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Nonqualified Deferred Compensation – IRS 409A

Axiom Valuation is one of the leading providers of Section 409A valuation services. Nonqualified common stock options and some other types of nonqualified deferred compensation are subject to the IRS Section 409A requirements. Deferred compensation amounts under these plans are subject to inclusion in a recipient’s gross income unless the plan meets the section’s specified election and distribution requirement. One of the key exclusions is when the exercise price of nonqualified stock options is equal to or greater than the fair value of the underlying stock as of the date of the option grant. Our staff has conducted hundreds of 409A valuations for companies ranging from early startups to established companies.
The IRS will accept a valuation of private company common stock, if done by “the reasonable application of any reasonable valuation method.” This includes:

  1. The fair value of tangible and intangible assets of the corporation;
  2. The present value of future cash-flows; and
  3. The market value of stock or equity interests in comparable companies.

The valuation may include other relevant factors, such as control premiums or discounts for lack of marketability, which are consistent with the standards laid out in IRS Revenue Ruling 59-60 regarding the valuation of private companies. Again, consistent with previous IRS valuation rulings, a valuation is considered reasonable if based on an appraisal by an independent appraiser as of a date that is within 12 months of the date for which the value is being determined. The IRS has also provided two other alternatives to an independent appraisal that are considered to meet the reasonable valuation test. One is a valuation of illiquid stock of a start-up company by experienced personnel, which may include employees or directors of the company. It would appear that a board of directors or a committee of the board of directors of a start-up company may do the valuation, where the board or committee is composed of experienced venture capitalists or private equity investors that have significant experience in valuing start-up companies. There are several additional requirements for this type of valuation to be reasonable, that are spelled out in the proposed regulations.
The other is a valuation based upon certain types of formulas. Examples of the formula-based valuation method would be valuing the stock based on a multiple of sales or earnings, or book value; however, for a formula-based valuation to qualify under the proposed regulations, it must be consistently applied to all valuations of the stock. Notice that this alternative valuation method will not be easily accepted by the government.
For more information:
409A Overview Podcast
Primer on Valuing Common Stock per IRS 409A and the Impact of FAS 157(now Topic 820)(2010)(PDF)

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