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Indemnity for IRC 409A valuation challenges

I have just seen my first lawyer prepared employee stock purchase agreement in which the employee is required to indemnify and make good any tax assessment, interest and penalties that may be imposed on the Company in respect of any subsequent IRS 409A challenge to the fair market value at which the stock was sold or granted to the employee.  This seems tough on the employee since he typically knows little about the Company's valuation and in the past has reasonably relied on the company to set a fair market value. While I suspect that the likelihood of IRS challenges is minimal for average employees and therefore the risk of agreeing to such a term is modest, I can imagine this could be a stumbling block in getting many an employee to sign such an agreement.  Has anyone else seen this indemnity clause appearing, and had any feedback from employees reluctant to sign?

Answers

Mark Stokes
Title: CFO
Company: Private
(CFO, Private) |

That's going to hurt! Employees and companies. I wonder how enforceable it will prove to be? I think, due to your points above, that companies will have a tough time saying that employees would be in a position to indemnify the company for a valuation that the company commissioned and signed off on and for which the employee is in no situation to assess. Seems a tall hill to climb, but it will be years before there is any case law.

To your point about employees signing off on this, I think independent-minded engineers (and don't we all know some of those) will have major problems with this and then the company will risk losing good talent over something which is ultimately unenforceable (or am I dreaming that). Or, these employees will force some one-off agmts where this clause is carved out and then proves unenforceable via the transitive property. Seems like a lose/lose situation: the company pays someone to write protections which are not valid and which employees hate. 409a, could it be wrong in more ways :) ?

Charles D'Ambrosio
Title: CFO Consultant
Company: Cadmus
(CFO Consultant, Cadmus) |

I've never seen a retention tool such as a stock option agreement, provide for such an indemnity. Would you like to be the person explaining the clause to the employee. I'd push back on the law firm.

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

From a tax standpoint, IRC 409A is a bit of an odd animal: part fish and part fowl. It requires the company issuing options to take certain steps to ensure that new options are being priced at or above fair market value. But it imposes (most of) the burden on the employees or others who receive the options if they are not priced at or above fair market value.

(There is a burden which could be imposed on the issuing company for failure to comply: basically the typical IRS penalties for under-withholding. But the burden on the option recipient is much, much higher: the entire difference between the option price and the ultimate recognition (sale) price is taxed at the highest federal rate (currently 35%), plus a penalty rate (20%), plus interest (the IRS "late payment" rate plus 1%) from the time of grant. And California has rules which mirror this, including a separate 20% penalty tax.)

Basically, the attorney who drafted the language to which you refer got it wrong. One, it is up to the issuing company to comply with IRC 409A and ensure that it issues stock options at or above fair market value (e.g. by obtaining an independent appraisal). It is next to impossible for an employee or other option recipient to ensure compliance. And, two, it would not be unreasonable for the employees and other option recipients to look to the issuing company to indemnify them against the tax burden which will fall on them if the company gets it wrong or otherwise fails to comply.

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