s First Connect program of experts and advisors. Learn more.