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J.L. Pierson & Co. LLC Business Valuation

BUSINESS VALUATION - OPTIONS ON CLOSELY-HELD STOCK IRC SEC. 409A

Our New Valuation Proposal Request Form Is Here!!


IRS NOTICE 2007-78 PUSHES BACK APPLICATION OF 409-A TO THE END OF 2008 !
Read the Notice here [all 27 Pages.]

Section 409A of the Internal Revenue Code now governs the valuation of deferred compensation arrangements, including equity-based compensation i.e. stock options. Non-qualified stock options continued to be taxable to the holder only when exercised, not at grant or at vesting time. However, it is now required that the option be granted at a price higher or equal to Fair Market Value of the stock on the date of the grant. If an option is granted with an a exercised price lower than FMV, it is treated as deferred compensation; accordingly, it is taxed to the holder at the date of the grant, AND is subject to a additional 20% income tax penalty.Thus it is important to make sure that the exercise price is clearly higher than the fair market value at the time of the grant !
In 2005, IRS published proposed regulations, now effective, which approved certain methods of valuation for the purpose of Section 409A. In the absence of an appraisal, the burden of proof falls on the issuer, if challenged. It would thus seem important to have an appraisal. The appraisal is not required by the regulations, howver, even for a closely-held company whose stock is generally not obvious to value. The issuer can use one of three presumptive methods described in the regulations, if used consistently; in that case, the burden of proof reverts to the Service in proving that the exercise price is below FMV and that the company's application of the presumptive method is grossly unreasonable.
The 3 presumptive methods are:
The Independent Appraisal presumption, which means just what it sounds like; the conclusion reached by the appraiser can be used for as long as 12 months after the valuation date, unless a material event occurs.
The Illiquid Start-up presumption, where a business less than 10 years old can be valued for the purpose of section 409A by a person with significant knowledge and training in performing similar valuations. The valuation must take into account certain valuation factors, including the value of tangible and intangible assets of the business; the present value of future cash flows; the private sale price of comparable companies' stock; control premiums and discounts for lack-of-marketability; whether the method is used for other purposes; whether all available information is taken into account in determining value.
Finally, under the Binding Formula presumption a valuation will be presumed reasonable if based on a formula used in a shareholder buy-sell agreement or similar binding arrangement; if used, the binding formula must be used for all non-compensation purposes requiring valuation of the stock.
You may wish to contact your corporate tax advisor. Please contact us for further details as they apply to your Company's valuation facts and circumstances. Overall, the most prudent course of action is, of course, to rely upon an independent appraisal to help make option price determination "tax-safe." JLP&Co.LLC has a long experience dealing with tax-based valuation issues.

Any article on IRC 409A should refer the reader to the valuation of option-based compensation for financial reporting purposes, which is governed by SFAS 123R. This links takes you to the Financial Reporting BV page.

Pre-409A Issues

We have experience applying the Black-Scholes model of option valuation, and have presented reasoned explanations of its applicability in employee compensation and blockage discount cases.

Click here for a 2001 article on Valuing Employee Stock Options.

Click here for a 2002 article on Employee Stock Options [Rev. Proc. 2002-13.]

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