Executives who receive non-incentive stock options to purchase common stock (“Options”) should consider obtaining a qualified appraisal of their company’s stock to avoid income tax liability under new IRS Section 409A. Failure to comply with 409A could result in executives having to pay income tax and a 20% penalty upon the granting of the Options. A qualified appraisal of a company’s stock is an important step in ensuring that the Options are exempt from regulation under 409A.
For Options to comply with IRS Section 409A, the executive may only exercise Options on account of death, disability, separation from service, an unforeseen emergency, a change in control, or a fixed date. Fortunately, Options are considered exempt from 409A if 1) the Options’ exercise price per share is greater than or equal to the fair market value per share of the company’s common stock on the Option grant date; 2) the number of shares subject to the Options are fixed on the grant date; and 3) the Options do not include other deferral features.
The key requirement to exempt Options from 409A is the valuation of the company’s common stock on the Option grant date. The IRS has proposed several alternatives for valuing a company’s common stock that will create Safe Harbor protection for the executive. If the executive uses one of these alternatives to value the company’s common stock, the IRS will presume the valuation approach to be reasonable.
The best alternative to value a company’s common stock for most executives will be to hire a qualified, independent appraiser to perform an appraisal within 12 months of the grant date of the Options. This alternative will provide the greatest protection from an IRS challenge. Second, a qualified independent appraiser will apply appropriate minority interest and marketability discounts (which often result in discounts to the common stock price of 30% to 50%), providing a company flexibility in setting the exercise price for the Options. Third, a qualified independent appraiser will factor in a company’s debt and preferred equity when determining the value of the common stock. Finally, the qualified independent appraiser will document all assumptions and findings in a comprehensive written report that can be submitted to the IRS.
The Malibu Group is qualified to serve as an independent appraiser for valuations that need to comply with IRS requirements. The Malibu Group professionals have performed hundreds of business valuations and hold professional designations including Accredited Senior Appraiser (ASA) with the American Society of Appraisers, Chartered Financial Analyst (CFA), CPA, and MBA.