Editor’s note: Linda Markus Daniels is a founder of and principal in the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.

RESEARCH TRIANGLE PARK, N.C. – It’s finally here—all 397 pages of it.

Yes, the IRS has released the final regulations for Section 409A, which will allow companies to know what they can and cannot do with various alternative methods of compensation (i.e., other than salary) without running into penalties. The Regulations specifically relate to any “deferral of compensation,” which as defined in the Regulations runs the gamut from stock options, to severance, to commission payments, to insurance, to retirement payments, and beyond. Between now and December 31, 2007, the date on which changes in current plans are permitted without penalty, companies will need to be looking at all forms of agreements with their employees and consultants to be sure necessary changes are made.

Over the next several weeks these articles will provide information on various types of deferred compensation covered by the Regulations. This article focuses on stock rights.

What Stock Rights Are Affected?

In general the Regulations relate to non-statutory stock options (such as used for consultants and board members) and stock appreciation rights, unless such stock rights fall within certain exemptions. In order to be exempt the stock rights must meet all of the following tests:

● the stock right is granted at an exercise or base price that is not less than fair market value as of the date of the grant
● the grant does not contain a deferral feature other than the right to exercise the stock right in the future; and
● the right relates to “service recipient” stock.

How Is Fair Market Value Determined?

The Regulations generally allow valuation of private company stock based on any reasonable application of a reasonable valuation method. The interim regulations had proposed that only one valuation method be permitted for all stock related matters, but under the final Regulations one method may be used to establish the fair market value for the exercise price and a different method to value the stock upon repurchase.

The Regulations provide that a valuation with respect to stock not readily tradable on established securities markets should take into account the value of the tangible and intangible assets of the company, the present value of its anticipated future cash flows, the market value of the stock or equity interests in other entities engaged in substantially the same business, recent arm’s length transactions involving the sale of such stock, and other relevant factors such control premiums or discounts for lack of marketability . The use of any given valuation method is not considered reasonable if it does not take into account all available information material to the value of the company. Similarly, the use of a value previously calculated is not reasonable as of a later date if the calculation fails to reflect information available after the date of the calculation that materially affects the value of the company.

The Regulations also provide three safe harbor valuation methods for stock not traded on an exchange, which if used must be accepted by the IRS absent a showing that either the method used or its application was grossly unreasonable. The first of these is a valuation by an independent appraiser. The second is a valuation based on tax principles governing the valuation of shares subject to nonlapse restrictions under IRC section 83. Finally, and certainly the most important to early stage tech companies, a valuation may be made based on a set of special valuation rules for “illiquid start-up” companies.

For public companies the value may be determined using any of the following methods: (i) last sale before or first sale after the grant; (ii) closing price on trading the day before or the day of the grant; (iii) arithmetic mean of high and low prices on the trading day before or the day of the grant; or (iv) any other reasonable method using actual transactions.

What Are the Valuation Rules for Start-up Companies?

To be eligible for the special valuation rules a company (and any predecessors) must have been in business for less than ten years and have no class of securities traded on an established market. The shares involved may not be subject to any put, call or other right or obligation to sell or purchase such shares (other than a right of first refusal or a right or obligation to purchase upon a Section 83 event of forfeiture). Finally, the company cannot anticipate a change in control will occur within 90 days of the valuation or that an IPO is reasonably expected within 180 days.

If these requirements are met then a valuation may be made by written report, taking into account the factors indicated above, by any person, whether inside or outside the company, who the company determines has significant knowledge, experience, education or training. The Regulations further provide that a person is qualified to undertake the valuation if a reasonable individual, being apprised of such knowledge, experience, education and training would reasonable rely on the advice of such person with respect to valuation in deciding whether to accept an offer to buy or sell the stock being valued. More specifically, the Regulations indicate that “significant experience” usually means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry” of the company for which the valuation is being made.

What is Service Recipient Stock?

In order to be subject to an exemption from deferred compensation penalties, the stock used with respect to the stock rights must be “service recipient stock.” This is defined in the Regulations as common stock with no preferences other than a permitted preference on liquidation. So, for example, if the stock involved carries a dividend right or is preferred stock then it would not be within the definition of service recipient stock.

Service recipient stock must also, as may be gleaned from the definition, be stock of the company to which the recipient provides services. It may also, include, however, stock of most companies within a parent-subsidiary chain between the ultimate parent and the company that employs the individual. Parent and subsidiary status is generally determined based on at least 50% ownership, but under certain legitimate business circumstances it can be as low as 20%. The chain cannot, however, go the other way, i.e., an employee of the parent cannot receive stock of a subsidiary. Further, stock from companies with common ownership that are not within a vertical chain, such as may be referred to as sister companies, is not within the definition.

What Happens if the Stock Rights Are Modified after the Original Grant?

In general a modification of a stock right will be considered to be a new stock grant and thus the stock rights must meet the requirements of Section 409A on the date of the modification to avoid penalty. In other words, the exercise price cannot be less than fair market value on the date of modification.

The good news is that acceleration of vesting is not considered a modification for these purposes, nor is an extension of the time to exercise if the extension (post termination) does not exceed the original option term, does not exceed 10 years from the date of the grant or the option is under water. This ability to extend is especially important with respect to options with an exercise period that is connected to termination of employment or service on the board of directors. Further, the addition of a right to tender previously acquired stock to pay an exercise price is not considered a modification that would trigger 409A penalties.

What About Incentive Stock Options?

Incentive stock options are exempt. It is important to understand, however, that if an incentive stock option should cease to qualified as such, then there will be a look back to the date of issuance to see if the now non-statutory option is exempt. Thus, for example, if the term of the option is extended beyond the statutory limit then there will be a look back to how the original determination of fair market value was established. This leads to the obvious question as to whether companies should adopt the same valuation process for ISOs as they do for NSOs and SARs. Further, is it only a matter of time before the IRS provides regulations under Section 422 providing fair market valuation guidelines that are the same as those under the 409A Regulations?

Do You Need to Worry About Options Already Granted?

If a stock right was granted before January 1, 2005 then the exercise price will be treated as having been set at not less than fair market value if the price was established based on a good faith attempt by the company to set the price at or above fair market value. If the stock right was granted on or after January 1, 2005, however, but before January 1, 2008, then the determination as to whether the exercise price is equal to fair market value on the grant date may be made using any of the methods described in the preliminary or final Regulations.

What Happens if the Stock Rights Granted Do Not Comply with the Regulations?

If a any stock rights fail to comply with the new Regulations then all compensation deferred with respect to the stock rights will become includable in the holders’ income for the taxable year in which the failure occurs, with interest. In addition, there will be added a 20% federal tax penalty.

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Linda Markus Daniels concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, technology and international matters. Comments or questions can be sent to ldaniels@d2vlaw.com