Jul 09, 2010

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Looking to offer stock-based compensation?

Here’s how to combat one obstacle that may be in your way.

Stock options are a common technique for employers to retain talent and align key executives’ interests with company interests. The tax treatment of options is divided into two categories, statutory and nonstatutory. Nonstatutory options are more commonly known as nonqualified stock options (NQSOs).

Statutory stock options include incentive stock options and employee stock purchase plan options. NQSOs, often preferred by private companies, are generally more flexible than statutory stock options. Upon exercise, they allow employers to take a tax deduction equal to the amount an employee includes in his/her income. Each NQSO and stock appreciation right (SAR) grant requires proper consideration of the fair market value of the business as of the date the options are granted in order to avoid problems with IRC Section 409A (§409A).

A Little Background

Originally enacted in 2004 as a component of the American Jobs Creation Act, IRC §409A has had a profound impact on the ways in which many companies compensate their employees. Intended partially as a response to Enron and the stock option craze of the dot-com era, §409A is broad enough to include NQSOs and SARs with exercise prices below fair market value at the grant date.

Recognizing that stock options granted “in the money” (exercise price below the fair market value of the underlying stock) are essentially just a form of deferred compensation, §409A requires that such option grants be treated as taxable income by the recipient to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. To add insult to injury, if an option plan is found to be subject to §409A and doesn’t meet certain documentation and operational requirements, substantial penalties and interest will be imposed on any amounts required to be included in income. These negative tax consequences are particularly burdensome for the employees receiving the options, as no cash has been received with which to satisfy the tax burden associated with the option grant.

Becoming Exempt From §409A

How then does a company ensure that NQSOs it issues (grants) don’t trigger §409A applicability? In order to be exempt from §409A:

1. The exercise price can never be less than the fair market value of the stock as of the grant date.
2. The option must be taxed under the rules of IRC §83.
3. The option cannot contain any feature allowing compensation to be deferred other than the deferral available under IRC §83.

On the surface, compliance is relatively straightforward: issue only stock options with an exercise price equal to or above the fair market value (as defined by the IRS) of the underlying stock as of the date of grant. The key is determining fair market value, and the greater the possibility of appreciation, the more important it is that the determination withstand scrutiny.

Determining Fair Market Value

For publicly traded companies issuing options to purchase shares of common stock, meeting this §409A exception isn’t burdensome. The exercise price can be set through reference to the freely traded price of the company’s common stock. Private companies, however, don’t have this same advantage. A private company is required to determine the fair market value of its common stock through the reasonable application of a reasonable valuation method.

In order to be considered a reasonable application of a reasonable method, the determination must consider the following factors:

• Value of a company’s tangible and intangible assets.
• Present value of company’s anticipated future cash flows.
• Market value of stock or equity interests in similar entities.
• Recent arm’s length transactions involving the subject stock.
• Other relevant factors, such as control premiums or discounts for lack of marketability.

These factors lend themselves to the application of the three generally accepted approaches to determining value: (1) the income approach, including discounted cash flow analysis, (2) the market approach, including guideline public company analysis and guideline transaction analysis and, to a lesser extent, (3) the asset approach.

The Importance of an Independent Appraiser

Nowhere does §409A require that the fair market value determination need to be made by an independent appraiser. To the extent that a company or taxpayer can demonstrate that its value determination was made through the reasonable application of a reasonable method, the standard will be met. However, there are potential advantages to retaining an independent third-party appraiser to assist with the analysis.

The potential audience for the valuation analysis (i.e. the IRS) is sophisticated, and the underlying analysis required in order for a fair market value determination to be considered reasonable can be complicated, particularly in situations where the issuing company has a complex capital structure consisting of more than one class of equity. Documentation of methodologies and reasonably supported assumptions are a necessity. It’s unlikely that many privately held companies employ staff with the necessary experience and credentials to make an adequate defense of an IRS challenge.

Additionally, one of the benefits afforded by using an independent appraiser is a “presumption of reasonableness.” §409A provides three safe harbors related to the determination of the fair market value of privately held stock, and use of any of the three prescribed methods of valuation is presumed to result in a reasonable valuation. The safe harbors generally are as follows:

• A formal valuation by an independent appraiser completed within 12 months of the date of grant.
• Valuation based on a formula that’s also used to determine the value of stock for purposes of any other nonlapse restriction under §83.
• For certain illiquid start-up corporations (as defined in the §409A regulations), a valuation made in good faith evidenced by a written report performed by a person with significant knowledge and experience or training in performing similar valuations.

Although not bulletproof (the IRS could still rebut the safe harbor methods by showing that the method or application was grossly unreasonable), reliance on one of the above-mentioned methods will result in a presumption of reasonableness and will typically avoid potential compliance issues down the road.

In Conclusion

For a privately held company that wishes to offer stock-based compensation, retaining the exclusion from §409A should be a priority. With proper structuring of your nonqualified stock option plan, including obtaining an independent valuation of company stock contemporaneous with granting nonqualified stock options, management can reasonably anticipate avoiding both the onerous penalties associated with issuing noncompliant options and the unnecessary hassle of defending an internal valuation analysis to the IRS.