Do you feel uncertain or frustrated when your accountant or lawyer talks about 409A valuations? Many entrepreneurs view this corporate tax code as a necessary evil. But, this process can benefit your company to help you manage tax burden and penalties for the business and employees.
What is a 409A Valuation?
Most venture-backed companies will offer stock options to employees. This benefit is designed to bring in the best talent and help the employees feel invested in the success of the company. If you issue these stock options in the wrong way then it means that you might be facing unnecessary penalties and taxes that are required by the IRS. This section of tax code applies to any type of deferred compensation, which means that the employee receives compensation in a year later than when the compensation was earned.
In 2005 the Internal Revenue Code was changed to include section 409A, which outlines the regulation for deferred compensation. This includes stock options that are provided to employees. Under this section the IRS has stated that companies can use “safe harbor” methods to avoid inclusion under 409A. Employers need to show that the stock options were issued at the strike price equivalent to the fair market share of the time when the stocks were given.
A 409A valuation is a report that shows the fair market value of the common stock in your start-up company. It is easy to see the value for a publicly traded company, but private companies need to have an independent valuation to determine the value of the stock. This valuation is required by law, to ensure that your company is maintaining compliance with deferred compensation.
Financial Strategy for 409A Valuations
The problem that employers and employees face is that the employee might receive the stocks, and then need to pay income tax even though no cash compensation was received. It is essential that employers talk to financial and legal professionals to qualify for an exemption under 409A.
If you are offering common stock options then you need to have a 409A valuation annually. Additional valuations might be needed if your company closes a new funding round.
You should appoint a valuation firm to perform the valuation and issue the report. Your CFO or outsourced CFO should be involved to ensure correct information is submitted as part of the information gathering process.
Do you have questions about your 409A valuation? Talk to us anytime for experienced, professional financial assistance from an outsourced CFO. Contact us for details about how we can support your business efforts!