409A Valuation Overview: Penalties and Compliance

Nothing jeopardizes a growing company’s viability like the IRS chasing it for non-compliance to the Internal Revenue Code’s Section 409A. While the laws are often found to be complicated, the penalties are extremely punitive, and the IRS offers no policy to negotiate settlements. So, if the company offers non-qualified deferred compensation (NQDC) to its employees, it should know about Section 409A of the IRC in detail.

An NQDC plan is a non-qualifying plan that is not covered by the Employee Retirement Income Security Act (ERISA). Section 409A plans and golden handcuffs are other names for NQDC plans. Employers utilise these strategies to attract and retain top executives and employees.

Following the Enron scandal in 2001, regulators sought strategies to prevent CEOs from misusing equity loopholes. As a result, in 2005, the IRS introduced IRC Section 409A, with a final version taking effect in 2009.

Here are a few things to keep in mind when a private company seeks to comply with 409A.

What is Section 409A?

For public companies, the stock value is determined by the market. However, in the case of private companies, it depends on appraisers.

A 409A valuation is an independent assessment of the fair market value (FMV) of a private company’s common stock, i.e., the stock reserved mainly for founders and employees, by a third-party valuation provider. The cost of purchasing a share is calculated using the IRC section 409A valuation.

A private company cannot offer equity without first determining the value of each share. Hence, it would need a 409A valuation if it intends to offer equity.

What is Deferred Compensation for Non-Qualified Deferred Employees?

For 409A compliance, NQDC plans contain stock options and Stock Appreciation Rights (SARs). The valuation determines the special price at which the options and SARs can be exercised.

Compensation in the NQDC plan:

• Is legally enforceable.
• Is due in a subsequent tax year.
• Is taxed in a subsequent fiscal year.
• Cannot be accelerated (in most situations).
• Is subject to performance or vesting conditions.
• And, short-term deferrals (i.e., up to 12 months) are not included.

Penalties for non-compliance with 409A rules

Noncompliance with 409A can lead to the following tax penalties for employees:

• Even if payment is made in the following years, employees should pay income tax and a 20% penalty on any deferred vested amounts as per the NQDC plan as of the last day of the vesting year.
• From the vesting date forward, employees must pay a premium interest tax of 1% above the federal underpayment penalty rate on failed compensation.
• Employees may be required to pay additional penalties because of understating their income.
• Employees will be subject to penalties as imposed by the state.

Employer Withholding Taxes

Employers will be subject to withholding taxes on the vested deferred compensation portion of employees’ earnings if the 409A valuation is deemed non-compliant with the Internal Revenue Code.

If employees do not receive their deferred compensation (actually or constructively), the IRS will consider it included in the taxable year of failure on December 31. Fortunately, the 20% penalty and premium interest tax are not subject to withholding taxes.

Aggregation of Plans

If the NQDC arrangements are subject to 409A requirements and there is an operational failure, the IRS can tax and penalize all NQDC arrangements. 

However, if there are multiple sets of NQDC stock options or SARs, the failure of one set does not immediately fail other NQDC stock options or SARs.

Reviewing non-qualified deferred compensation plans for 409A compliance

Double-checking is a good idea even if a company believes it has achieved a safe harbor 409A valuation. Reviewing the non-qualified deferred compensation plans regularly ensures that the company has complied with all requirements.

This reduces the chance of missing something on the valuation and helps stay in compliance with IRC 409A in the future. Pay special attention to these five areas of concern when assessing non-qualified deferred compensation plans:

• Initial deferral election
• Payment timing
• Payment acceleration
• Payment re-deferral
• The fair market value of the company.

Employees must elect to receive deferred remuneration in the calendar year before beginning to provide services to the company. For example, the company must choose to delay compensation for services rendered in 2020 in 2019.

For newly eligible employees, the rules are slightly different. This usually refers to one of two scenarios:

• Cases in which a company for the first time employs deferred compensation plans.
• Cases in which a previously unqualified employee is now eligible to participate in a non-qualified deferred compensation plan.

To opt for deferred compensation for the first time (in the middle of a calendar year), newly eligible employees must do so within 30 days of becoming eligible. Only compensation earned for services rendered after the election date is applicable.

Employees who opted not to participate in NQDC plans previously available are exempt from these rules. Hence, newly eligible employees are often people who have been hired or promoted recently.

In addition, the requirements for newly eligible elections do not apply in cases where the employer’s existing NQDC plan is being replaced with a new one.

409A Compliance: Payment Timing, Acceleration, and Re-Deferral

Under 409A compliance, the timing of payments in non-qualified deferred compensation plans is critical. Six primary triggers lead to a payout:

• Death
• Disability
• Unforeseeable emergency
• Change in company control
• Predetermined time or payout schedule
• “Separation from service” (e.g., retirement, termination, resignation, etc.)

The Bottom Line

It takes a lot of effort to verify that 409A valuations and non-qualified deferred compensation plans align with IRS laws. However, the time and money spent on compliance outweigh the penalties.

Compliance and 409A values are the most critical aspects of a company and are crucial to the long-term success of a business. Third-party 409A valuations can help protect the company from costly audits and employees from penalties.

With trica equity, startups can get their 409A valuation done at a reasonable cost. Visit the trica equity website to learn more about executing a 409A valuation securely.

Request a demo today to discover more about our cap table management software and partnerships with fully independent 409A valuation providers.