Deferred Compensation Plan - Stock Option Valuations and Code Section 409A

What is 409A?
Starting in 2005, new deferred compensation income tax rules place a regulatory burden on businesses and employees. The United States Treasury Department has now published proposed regulations that interpret these new rules (the "Section 409A" rules, named for the tax code section where they are located). The new rules apply to a broad array of arrangements including traditional deferred compensation plans, supplemental executive retirement plans as well as several forms of equity based compensation, change in control agreements, incentive plans, severance pay plans, and any other plan, policy or agreement that defers the taxation of compensation earned in one year to a future tax year ('arrangement' or 'arrangements'). Any deferred compensation arrangement covering anyone who provides personal services for pay, whether as an employee or as an independent contractor, is potentially subject to these requirements. Compensation deferred under so called 'tax-qualified' plans is not subject to the new rules. (This includes pension and retirement plans under Code Section 401, such as 401(k) plans, Code Section 403(b) tax sheltered annuity plans, and Code Section 457(b) plans of governmental and tax exempt employers.) In general, if the new rules are not satisfied, tax deferral will be lost and a 20% federal tax penalty and interest charges will be assessed to the executive, director or employee ('worker' or 'workers') whose income was being deferred.

What do You Need to do Today?
ection 409A has been described as a "sea change" for nonqualified deferred compensation. There is little doubt regarding the significance these new rules will have on the design and operation of nonqualified deferred compensation plans, and on those who sponsor them. As a result, plan sponsors need to be familiar with the new rules, and have the information and resources necessary to implement the changes required by this 'sea change.'

Asides from the basic tax filings, arguably the most difficult compliance issue that stems from these new regulations is arriving at an accurate valuation for options granted. Determination of the FMV ("Fair Market Value") of company stock when making grants of stock options is important for several reasons, including supporting the claim that an option is an incentive stock option (an 'ISO'), determining the income to be recognized by an optionee upon the exercise of a stock option, avoiding the accounting charges associated with the issuance of cheap stock, and perhaps most importantly, exempting the option grant from the application of recently enacted Section 409A of the Internal Revenue Code, as an option on common stock with an exercise price that is at fair market value (or greater). It is paramount that the valuation method chosen for stock options rights satisfy the requirements for exemption from Code Section 409A. As mentioned, an option that fails to satisfy Code Section 409A may result in tax on vesting, possible interest and penalties, as well as a 20% additional tax penalty on the option holder.

The proposed regulations under Code Section 409A provide that fair market value is to be determined through the reasonable application of a reasonable valuation method. The proposed regulations describe the factors that will be taken into account in determining whether a given valuation method is reasonable and, provide presumptions with respect to the reasonableness of certain valuation methods. If an Independent Appraiser is used consistently, the valuation determined by applying such method will be presumed to equal the fair market value of the stock for the purpose of Code Section 409A, and such presumption will be rebuttable only by a showing that the valuation is grossly unreasonable. If a company does not use an Independent Appraiser, the company will bear the burden of proving that its valuation method is reasonable.

Conclusion
From examining the relevant literature and regulations, there appears to be little doubt that to avoid substantial tax penalties in equity base compensation, fair market value will need to be established for the firm and at each grant date. This will need to be done at the frequency of award, using the established techniques and procedures that are commonly used in estate and gift tax valuation.

Companies can expect to face challenges from the Internal Revenue Service with respect to their valuation used to justify their equity compensation scheme pricing, just as estates and gift tax filings routinely face challenges in tax court. Companies that rely on equity compensation have been moved into the arena of taxation, and very similar to estates, must prudently perform a valuation and have it on file as supporting evidence, as many will be certainly challenged in the new era of Section 409A.

An expert valuation is a prudent investment to establish a reasonable, good-faith estimate of fair market value to avoid issues with the taxing authorities, alleviating the costly penalties to both the firm and the employees for lack of compliance with Section 409A. An expert valuation ultimately cannot be avoided, for those firms with any significant equity compensation will be targets for Internal Revenue scrutiny and face the daunting prospect of a post-hoc valuation where their successes may skew the court in favor of higher costs and penalties. Overall, the approach of "do it right the first time" in 409A valuation is the only rational approach to ensuring against significant costs in time, energy, penalties and interest in the new era of equity compensation taxation.

Brereton, Hanley & Co.

Experience
The Brereton, Hanley team has been engaged in Fair Market Valuations (FMV) for over 10 years. We maintain a staff of experts in high tech, retailing, marketing, food processing, construction, automotive, light manufacturing, and a host of other disciplines.

Our Solution

100% Compliance to the standard of FMV required by IRS.
100% Independence and Objectivity.
100% Confidentiality.
Low Fixed Price for standard report scope.

Value Proposition;
The most comprehensive, objective work product available for the lowest price possible.

Bandwidth
Full-time dedicated staff of six 409a advisors and 15 analysts holding CFA and ASA designations.

Our Approach
We employ an integrated modular structure for Business Analysis. This modular approach enables us to create better scheduling through parallel analysis rather than serial solutions yielding a timely report for you. This approach also enables us to provide fixed price quotations for standard work task rather than only billable hour solutions.

The 409A process is one that must capture significant internal as well as external data. Our methodology includes building detailed Industry and Market models that are aggregated and integrated into the final valuation calculation. These detailed models are optionally available to clients for either a more complete 409A report or as standalone reports.

Our Database
We have developed a very sophisticate database structure specifically for enterprise valuations. Among other attributes, our database ensures complete privacy of your corporate data and easy update and version control. We can provide subsequent valuations at a lower cost because we need only update your existing corporate information. Key attributes of our database include:

Corporate knowledge base with integrated modules/table structure shortens evaluation cycle-time for evaluation.
IT system capability integrates all module data into an integrated report finding which ties all data into findings.
The group provides integrated solutions because it is 'in the business of being right'.
Valuation/validation results have been tested in court

System Controls
Quality control program ensures sign off at all key phases of data input, staging of data, data integration input and integration completion. Configuration control is maintained at a client master control level and maintained across all key modular steps.

Strategic Liaison partner of data
Our team establishes a baseline foundation of all data for report integrity and more importantly for future changes that will come.

Team Capabilities
In addition to certified CFA and ASA personnel, our team provides experienced industry executives who are involved in the process from start to finish.

To correspond with an advisor on an un-billed basis, contact us at info@409a-valuations.com