A Stock Option gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain period, usually three to six years. The price at which the stock option is granted to the employee is called the grant price. Employees who hold stock options expect the exercise price to be lower than the market price of the underlying shares which implies that they have an opportunity to profit from buying the shares at a lower price (exercise price) and selling them at a higher one (market price).
There are two kinds of stock option plans: incentive stock options (ISOs) and non-qualified stock options (NSOs). The key differences between the two are summarized below:
Stock options are a way for companies to reward their employees for their performance, provide an incentive to align their interests with those of the company and contribute towards its growth and attract motivated employees. Smaller companies focusing on growth can use stock options to maintain cash reserves for investments by redirecting the cash from traditional compensation and replacing part of the compensation for the employees with stock options. This allows employees holding these options to access a piece of the future growth. Public firms on the other hand already have well-established benefit plans in place. These companies can make use of stock options to include the employees in ownership of the company. The dilutive effects of stock options are often very small, offset by the benefits of retaining productive employees promising future growth.
It is important for the companies granting stock options as compensation to set the exercise price of the underlying shares at or above the fair market value (FMV) arrived at by having an independent valuation performed at the time of grant. Failing to do so results in the employees holding the options, that cannot be shown to be at or above a reasonably-determined FMV at the time of grant, face tax implications on vesting at a tax rate as high as 85%.
Section 409A of the Internal Revenue Code requires the options holder to have an exercise price below the FMV at the time of grant to report taxable income equal to the spread between the exercise price and the FMV of the underlying shares as the options vest. The option holder, consequently, is taxed on the income the holder does not actually receive. In addition to the federal income and employment taxes, an additional 20% federal tax applies under these conditions. The company is required to withhold these taxes with respect to employees and failure to do so makes the company liable for these taxes, penalties and interest.
To avoid these tax implications and to qualify the stock options granted by a company to be exempt from Section 409A, it is important for the companies granting the stock options as compensation to set the exercise price of the underlying shares at or above the FMV arrived at by having an independent valuation performed at the time of grant. For public companies, the FMV of the underlying shares is determined daily. For private companies, FMV needs to be determined by an independent valuation applying appropriate valuation methodologies. The regulations under Section 409A state that if a method is applied reasonably and consistently, such valuations will be presumed to represent FMV, unless shown to be grossly unreasonable. Consistency in application is assessed by reference to the valuation methods used to determine FMV for other forms of equity-based compensation. An independent valuation will be presumed reasonable if ‘the appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee ownership plan’. A reasonable valuation method considers the following factors:
Therefore, a reasonable valuation considers the market, income and replacement cost approaches, and considers the specific control and liquidity characteristics of the subject interest. The Code also requires that the valuation of common stock for the purposes of Section 409A be consistent with valuations performed for other purposes. The valuation applies for up to 12 months. It needs to be revised earlier than 12 months when intervening events would reasonably and materially impact the FMV.
So, what makes a qualified determinant of FMV? A reliable independent valuation is prepared by an independent valuation firm with a background
in valuation and finance, has accumulated significant professional experience and holds one or more professional credentials, CVA, ASA, ABV, CBA
or CFA. The professionals at Avenue M® Advisors, Inc. possess the professional credentials, designations, knowledge and experience necessary
to be entrusted with your 409A valuation and assessment needs. We perform §409A business valuations for companies on a regular basis. If
your company is in need of a §409A business valuation contact us today.
Business Owners: You are cordially invited to attend the Walking to Destiny Workshop in Los Angeles on October 14th. Read More
You are cordially invited to participate in an Exit Planning Awareness Event. Within the next 20 years, in excess of 90 million people in the United States and Canada will be
retiring (the baby boomer generation born between 1946 and 1964). It is estimated that one of every two privately held businesses will transition during
this period, representing in excess of $10 trillion in wealth, the largest wealth transfer in the history of mankind.
The following article was written by Steven A. Horowitz, a tax attorney that Avenue M Advisors, Inc. works with and we found the article to be very compelling
about the new proposed regulation changes under IRC §2704(b).
The valuation community has gone head to head time and time again with the Internal Revenue Service when it comes to tax-affecting S-Corporations, and history reflects that the Tax Courts have sided with the IRS’s position time and time again.
How would you answer the following three questions?