Nonqualified deferred compensation: Independent appraisals offer protection against 409A challenge

Businesses that provide employees with stock options, stock appreciation rights (SARs) and other types of nonqualified deferred compensation have been subject to Internal Revenue Code (IRC) Section 409A for years. As you can imagine, compliance is particularly challenging in the current economic environment. To avoid Sec. 409A problems, options and SARs must be issued at or above fair market value (FMV), so accurate valuations are critical. The best way for privately held companies to protect themselves now is to have regular, independent stock appraisals by a qualified valuation expert.

What Sec. 409A requires

Sec. 409A was designed to help discourage certain types of compensation arrangements that give executives too much control over the form and timing of benefits. It applies to most deferred compensation arrangements other than qualified retirement plans. Failure to comply results in immediate taxation of vested benefits plus a 20% excise tax and interest.

Sec. 409A and the regulations that accompany it are complex, and a detailed discussion is beyond the scope of this publication. But, generally, it requires deferral elections to be made well in advance and imposes strict limits on an employee’s ability to alter the form or timing of deferred compensation payments.

The rules don’t present a significant problem for supplemental executive retirement plans (SERPs) or other nonqualified deferred compensation plans that contemplate payments on a specified date or according to a fixed schedule. But they do defeat the purpose of stock options and SARs, whose value lies in an employee’s ability to choose the optimal time to exercise them.

Fortunately, the regulations provide an exception for options or SARs that have:
1) an exercise price that can never be less than the stock’s FMV on the grant date, and
2) no other feature for deferring compensation.

Establishing fair market value

The regulations permit a company to determine FMV through “reasonable application of a reasonable valuation method.” A reasonable valuation method should consider the following factors, as applicable:

• The value of the company’s tangible and intangible assets,
• The present value of anticipated future cash flows,
• Stock prices of comparable public companies,
• Recent arm’s-length sales prices of comparable private companies,
• Other relevant factors, such as control premiums and discounts for lack of marketability, and
• The valuation method’s use for other material purposes.

A valuation method is not reasonable if it fails to consider all available information that’s material to the company’s value, including a previously calculated value that fails to reflect material information available after the calculation date. Moreover, valuations performed within 12 months before the grant date are presumed to be reasonable.

3 presumptive valuation methods

To provide some peace of mind, Sec. 409A outlines three “presumptive” valuation methods. Using these methods is presumed to be reasonable unless the IRS can show that the method — or its application — was “grossly unreasonable.”

1) The formula method allows a company to set exercise prices according to a formula based on book value, earnings multiples or some combination of the two, provided the formula is used consistently to value the company’s stock for certain compensatory and noncompensatory purposes and meets certain other requirements. Given these restrictions, this method won’t be an option for most private companies.
2) Under the illiquid startup method, a valuation of stock in a privately held company that’s less than 10 years old is presumed reasonable if it meets several requirements. It must be performed by a person who’s qualified based on “significant knowledge, experience, education or training.” In addition, the valuation must be documented by a written report that considers the valuation factors set forth in the regulations; the stock must not be subject to any put or call rights (with certain exceptions); and the company must not reasonably anticipate a sale, initial public offering or change in control within 12 months after the grant date.

The illiquid startup method may be less costly than an independent appraisal, especially if it’s performed in-house, but it’s also riskier. There are many uncertainties that make valuations vulnerable to IRS attack. The IRS may be more likely to challenge an employee’s qualifications or methods. And it may be difficult to rebut a claim that the company anticipated a sale or IPO.
3) Independent valuations are presumed reasonable if they’re performed within 12 months before the grant date (unless subsequent events have a material impact on value). So long as the appraiser is qualified and his or her valuation methods aren’t “grossly unreasonable,” it’s difficult for the IRS to mount a successful challenge under Sec. 409A.

Noncompliance isn’t an option

Companies that use stock options or SARs as part of their compensation programs should pay close attention to valuation issues. Awards with a below-FMV exercise price, or which otherwise violate Sec. 409A, can quickly erase the benefits these programs are designed to confer.

The most effective way for a privately held company to comply with Sec. 409A is to obtain independent appraisals of its stock within 12 months before each grant date and after any significant events that have a material impact on stock values.