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IRS Code §409A Necessitates Case in Setting Stock Option Exercise Prices

March, 2006 | Issue 1

Introduction
In 2004, Congress passed the American Jobs Creation Act. One of the things this act did was to add Section 409A to the Internal Revenue Code. This code section imposes sweeping new rules on deferred compensation arrangements maintained by employers. Among other things, the act significantly impacts employee equity compensation arrangements, including stock options.

Impact on Stock Options
Employee stock options generally fall into two categories, qualified or statutory options, and non-qualified options (also called NSOs). The impact of §409A will be felt primarily on holders and issuers of non-qualified options.

Non-qualified stock options are generally taxable to the holder at the date of their exercise, not at the date of grant or vesting. Section 409A preserves this tax treatment, but only if the stock option is granted with an exercise price which is at or above the fair market value of the underlying stock on the date of the grant.

A stock option which is granted with an exercise price that is lower than the fair market value of the stock on the date of the grant is treated as deferred compensation. The effect of this is that the option will become taxable at the date of vesting, rather than the date of exercise. Furthermore, there will be assessed an additional 20% tax on the holder of the option on top of regular income tax. It therefore has become very important to be sure that a stock option issued have an exercise price which is equal to or greater than the fair market value of the underlying stock at the date of grant.

Determining Fair Market Value of Underlying Stock

In September 2005, the IRS issued Proposed Regulations under Code Section 409A, which approved certain methods for determining the fair market value of a company’s stock for purposes of granting stock options which would be free them from the application of §409A.

The new regulations do not mandate a valuation of the underlying stock by an independent appraiser. In the absence of an outside appraisal, however, the burden will be on the company, if challenged, to prove that its stock valuation method was reasonable.

On the other hand, a company may choose to adopt one of the “presumptive” stock valuation methods set forth in the proposed regulations, thereby putting the burden on the IRS to prove both that the option’s exercise price was below fair market value, and that the company’s application of the presumptive method was “grossly unreasonable.”

There are three valuation methods that will be presumed reasonable under the regulations if consistently used to value underlying stock for all of a company’s equity-based compensation arrangements. The valuation resulting from any of these methods will be considered to be fair market value and may be rebutted by the IRS only if the company’s application of these methods is found to be “grossly unreasonable.”

Presumptive Valuation Methods

The three methods, (called presumptive valuation methods) are (i) the independent appraisal presumption, (ii) the illiquid start-up presumption, and (iii) the binding formula presumption.

Under the independent appraisal presumption, a valuation performed by a qualified independent appraiser using traditional appraisal methodologies will be presumed to be reasonable if it values the stock as of a date that is no more than 12 months before the related stock option grant date. This presumption would not apply if events subsequent to the appraisal date have a material effect on the value of the stock.

The illiquid start-up presumption is a special presumption available only to a privately-owned company which is less than 10 years old. Under this presumption, a valuation will be considered reasonable if it is evidenced by a written report and is performed by a person with significant knowledge and experience or training in performing similar valuations. In addition, the valuation must take into account certain “valuation factors” specified in the proposed regulations. The valuation factors are as follows:

  • The value of tangible and intangible assets of the company
  • The present value of future cash flows
  • The public trading price or private sale price of comparable companies
  • Control premiums and discounts for lack of marketability
  • Whether the method is used for other purposes
  • Whether all available information is taken into account in determining value

Finally, the valuation cannot be more than 12 months old, nor can there have been a significant event (financing, IPO, etc.) since the performance of the valuation, nor can there be a reasonable anticipation of an IPO, sale or change of control of the company within 12 months following the equity grant to which the valuation applies.

Under the binding formula presumption, a valuation will be presumed reasonable if it is based on a formula which is used in a shareholder buy-sell agreement or similar binding agreement. The formula must be used for all noncompensatory purposes requiring the valuation of the company’s stock.

What to do about already-issued options

If a company has outstanding non-statutory options which may have been issued with a strike price that is lower than the fair market value of the stock at the date of issue, the proposed regulations permit a corrective adjustment to the exercise price. The company may raise the exercise price of the noncomplying option to fair market value of the stock as of the option grant date. This must be done before January 1, 2007.

Conclusion

The advent of §409A and its regulations shines a spotlight on company and board practices and procedures for setting stock option prices. The stakes are now higher, for both the company and the employee. In many instances, the most prudent course of action for management is to rely upon an independent appraiser to help make option price determinations.