IRS Section 409A – Stock Options and Other Securities

IRS Section 409A and FASB ASC 718 greatly increased the need for companies issuing stock options and other securities to have the underlying stock valued by an independent appraisal firm like Center Point.

There are a wide variety of equity grants that can be made under deferred compensation arrangements, with the most common being Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). A stock option is typically a grant of common shares that become valuable once the share price exceeds the exercise price as determined by an independent appraiser. The following is a representative list of equity and equity-like arrangements that can be awarded to executives, employees, directors, and vendors:

  • Incentive Stock Options (ISOs) – A type of stock option that can be granted only to employees and has special tax benefits
  • Non-qualified Stock Options (NSOs) – Stock options where the tax advantages shift from the option recipient to the issuer
  • Stock Appreciation Rights (SARs) – SARs resemble stock options in that the holder benefits from an increase in stock price but rather than exercising the option and paying the exercise price, the increase in value is paid to the recipient in stock or cash
  • Phantom Stock – Like SARs, phantom stock is a contractual agreement between a company and recipient that bases a future cash payout on the increase in the value of the underlying stock without actually issuing stock
  • Restricted Stock Units (RSUs) – RSUs involve a promise by the employer to grant restricted stock at a specified point in the future, with the general intention of delaying the recognition of income to the employee while maintaining the advantageous accounting treatment of restricted stock (restricted stock becomes unrestricted upon satisfaction of a certain event, usually based on time)

IRS Section 409A

Section 409A was added to the Internal Revenue Code in the 2004 American Jobs Creation Act. The effects of Section 409A are far-reaching because of the exceptionally broad definition of “deferral of compensation.” Section 409A was enacted, in part, in response to the practice of company executives accelerating the payments under their deferred compensation plans in order to access the money before the company went bankrupt, and also in part in response to a history of perceived tax-timing abuse due to limited enforcement of the constructive receipt tax doctrine.

Section 409A regulates the treatment for federal income tax purposes in the United States of non-qualified deferred compensation paid by a “service recipient” to a “service provider”. Service recipients are generally employers, but those who hire independent contractors are also service recipients. Service providers include executives, general employees, some independent contractors and board members, and service providers.

One of the common types of deferred compensation covered by the law is executive and employee stock option grants. If a stock option is issued to an employee at an exercise price that is lower than the fair market value of the stock on the date of issuance, the employee is exposed to certain adverse tax consequences, including:

  • Tax due at the time of option vesting rather than the date of exercise or sale of the common stock
  • A 20% federal tax penalty applied to the optionee in addition to regular income and employment taxes
  • California imposes an additional 409A tax penalty of 5%

In addition to penalties levied on the optionee, the employer is liable for unpaid withholding taxes upon option vesting. There are various exceptions, excluding from the Section 409A rules compensation that would otherwise fall within this definition, including: qualified plans such as pension and 401(k) plans, and welfare benefits including vacation leave, sick leave, disability pay, or death benefit plan.

Under Section 409A, a formal appraisal is defined as a valuation conducted by an independent appraiser on the basis of generally accepted valuation principles. For the IRS to accept a valuation of private company common stock, it must be done by “the reasonable application of any reasonable valuation method.” The following factors should be considered in developing a reasonable valuation:

  • Recent company financing
  • Stage of development of the company’s business and industry
  • The value of tangible and intangible assets of the corporation
  • The present value of future cash-flows
  • The market value of stock or equity interests in similar corporations and other companies engaged in trades or businesses substantially similar to those engaged in by the corporation being valued
  • Selection of appropriate valuation methods and techniques
  • Other relevant factors, such as the applicability of control and marketability discounts

A valuation should be performed by someone who is qualified in 409A valuations (based on their knowledge, training, experience, etc.). In most cases, companies choose to hire an outside appraisal firm such as Center Point to meet this requirement. A valuation must be completed at the time the options are granted and every 12 months thereafter (sometimes sooner if there is a material change in the value of the company, such as an interim round of financing).

The best way to avoid the potential adverse tax consequences of 409A is to hire Center Point as your independent appraiser. If an appraiser is used, the valuation will be presumed to be reasonable under 409A, and such presumption can only be challenged if the valuation is deemed grossly unreasonable. If a company does not use an independent appraiser, management will bear the burden of proving that its valuation methodology is reasonable and has been reasonably applied.


A valuation report that provides the fair market value of the common stock to satisfy Section 409A can also provide the fair value of the common stock to satisfy financial reporting requirements. This “dual purpose” valuation will provide consistency between book and tax accounting treatment, and will ensure that the company does not have to obtain a second valuation to satisfy its auditors. Center Point adheres to the allocation methods proscribed in the AICPA Practice Aid, Valuation of Privately-Held-Company Equity Securities Issued as Compensation.

The valuation will generally not be accepted for financial reporting purposes if it does not comply with the methodologies outlined in the Practice Aid. The 409A tax guidance is less specific. To our knowledge there is no proscribed valuation methodology or guidance comparable to that contained in the Practice Aid. However, Section 409A does mandate that the valuation be done using reasonable valuation methods and that the valuation professional has the proper experience and training.


Private company common stock virtually always has value; therefore, obtaining a defensible appraisal is an important step in potentially saving you from unnecessary IRS challenges and saving your employees from unexpected taxes and penalties. Center Point is here to help. Our commitment to quality provides clients with a well-documented, auditable valuation report that can be used for both tax and financial reporting purposes. We strictly adhere to industry-standard valuation and allocation techniques, giving clients the highest level of assurance possible.