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I haven’t heard anything about the IRS enforcing an IRC 409A valuation, why does it matter?

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Topic Expert
Jim Timmins
Title: Managing Director
Company: Teknos Associates
(Managing Director, Teknos Associates) |

That is a good question. The IRS proposed IRC 409A in 2005 and it went into full effect at the beginning of 2009. Why have we not heard anything about IRS enforcement? Because, like any new tax regulation, enforcement takes time. And it takes even more time for enforcement results to become visible to the community.

The IRS is going to choose its first few cases very carefully. It wants to win them and it wants to send a message. Once it chooses its cases, it has to pursue them through a couple of layers of internal appeals and then into Tax Court. Only after all of that will there be a published decision. The process can take several years.

We know that the IRS is pursuing IRC 409A enforcement. Representatives of the IRS have said so at various accounting and valuation conferences and in private meetings. We even know the three main issues on which the IRS is concentrating as it looks at companies and valuation reports.

The "red flag" issues on which the IRS is focusing as it enforces IRC 409A are: (1) valuation reports which are not prepared in conformity with an accepted standard (most credible valuation organizations use the AICPA Practice Aid); (2) valuation reports which are not prepared by qualified valuation personnel (most credible valuation organizations are staffed with people who have earned valuation credentials such as ASA, CFA, or CPA/ABV); and (3) companies which record "cheap stock" charges (because of a difference between the value determined for tax purposes under IRC 409A and GAAP purposes under ASC 718 (formerly FAS 123R)).

Even while the IRS is slowly pursuing its own enforcement strategy out of sight from the general public, there has been a much more rapid enforcement program underway in plain view. For the last several years, audit firms have been aggressively examining the valuation reports used to support option issuance. They are required to do this under the provisions of SAS 73, which dictates what they must do to rely on the work of a specialist (the valuation firm) during an audit.

It is reasonable to believe that the standards of the audit firms are higher than the standards of the IRS, because the there is much more written in ASC 718 and the AICPA Practice Aid than there is in IRC 409A. (IRC 409A is a fairly long regulation, but most of it is devoted to taxation of deferred income and similar subjects, only a small portion of it is about stock options.)

Almost all early stage companies understand the requirements of IRC 409A and get a valuation report at least every 12 months. But most of these valuation reports are not reviewed by an auditor for several years (because it does not make sense to hire an audit firm until the company has grown and looks like it will be successful -- and some companies will be acquired before they are ever audited).

Because the standard for a tax-compliant report (under IRC 409A) is fairly low, most valuation reports will pass it. However, because the standard for a GAAP-compliant report (under ASC 718 and the AICPA Practice Aid) is much higher, many valuation reports do not pass it. And, because of the lag in getting auditor scrutiny, many companies will not find out until late in the process -- sometimes too late, if the report is rejected during acquisition due diligence. Acquirers are looking closely at compliance in this area and negotiating to reduce purchase prices (or at least increase escrow amounts) if there are any weaknesses.

The best advice is to assume that any valuation report obtained to support stock option issuance (IRC 409A / ASC 718) will be scrutinized someday. There is only a small probability that scrutiny will come from the IRS. But there is a near certainty that scrutiny will come from an audit firm. So, a company should ensure that any valuation report it obtains meets the high GAAP standard -- not just the low tax standard.

Achaessa James
Title: Product Manager
Company: National Center for Employee Ownership
(Product Manager, National Center for Employee Ownership) |

Hi, Mark. The other big issue covered by 409A is deferred compensation arrangements and, though the IRS has been busy promulgating supplemental materials on what this covers, they've also extended the document correction deadline to 12/31/2010. The equity compensation community is gearing up for enforcement actions on this issue akin to enforcement of the backdating violations. Here are some good reference materials:

http://www.millerjohnson.com/pubs/xprPubDetail.aspx?xpST=PubDetail&pub=1772

http://www.irs.gov/pub/irs-drop/n-10-06.pdf (see pp.67-68)

Topic Expert
Darren Cordier
Title: President
Company: FV Specialists, Inc.
(President, FV Specialists, Inc.) |

As the previous commenters have noted, enforcement potential is growing. Additionally, you should consider the risks and why you put stock options in place. Penalties under IRC 409a are to the employees themselves, not the company. An enforcement action will cause your key personnel to be distracted from their duties and potentially file an employee lawsuit. What was initially intended to be an employee incentive becomes a disincentive.

One last item, your own success can potentially work against you. Say you build your company and get a ripe purchase offer. Previous valuations can lay the groundwork for the difference in historical stock price and the exit event price. Without this work, you are in a weaker position to rebut any IRS challenge. Remember, the IRS is notorious for using after the fact transaction events to argue that prices of stock prior to the event were higher. For IRC 409A, this results in strike prices below fair market value, moving the options into non-qualified option status.

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