Section 409a and the value of your stock plan

Internal Revenue Code Section 409A restricts compensation deferrals for income tax purposes. The restrictions apply to most types of deferred equity-based compensation, including stock options, stock appreciation rights (SARs) and phantom stock plans.

Plan sponsors, employees and board members who fail to meet the timing and form requirements of Sec. 409A may face substantial risks. Reasonable stock valuations prepared by qualified independent valuators can limit exposure.

Violations can be costly - If a deferred compensation plan violates Sec. 409A, tax deferral is lost upon vesting (not exercise). Participants in noncompliant plans must, therefore, include deferred compensation in gross income as soon as they become vested in the plan. This means that employees may have to come up with cash to pay taxes before they receive any money from exercising options and subsequently selling the stock. Sec. 409A also imposes interest charges and an additional 20% tax penalty on plan participants. These items can add up to a large bill for an employee.

Sec. 409A violations may require plan sponsors to modify payroll tax filings, withholdings and financial reports. In addition, board members and directors may risk potential lawsuits for indiscriminately sponsoring plans that impose an undue burden on employees.

Valuators to the rescue - Stock options and SARs may be exempt from Sec. 409A if granted at an exercise price equal to or greater than the fair market value per share. An independent valuation is necessary to ensure that a company’s plan isn’t granting deferred compensation at a discount.

Factors a valuator considers in a “reasonable” valuation method include:

• The value of the company’s tangible and intangible assets,
• The present value of cash flows,
• The market value of comparable transactions,
• The type of underlying stock in relation to the value of other stock (common vs. preferred), and
• Other relevant factors, such as control premiums and marketability discounts.

Under Sec. 409A, the IRS presumes that independent appraisals estimate fair market value, so plan sponsors should seek outside valuation expertise. This shifts the burden to the IRS, which must prove that the sponsor’s valuation is “grossly unreasonable.”

Act now - IRS Notice 2006-79 postponed the effective date of Sec. 409A until Jan. 1, 2008. Thus, plan sponsors have until Dec. 31, 2007, to identify plans subject to Sec. 409A, modify existing plans and hire qualified valuation experts. It’s important to ensure that plans will be in compliance.