IRS Rules Governing Deferred Compensation (Section 409A) Allow for Significant Penalties

Whether you are a CFO holding stock options or an employee looking forward to a year-end bonus, you need to be aware of the new provisions in Section 409A of the IRS code. Broadening the definition of deferred compensation, the rules now cover stock plans, option plans, stock appreciation rights (SARs), bonus arrangements, and more. Penalties for noncompliance are significant, making it essential that you are aware of how your compensation is valued and reported.

Section 409A extends definition of “deferred compensation”

Section 409 covers much more than “traditional” deferred compensation plans; it defines “deferred compensation” to include any compensation arrangement whereby an individual earns the right to receive compensation in one tax year but is paid in a later tax year. This definition is broad enough to include situations in which an employer declares year-end bonuses, which are then paid out in the following tax year, as cash flow permits. In addition, 409A applies to directors, and other non-employees.

Determining fair market value: a key to compliance

Consider the following scenario involving the CFO of a small company:

The CFO receives a salary of $100,000 per year, and taxes are withheld accordingly. He also receives stock options. According to 409A, the stock options must be issued at or above “fair market value” (FMV). Anything issued below FMV, or “in-the-money,” will be treated as deferred compensation and considered includable in the option-holder’s gross income, in the amount of the difference between the strike price and the FMV. This is particularly important to the CFO, as amounts includable in his gross income are subject to interest on prior underpayments and an additional 20% excise tax. Without exercising the options and selling the underlying stock, the CFO has received no actual cash with which to pay this liability.

In addition, the CFO’s employer, the company, may be held responsible for normal withholding for all amounts includable in the CFO’s gross income under Section 409A. Additional penalties may be assessed to the company for under-reporting and under-withholding.

Clearly, the CFO in the above scenario is not a happy executive. In order for the CFO to avoid the onerous provisions of 409A, he must show that the options were issued at, or above, FMV.

Regulations outline acceptable valuation method

IRS regulations provide that FMV may be determined through the reasonable application of a reasonable valuation method. The regulations further state that if a method is applied reasonably and consistently, the valuation will be presumed to represent FMV (unless proven to be grossly unreasonable). An appraisal will satisfy these requirements if it would also satisfy the requirements of the code with respect to the valuation of stock held in an Employee Stock Ownership Plan (ESOP). So, the valuation standard to apply is the same as the one applied for other IRS purposes (estate tax, etc.), and must be consistent with valuations of the same company performed for other purposes. One further caveat is that the valuation must be performed by someone with “significant knowledge and experience or training in performing similar valuations.”

Avoid penalties with proper valuations

The consequences of receiving deferred compensation, whether known or not, could be devastating. Any officer, director, or employee receiving any form of compensation that falls under the rule of 409A (including options, SARs, and potentially employment agreement provisions), should consider carefully how that compensation is valued and reported.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
Robert Buchanan

Valuation | ESOP
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