IRS EXTENDS § 409A COMPLIANCE DEADLINE

Introduction
The IRS announced on September 10, 2007, that taxpayers will have until December 31, 2008 to bring documents into compliance with the deferred compensation regulations under Section 409A of the Internal Revenue Code. See IRS Notice 2007-78.

By way of background, on April 10, 2007, the Treasury Department and the IRS issued final regulations on the treatment of nonqualified deferred compensation plans under Section 409A of the Internal Revenue Code. Affected plans had been required to comply with the documentation requirements established by these regulations by December 31, 2007. That date has now been extended by a year. The Notice does not, however, postpone the January 1, 2008 effective date of the final regulations.

We will summarize below the portion of the regulations that applies to stock option exercise price valuations. A copy of the regulations can be found here.

Options as Deferred Compensation
Section 409A provides that an option granted with an exercise price less than fair market value as of the date of the grant is a deferred compensation arrangement. The recipient of such an option is subject to the following adverse tax consequences: (a) taxation at the time of vesting, and (b) a 20% tax penalty in addition to income taxes. There has been great uncertainty, prior to the issuance of these regulations, as to how private companies should value their stock when issuing options in order to avoid these significant adverse tax consequences. Now we have some help.

General Principles
The valuation guidance provided by the new regulations includes the following general principles:

“the fair market value of the stock as of a valuation date means a value determined by the reasonable application of a reasonable valuation method…Factors to be considered…include… the value of the tangible and intangible assets of the corporation, the present value of anticipated future cash flows of the corporation, the market value of stock or equity interests in similar corporations and entities engaged in trades or businesses substantially similar to those engaged in by the [subject] corporation,…recent arm’s length transactions involving the sale or transfer of such stock or equity interests, and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes[.]” §1.409A-1(b)(5)(iv)(B)(1) [Read More]