Private firms' stock options pose risk of tax bite
Business Journal - March 31, 2006
by John Hession and Andrew Liazos
Private companies confront complications from granting options with an exercise price less than fair-market value. In the past, accounting standards required a charge to earnings for the amount of any discount to fair-market value, but many private companies ignored the rule.
At the time of an initial public offering, such companies often battled with the Securities and Exchange Commission over "cheap stock" issues, sometimes taking a nonrecurring, non-cash expense on their financial statements.
However, private companies can no longer ignore or defer the issue. Under Section 409A of the Internal Revenue Code, there is a new and onerous threat for private companies considering stock-option pricing -- significant, adverse tax consequences to the option recipient.
An option with an exercise price that is at least equal to the stock's fair-market value on the grant date will ordinarily be exempt from Section 409A. But the IRS has interpreted Section 409A to cover options issued with an exercise price that is less than the then-current fair-market value of the stock, even if only by a small amount. Unless a company imposes severe restrictions on exercise, a discounted stock option will violate the rule.
In addition to valuation issues, there are other dangers lurking. Currently, only common stock can be used for exempt stock options. Even if a stock option is exempt, it may later become subject to Section 409A due to changes made after the grant date, such as providing extensions of the exercise period.
Section 409A provides harsh penalties for granting discounted stock options that have vested. The employee will be taxed upon violation -- even if the option has not been exercised -- and interest will be charged from the vesting date.
In addition, the IRS will impose a 20% penalty with respect to the compensation required to be taxed. The company must then withhold payments for these taxes, and possibly additional amounts if the stock increases in value.
The IRS recently issued guidance and proposed regulations regarding how to determine the fair-market value of private-company stock. Fortunately, the IRS has provided private companies some small relief for options granted before 2005, by only requiring that fair-market value be determined in good faith. However, it may be difficult to demonstrate good faith without some record of the process and procedures used to determine fair-market value.
There is no such break, however, for stock options granted after Jan. 1. Private companies must meet the valuation standards under Section 409A to avoid having their stock options inadvertently treated as nonqualified deferred compensation. For now, private companies can use any reasonable valuation method but will be required to demonstrate fair-market value to the IRS on audit.
Private companies can mitigate significant valuation risks by using a safe harbor when determining the exercise price for option grants. The primary advantage of using a safe harbor is the IRS must respect the valuation unless the private company is grossly unreasonable in relying on the valuation method.
Two primary safe harbors exist. The proposed regulations provide for a private company to rely on a report by a qualified independent appraiser using traditional valuation methodologies.
The other safe harbor is available for early-stage private companies (not yet 10 years old) for valuations performed by a professional with significant knowledge, experience or training performing similar valuations, provided the stock is not subject to put or call rights and it's not reasonable to anticipate a liquidity event in the ensuing 12 months.
Private companies can take steps by the end of 2006 to avoid adverse tax consequences due to having previously issued a discounted stock option.
The simplest correction is to increase the exercise price to the stock's fair-market value on the grant date.
Alternatively, the discount at grant can be paid in cash on a fixed date after 2006. The option also can be structured so the employee can exercise each tranche only within 2½ months of the tax year in which it vests.
It makes sense to minimize the number of times during the year options are granted to avoid the time and expense of additional valuations. It may not make sense to make new grants immediately when an individual joins the company.
Executives should be sure the company has taken all proper legal actions to grant options. A valuation at a given date will be worthless if the grant is actually accomplished later when the stock value is higher.
John Hession and Andrew Liazos are partners in the Boston office of law firm McDermott Will & Emery.