The IRS Audit Risk Profile of Section 409A is Changing
Is your company prepared?
By Mitchell Kopelman, partner-in-charge of Tax
If your company has issued or is planning to issue stock options or similar instruments to employees as part of their compensation package, then you are likely already familiar with Internal Revenue Code section 409A (409A). 409A is the federal tax rule that is used as a test to determine whether stock options granted to employees qualify as deferred compensation.
If stock options are “in the money,” meaning that they could be theoretically exercise profitably when they are issued (exercise price is less than the fair market value), then the profit earned from exercise is subject to a 20 percent penalty.
Since 409A was enacted in 2004, it has largely gone unenforced. Even companies who were targeted for IRS audits on other parts of their tax returns found their 409A reporting ignored. Accordingly, many companies and boards have been unsure of how rigorously to comply with 409A – with companies opting for “bare bones” valuations as documentation or choosing to take their chances with no documentation at all because the audit risk was perceived to be so low.
The risk profile is changing this year. After many years of threats by the IRS to begin systematically reviewing 409A compliance, the IRS is finally following through.
The IRS is starting with 50 companies that have previously been selected for employment tax audits, and, after gaining experience with those audits, the IRS is expected to expand its 409A audit program.
This IRS action means that you must take 409A as seriously as every other part of your tax compliance regime.
Wondering if you’re in compliance with 409A?
- Have you issued stock options, warrants, stock appreciation rights or phantom stock to employees?
- For each option grant, is there an independent valuation that was performed no earlier than six months prior to each grant?
- Is there any reason to question any of the valuations previously performed for your 409A compliance?
- Is the exercise price for each grant greater than or equal to the fair market value of the underlying shares?
- Are the valuation reports comprehensive and compliant with the standards set forth in the Uniform Standards of Professional Appraisal Practice, or some similar professional standards?
- Do the valuations contain certifications of independence and compliance with a set of professional standards?
- Do the valuations contain a declaration of appraiser, whereby the valuator acknowledges his or her liability if the valuation he or she provided causes a gross underpayment of taxes?
- Were multiple valuation approaches considered?
Corrections to prior 409A compliance documentation and relief may be available per IRS Notice 2008-113. However, once an audit has begun, corrections will generally not be accepted. Accordingly, if you are concerned about compliance deficiencies, you may have actions available to you that will mitigate or even avoid any penalties.