Editor: Greg A. Fairbanks, J.D., LL.M.
When a stock option is granted to an employee, great care must be taken to ensure that the exercise price is equal to or greater than the stock's fair market value (FMV) on the option's grant date. If the exercise price is lower than the FMV, resulting in a "discounted" option, the option is subject to the Sec. 409A rules for nonqualified deferred compensation plans.
This produces an undesirable result for an option because in order to comply with these rules, the option may be exercised only upon a change in control, separation from service, disability, death, an unforeseeable emergency, or a specified fixed date in the future (Sec. 409A(a)(2)(A)). The decision as to which event will trigger the exercise must be made when the option is granted. Moreover, if any errors are made in fully complying with Sec. 409A, the employee will be subject to a 20% additional tax, over and above regular income tax, on the option's value. Thus, in order for the option to be exercised in the normal fashion of an option (i.e., the option can be exercised at any time in the future, at the discretion of the employee), great care should be taken to ensure that the option is not a discounted option.
The correct determination of a stock's FMV is a particular challenge for private companies because there generally is no market for the stock. Fortunately, the regulations under Sec. 409A provide guidance for determining the stock's FMV. The regulations set forth factors that must be taken into account in determining FMV, including the value of assets (both tangible and intangible), the present value of anticipated future cashflows, the market value of stock or equity interests in similar corporations, or equity interests in similar corporations or other entities engaged in substantially similar trades or businesses (Regs. Sec. 1.409A-1(b)(5)(iv)(B)(1)). In addition, the valuation may reflect control premiums or discounts for lack of marketability. The valuation may be used for up to 12 months, but it must be updated to reflect information that materially affects the corporation's value, such as the resolution of litigation or the issuance of a patent.
The regulations also provide safe-harbor valuation methods. When one of these safe harbors is used in lieu of the general valuation approach describe above, the valuation is presumed to be reasonable. The IRS may rebut the presumption only if the valuation is "grossly unreasonable."
There are three safe-harbor methods under Regs. Sec. 1.409A-1(b)(5)(iv)(B)(2):
- Appraisal by an independent party;
- Appraisal by a qualified individual who does not have to be independent (available only for start-up companies); and
- Formula value.
Independent AppraisalThe independent appraisal safe harbor is largely self-explanatory. The regulations provide that in applying this safe harbor, the standards for the appraisal of stock held by an employee stock ownership plan under Sec. 401(a)(28)(C) and its accompanying regulations should be used (Regs. Sec. 1.409A-1(b)(5)(iv)(B)(2)(i)). Sec. 401(a)(28)(C), however, simply states that the valuation must be performed by an independent appraiser, and the regulations provide no additional guidance. Thus, this safe harbor appears to rest solely on having an appraiser who is independent. The only additional guidance on this safe harbor is a requirement that in order for the valuation to be used, it must be as of a date within the past 12 months.
Nonindependent AppraisalUnder the second safe harbor, an appraisal is required but the party performing the valuation need not be independent. The appraisal must take into account all the factors described above in the discussion of general valuation principles. This safe harbor is available only for a corporation that has conducted its trade or business for fewer than 10 years (a start-up corporation) (Regs. Sec. 1.409A- 1(b)(5)(iv)(B)(2)(iii)). Thus, this safe harbor exists so a newer corporation can avoid the cost of an independent appraisal.
The second safe harbor is not available if either the employer or the employee reasonably anticipates that the corporation will undergo a change in control event in the next 90 days or an initial public offering within the next 180 days. The rationale appears to be that such events have the potential to cause a major change in the corporation's value (most likely an upswing). In addition, this safe harbor may not be used if the stock is subject to any put, call, or other right to purchase the stock, other than a right of first refusal upon an offer to purchase by an unrelated third party or a nonpermanent right to sell or buy the stock at a formula value (a lapse restriction).
Although the individual who performs the valuation does not have to be independent, he or she must be qualified to perform the valuation. The individual's qualifications are based on his or her knowledge, experience, education, or training. "Experience" generally means at least five years of relevant experience in valuations, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the corporation operates.
Formula ValueThe final safe harbor is the use of a formula value (Regs. Sec. 1.409A- 1(b)(5)(iv)(B)(2)(ii)). At first, this may appear to be a very useful safe harbor, especially in light of the fact that many private companies have typically used a formula to determine FMV. However, a taxpayer may use this method only if certain very restrictive conditions are met.
First, if the employee wishes to sell the stock, he or she must offer to sell it to the prospective buyer at the formula value. A party that buys the stock from the employee also must offer to sell it to a prospective buyer at the formula value. If anyone else holds stock in the same or a similar class of stock, that individual must also use the formula value whenever he or she sells the stock to the company or to someone who owns more than 10% of the voting power of the stock. All of the foregoing restrictions must be permanent, except that the restrictions are lifted for an arm's-length transaction involving the sale of all or substantially all of the company's stock.
ConclusionGiven the inexact science of determining the FMV of a private company's stock for purposes of setting the exercise price of a stock option, it is important to understand the regulatory guidance for making the determination. Careful consideration should be given to using one of the safeharbor methods because the IRS may challenge the valuation only if it is shown to be a grossly unreasonable valuation.
Greg A. Fairbanks, J.D., LL.M., is a tax manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.