Deferred Compensation and the IRS: 3 Things You Need to Know about 409 A and Payments
Stock options and other nonqualified deferred compensation plans have become increasingly popular ways for private equity firms, investment companies, startups, and other businesses to reward employees. Many choose to defer compensation, and thus the taxes paid on it, into the future. If done without careful planning, however, both service providers and receivers may end up with a greater liability than if they had simply accepted payment at the time the services were rendered. Before electing to do so there are three things you should know about the IRS and 409 A.
What is Section 409 A?
In the wake of the Enron and Worldcom scandals, the Congress established Section 409 A of the Internal Revenue Code to regulate when distributions from a nonqualified deferred compensation plan can be made. This includes bonuses, stock options, stock appreciation rights, severance packages, and more. A qualified deferred compensation plan, on the other hand, includes programs such as a 401(k) option. Employees and companies alike should beware the additional tax liabilities and penalties that incur when they are paid outside one of the six allowed deferred payment periods, including
- When the employee separates from service.
- When the employee becomes disabled.
- Upon the death of the employee.
- At a fixed time or on a schedule specified by the plan's documents.
- Upon a change in ownership or control of the company.
- In the event of an unforeseen emergency
A key element in avoiding the tax penalty is to elect to defer payment before the money is earned. A service provider must choose to defer income expected in the following year before December 31st of the current year. A service provider is commonly an employee, but may also be an independent contractor.
Know the Fair Market Value of Compensation
Knowing the fair market value of the business is critical before issuing stock options so as to avoid additional tax penalties. Stock options are considered a deferral of compensation if they have an exercise price below the fair market value, or are "in the money," on the day they are granted. For example, if the value of one common share of the company is $100, and an option to purchase 100 shares is offered at $50, there is an intrinsic value of $5,000 that can be considered nonqualified deferred compensation, and thus subject to a greater tax liability.
Additionally, if the share price is undervalued, creating an unreported higher intrinsic value, companies may face the 20% penalty in addition to a federal underpayment penalty, plus an additional 1%. Some states such as California also impose additional taxes, penalties, and interest on undervalued stock options. Employees are personally liable as well, and will be subject to regular income tax liability as soon as the options vest. They may also have to pay underpayment penalties on top of that.
When and how to get a Fair Market Valuation
In most cases, companies will need to have their companies valued at least once a year. In some cases, such as if there is a new round of financing in between grants, the valuations will need to take place more frequently. While many executives may believe they have a firm grasp on their own company's value, to avoid running afoul of the IRS it is best to hire a qualified outside appraiser who will use a “reasonable application of a reasonable valuation method.”
Hiring an independent appraiser who can produce a defendable valuation can be expensive. Doing so, however, will help protect employers and employees from unwanted IRS challenges and tax liability, and will save executives and angel investors alike time and money.
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