Valuation for IRS 409A Requirements
Setion 409A (effective from 01.01.2005) of the Internal Revenue Code of the United States deals with the nonqualified deferred compensation. It was enacted in response to the practice of Enron 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 tax law.
Putting simply, 409A valuation is conducted to arrive at the valuation of the stock options being offered by the Employer to Employee in US in order to claim it tax free.
Calculation of the Value under 409A requires following steps:-
Calculate enterprise value. The first and arguably most important step is estimating the company’s valuation (“enterprise value”). This is straightforward if you’re doing your 409A valuation immediately after a fundraise, but becomes difficult after a year (or more). Typically this involves arriving at the fair valuation of the business using cost, market or income approach depending upon the industry in which the business operate and the size and operations of the business.
Determine the value of the common stock. The second step is to take that enterprise value and divide it up among all the different share classes (e.g. preferreds, warrant holders, common) to determine the current value of the common shares – what is also known as the “fair market value” (FMV). This step takes into account all of the economic rights of each share class, otherwise known as liquidation preference (i.e. the order in which stockholders are returned their investment in a liquidity event) and rights related to conversion, dividends, and participation. This step involves allocating the value through application of OPM Backsolve/ Probability Weighted Expected Return Method (PWERM).
Apply a discount for lack of marketability (DLOM). The third and final step is to take the calculated FMV for the common shares and apply a discount to adjust for the fact that the company is not publicly traded – in other words, none of your employees could actually go and sell their shares at that price because there is no liquid market for them.
Other important US Tax Issues
83(b) election – The Internal Revenue Code’s (IRC) 83(b) election allows an employee or startup founder to pay taxes on the complete fair market value of restricted shares at the time of grant. The 83(b) election is for equities that have a vesting period. The 83(b) election instructs the IRS to tax the elector for stock ownership at the time of gift rather than when the stock vests.
ASC 718 – Employee stock-based compensation is expensed on an income statement in accordance with ASC 718. Equity awards are a type of compensation that is subject to a set of accounting regulations known as ASC 718 that corporations must adhere to. Expense accounting was previously known as FAS 123(r), but it is now governed by ASC 718.
ISO 100k – In contrast to Non-Qualified Stock Options (NSOs or NQSOs), Incentive Stock Options (ISOs) receive preferential IRS treatment. The key advantage is that when the option is exercised, the spread between the Fair Market Value (FMV) and the initial exercise strike price is not subject to ordinary income tax. Ordinary income tax is withheld on the spread by NSOs at the time of exercise. ISOs, on the other hand, are nevertheless subject to the Alternate Minimum Tax (AMT) in order to prevent affluent persons from hiding all of their income in this method. Another IRS rule designed to prevent the ISO program from being utilized as a tax shelter is the $ 100K Limit(100K ISO Limit).
Form 3921 & 3922 – The IRS has issued two forms (and instructions) for reporting ISO workouts and ESPP share purchases: Form 3921 for ISO exercises and Form 3922 for ESPP share purchases. For each workout or purchase made during the calendar year, a new form must be completed and filed. As an example, if an employee used many ISO awards over the course of a year, in a calendar year, the employee must receive a copy of Form 3921 for each exercise, and the corporation must receive a copy of Form 3921 for each exercise, will be required to file numerous tax returns with the IRS.
HOW FINEX CAN HELP
With the team of expert valuers, we will ensure that we arrive at the fair value of the stock options so that you may calculate your tax liabilities payable to IRS accordingly.