History
Section 409A was added to the Internal Revenue Code, effective January 1, 2005, under Section 885 of theBasic summary
Section 409A generally provides that "non-qualified deferred compensation" must comply with various rules regarding the timing of deferrals and distributions. Under regulations issued by theQualified and non-qualified deferred compensation
Section 409A makes a distinction between deferred compensation plans and deferral of compensation. The term "plan" includes any agreement, method, program, or other arrangement, including an agreement, method, program, or other arrangement that applies to one person or individual. Section 409A specifies that unless any deferred compensation falls into a specified set of "qualified deferred compensation" categories, the IRS will automatically consider it unqualified deferred compensation. The qualified deferred compensation categories are: * Qualified employer plans (these are basically employer retirement plans) * Certain foreign plans * Section 457 plans * Certain welfare benefits * Stock optionsTiming restrictions
Section 409A's timing restrictions fall into three main categories: * restrictions on the timing of distributions * restrictions against the acceleration of benefits * restrictions on the timing of deferral elections Distributions under a nonqualified deferred compensation plan can only be payable upon one of six circumstances: * the employee's separation from service * the employee's becoming disabled * the employee's death * a fixed time or schedule specified under the plan * a change in ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of thePenalties
Section 409A assigns compliance-failure penalties to the recipient of deferred compensation (the "service provider") and not to the company offering the compensation (the "service recipient"). The sanctions for non-compliance can be severe. The specific penalties written into law are: * all compensation deferred for the taxable year and all preceding taxable years becomes includible in gross income for the taxable year to the extent the compensation is not subject to a "substantial risk of forfeiture" and has not previously been included in gross income * accrued interest on the taxable amount * an additional penalty of 20% of the deferred compensation which is required to be included in gross incomeImpact on privately-held companies
One area of concern in early drafts of 409A was the impact on companies with stock that is not readily tradeable on an established securities market and these companies' employees. As of 2014, approximately 8.5 million American workers held stock options. Since options often vest and become taxable more than 1 year after they are granted, it would seem that 409A would apply to this as a form of deferred compensation. However, 409A specifically does not apply to incentive stock options (ISOs) and non-qualified stock options (NSOs) granted at fair market value. However, if a company issues options to a service provider at a valuation below fair market value, section 409A will apply. The fair market value of an option on common stock is defined as the fair market value of the common stock (the underlying security) on the date of issuance. Therefore, the valuation of common stock is critical. Anticipating this problem, those drafting the regulations created a set of valuation standards for companies. The code provided a way for companies to achieve a safe-harbor valuation. A safe-harbor valuation is one where the IRS must accept the valuation as valid unless the IRS can demonstrate that the valuation is "grossly unreasonable". The code provides three possible ways for companies to achieve a safe-harbor valuation of their common stock: * Securing an independent appraisal * Using a generally applicable repurchase formula * In the case of an illiquid startup, securing a valuation by a qualified individual or individuals applied at a time that the corporation did not otherwise anticipate a change in control event or public offering of the stock The code defines "illiquid stock of a startup corporation" as stock of a corporation that meets the following criteria: * the corporation is less than 10 years old * the corporation has no class of equity security that is publicly traded * the stock granted is not subject to a put, call or similar derivative * neither the company nor the stock recipient could reasonably anticipate that the company would be acquired within 90 days or go public within 180 days Industry commentators pushed for specific guidelines regarding the definition of a "qualified individual" who could perform the valuation for an illiquid startup. The final regulations did not provide specific examples of the qualifications necessary to perform a 409A valuation for an illiquid startup, highlighting that the requisite experience "could be obtained in many ways". However, the final regulations clarified that: * the standard to be applied is whether it would be reasonable to rely on the advice of the person performing the valuation in deciding whether to accept an offer to purchase or sell the stock being valued and * having the requisite experience generally means having at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience Given the small budgets of illiquid startups, many industry participants (including companies and their investors) became frustrated by the need to pay for potentially costly valuations by independent valuation firms. Some valuations could initially cost $50,000, a sum that most startups could never pay. However, recent 409A valuation prices for startup companies have decreased to $1,500–5,000 range, depending on the stage of the company receiving the valuation. For pre-IPO companies and very late-stage companies the prices can be significantly higher as the need for more frequent valuations increases.Criticisms of IRC 409A
Industry commentators have had ongoing concerns with Section 409A. From its announcement and finalization, the IRS itself has recognized that many industry commentators have expressed concerns about the complexity and reasonableness of several aspects of the law. Particular criticisms have included: * 409A adds complexity and cost to some business transactions that do not even create tax advantages * 409A's scope is too broad and captures non-tax-motivated transactions * Its technical complexity can be a trap to the unaware or unsophisticated * Its complexity may also limit the ability for people to engage in legitimate deferred compensation transactionsSee also
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