Friday, February 17, 2006

Section 409A and its Impact on Nonqualified Deferred Compensation Plans
William Redpath, VP Consulting BIAfn

To stem the tide of corporate finance scandals of recent years, Section 409A of the Internal Revenue code was enacted on October 22, 2004 as part of the American Jobs Creation Act. This new law specifically addresses taxation of nonqualified deferred compensation plans and has been described as an "about face" for how nonqualified deferred compensation plans are managed and executed. Any company that has nonqualified deferred compensation plans will feel the impact of 409A. As such, this law will have a considerable impact on both the design and operation of plans, and on companies who sponsor them. The onus is on companies to understand the new rules and bring about the required changes to their plans.

On September 29, 2005, the Internal Revenue Service issued proposed regulations governing Section 409A in IRS Notice 2005-1. One of the forms of deferred compensation that Section 409A addresses is stock options issued by employers to their employees. It's important to note that Section 409A also applies to any "service recipient," including entities receiving services from independent contractors, however the term "employees" is used in this article for simplicity's sake.

Normally, employees do not recognize income on stock options and Stock Appreciation Rights (SARs) until the time of exercise. "Phantom Stock" is usually not included in gross income until the actual payment is made to the employee. Sec. 409A addresses deferral of compensation for stock options and SARs.

According to Sec. 409A, a stock option will not be considered "nonqualified deferred compensation" if the option or SARs are granted with an exercise price that is equal to or greater than the fair market value of the underlying stock on the date of grant, and if it does not include some feature of deferred income other than the right to exercise the option.

If it is later determined by the IRS that income should have been reported by a taxpayer, but was not, the participant, back taxes, plus interest, plus a tax penalty of 20% of the underreported compensation may be assessed by the IRS. That potentially harsh penalty makes it imperative for the stock underlying granted options to be properly valued.

So, how can the fair market value of the underlying stock be reasonably established?

For stock that is publicly traded, the value can be quickly established by its price quotes. For private companies, however, the regulations state that "factors to be considered" include asset values, future cash flows, objectively determined values of similar entities, control premiums or discounts for lack of marketability, and whether the valuation method is used for other valuation purposes. A valuation method will only be determined to be reasonable if all material available information is considered.

There are three methods of valuation that will result in a value that will be deemed to be a reasonable valuation by the IRS, unless the use of such method was "grossly unreasonable" under the circumstances.

Method #1: For some startup companies, a written valuation report that evaluates the valuation factors listed above can be prepared by a person with "significant knowledge and experience or training in performing similar valuations." For this valuation method to be used, the entity must have been in business for less than ten (10) years. Also, the stock must not be publicly traded and not subject to any non-lapse put or call right (other than a right of first refusal). This method is not acceptable if an IPO or change in control is likely within the next twelve (12) months.

Method #2: If the entity has a valuation formula that is to be used to value any future transfer of shares and is to be used for all valuations of the entity's stock, it may be used as a valuation method under Section 409A.

Method #3: An appraisal from an independent business appraisal firm that complies with rules in the Internal Revenue Code that govern valuations of Employee Stock Ownership Plans (ESOPs). Such an appraisal will be deemed valid only if the valuation date in the report is not more than twelve (12) months before the option grant date.

Now is the time to review your policies that may be subject to Section 409A and to determine the necessary steps to bring everything into compliance with the statute. If you determine that Method #3 is the best approach for your company, BIAfn can assist you with the requirements.

BIAfn would be pleased to submit a bid to complete a written, fully documented appraisal on the stock of your firm. BIAfn is a financial and strategic consulting firm with a twenty five year history of performing business valuation and appraisal services. Our reputation and experience has allowed us to perform work for some of the largest most respected business in the country as well as leading law firms, lenders and investors. For more information please visit our website at www.bia.com or contact us at 800.331.5086.