409a Valuations: Background & History

The Internal Revenue Code (IRC) is the domestic portion of federal statutory tax law in the United States implemented by the Internal Revenue Service (IRS). The IRC contains 9,000+ sections that cover how income taxes, payroll taxes, estate taxes, gift taxes, and excise taxes are to be calculated and reported.

As it stands today, the United States currently has the world’s highest statutory corporate income-tax rate (39.1%). Many domestic and multi-national companies are re-incorporating offshore to take advantage of lower corporate income-tax rates and avoid paying U.S. tax on their foreign subsidiaries’ profits to remain competitive in the world economy.

Section 409a of the Internal Revenue Code explicitly states the treatment for federal income tax purposes in the United States of non-qualified deferred compensation paid by a “service recipient” to a “service provider”. A non-qualified deferred compensation plan defers the payment of a portion of the employee’s compensation (salary, bonus, stock options, commissions, etc.) to a later date once certain stipulations are met like when an employee enters retirement, leaves the company, passes away, becomes disabled, etc.

Why should I consider hiring a third-party firm?
Understanding the Internal Revenue Code in its entirety is an onerous task for anybody to undertake, let alone an entrepreneur that wears many hats and doesn’t necessarily have the time to routinely delve into the complex legal document at a granular level.

A third-party firm offers a fair market valuation using “reasonable application of a reasonable valuation method” and essentially shifts the burden of proof off an individual company and places it on the IRS. Failure to ensure all requirements within Section 409a have been met have the potential to have a profound adverse impact on startups, especially those that are already strapped for cash. Those found in violation of Section 409a may be subject to a 20% penalty fee and interest payments in addition to immediate taxation.

Deal Capital provides 409a valuations for Employee Stock Ownership Plans (ESOP). Each company is evaluated using an individualized approach to determine the appropriate valuation methodology that aligns best with their desired outcomes. For further inquiries, contact us.

Josh Barnhouse
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