Section 409A was added to the Internal Revenue Code of 1986, as amended (the “Code”), by the American Jobs Creation Act of 2004 to address concerns about nonqualified deferred compensation arrangements. Section 409A covers a broad array of nonqualified deferred compensation arrangements, including any plan, agreement or arrangement between an employee (or other service provider) and an employer in which there is a legally binding right to compensation that is or may be payable in a later tax year. The scope of section 409A encompasses the grant of stock options and stock appreciation rights, but restricted stock, by definition, is not subject to section 409A.

If the grant of a stock option or appreciation right is not exempt from section 409A or does not comply with section 409A’s provisions, then a punitive excise tax may be imposed along with other potential adverse consequences.

Stock option and stock appreciation rights are generally exempt from section 409A if:

  • The exercise price of the stock option or the base price for the stock appreciation right equals or exceeds the fair market value of the underlying stock on the date of grant
  • The stock award has no other feature that permits the deferral of compensation
  • The stock award is limited to common stock

Fundamentally, as long as the company grants stock options or stock appreciation rights at or above fair market value, section 409A will not apply. Section 409A provides detailed guidance for determining what is fair market value. The factors to be considered in determining fair market value are:

  • The value of tangible and intangible assets
  • The current value of future cash flows of the company
  • The market value of stock or equity interests in similar corporations
  • Other relevant factors such as control premiums or lack of marketability
  • The consideration of any recent equity sales made by the corporation in arm’s-length transactions

Section 409A provides certain safe harbors for valuations that will be presumed reasonable, which are:

  • A valuation determined by an independent appraiser dated no more than 12 months before the grant of the stock option or stock appreciation right will be presumed reasonable unless subsequent events have occurred that have had a material effect on the stock value.
  • A valuation method based upon a buy-back formula will be presumed reasonable if the formula is consistently applied to both compensatory and non-compensatory transactions with the company, or a person owning more than 10 percent of the stock of the company.
  • For a private company that has conducted business for fewer than 10 years, a valuation will be considered reasonable if:
    • It is made in good faith
    • It is evidenced by a written report
    • It takes into account the factors set forth above in determining fair market value
    • It is made with respect to stock not subject to any put or call right other than a right of first refusal and certain repurchase rights that arise in connection with a termination of employment
    • It is performed by a person with knowledge and experience in performing valuations

The standard for determining whether an individual possesses the requisite knowledge and experience to conduct an evaluation is whether a reasonable person, with knowledge of such individual’s experience and training, would reasonably rely on the individual’s advice. “Significant experience” means at least five years of relevant experience in certain specified fields (e.g., business valuation, appraisal, financial accounting), or other comparable experience within the line of business in which the company operates.

While options and stock appreciation rights that are granted at fair market value are generally excluded from section 409A, a modification to or extension of the stock award would cause it to be subject to 409A. A modification or an extension of the stock award that expands the holder’s rights essentially results in the grant of a new award. If the option or stock appreciation right is “in the money” at the time of the modification or extension, then the “new award” will be considered granted at a discount and therefore is no longer exempt from 409A. An important caveat, however, is when an exercise period is extended in connection with termination of employment or other separation from service. If an option or stock appreciation right exercise period is extended following a separation from service, the extension will not be considered to result in a new grant so long as the exercise period is not extended beyond the earlier of the original maximum term of the option, or 10 years from the date of original grant of the option. In addition, the extension of an exercise period at a time when the stock is “underwater” does not constitute an additional deferral feature (i.e., will not, in and of itself, cause the option to become subject to section 409A).

Further reading:

What Are Share Repurchase Rights and What Is the Benefit to the Company?

Can I Grant Stock Awards to My Employees and Independent Contractors Who Live Outside of the United States?

Rule 701: Securities Exemption for Stock Awards Offered by Private Companies

IRC Section 83 and Treatment of Stock Repurchase Rights.