Section 409A

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Many severance and other compensation arrangements provide for payment only if and when the employee signs a release of claims and the release has become irrevocable.

For a general release of claims to be valid under federal employment law, the employer may be required to give the employee a specified number of days to consider the release and then an additional period of time in which to revoke the release after signing it.

The IRS believes that a release contingency for payment of severance or other deferred compensation could violate Section 409A of the Internal Revenue Code if not drafted correctly.

The IRS has given employers until the end of this year to correct the release contingency language in arrangements subject to Section 409A.Continue Reading December 31 is IRS deadline to correct Section 409A violation due to severance conditioned on release of claims

As a general rule, all stock option grants need to have an exercise price at or above the fair market value of the company’s common stock on the date such grant is made. This requirement, and its many related complexities, generally comes from Section 409A of the Internal Revenue Code and the related Internal Revenue Service (“IRS”) regulations (collectively, “Section 409A”). Section 409A was enacted several years ago in response to perceived abuse of deferred compensation arrangements brought to light during various high-profile corporate scandals.

The two main penalties imposed by Section 409A for granting a stock option with an exercise price below fair market value are (i) immediate tax upon vesting of the option (as opposed to at exercise or sale) and (ii) an additional 20% federal tax penalty (on top of the regularly applicable federal and state taxes). In addition, some states, such as California, may impose their own Section-409A-equivalent penalty tax. In order to avoid these penalties, the IRS requires that a stock option must be granted with an exercise price no less than the underlying shares’ fair market value determined as of the grant date and that such fair market value must be “determined by the reasonable application of a reasonable valuation method.”

The good news is that Section 409A provides three “safe-harbor” methods for determining fair market value, two of which are most commonly relied upon by startups and venture-backed companies (discussed below). If one of these safe harbor methods is used, then the resulting fair market value is presumed to be “reasonable” unless the IRS can establish that the company’s determination was “grossly unreasonable.”Continue Reading Establishing fair market value for purposes of Section 409A and stock option grants