In October 2004 the IRS issued a new regulation, Internal Revenue Code §409A ("409A"), as a part of the American Jobs Creation Act of 2004 in response to perceived abusive compensation practices and stock option pricing practices (i.e. issuing stock options below fair market value).
What is 409a?
409A governs all privately held companies seeking to issue any form of deferred compensation, which includes many types of equity-based compensation such as stock options. The IRS requires that private companies establish that their stock options are not being issued "in-the-money" or with an exercise price below "fair market value"
Having served more than 400 companies for 409a purposes, we have perfected an efficient process that keeps management distraction to a minimum, while providing a high quality, highly defensible report. Our work has withstood the toughest scrutiny from top-tier VCs, Big Four accounting firms, and most of the top venture-law firms in the industry.
Implications of Non-Compliance
The tax penalties stemming from non-compliance can be severe and are enforced on the recipient of the deferred compensation or equity compensation. On a combined basis, federal and state taxes with penalties can reach upwards of 80% On the federal level, penalties include taxation on the value of the compensation at ordinary income tax rates in addition to an excise tax equal to 20% of the compensation. Taxes are also imposed on the state level, and in California, consist of a 9.4% individual tax rate plus a 20% state excise tax. In addition to monetary costs, failure to be 409A compliant can impede an institutional financing or exit transaction as investors/buyers are now requiring compliance prior to completing a deal.
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