Issuing Stock Options (Profits Interests, Phantom Stock) to Employees

If your company has issued equity instruments (such as stock options, profits interests, or phantom stock) to its employees, chances are that your accountant, lawyer, or other advisor informed you that you need a valuation (sometimes called a 409a valuation.)

Under U.S. and some other countries’ tax laws, such equity instruments must be configured in a certain way, or the recipients will be subjected to tax on those instruments. This can be disastrous for employees as they would be required to pay cash tax on compensation that is illiquid.

Accordingly, Issuing stock options to employees triggers at least one and possibly two financial reporting requirements. Both require an independent appraisal of the company’s stock to receive the desired tax treatment for the company and the employees. Are you familiar with the rationale behind these requirements?

  • Section 409A of the Internal Revenue Code (“IRC409A”): IRC409A subjects options, profits interests, and phantom stock to a test as to whether option grants (“Options”) can be considered deferred compensation for tax purposes. If the strike or exercise price of the Options is equal to or greater than the fair market value of the underlying stock at the date the Options are issued, there are no immediate tax consequences to the employee from receiving the grant or additional compensation taxes assessed on the company by granting it.

    However, if the Options have a strike price that is below the fair market value of the underlying shares, they may be treated as current income equal to the difference between the current share value and the strike price per share and, therefore, subject to personal income as well as employment taxes. This is potentially disastrous to recipients of Options as they would be assessed a cash tax obligation on a nonliquid asset.

    While companies are not prohibited from performing their own valuations, such valuations would not be independent and thus are subject to additional scrutiny, as well as penalties if the IRS disagrees with the valuation. An independent valuation of the shares generally provides a safe harbor to issuing companies. Further, companies with complex capital structures find it technically challenging to isolate the value of common shares and thus find it worthwhile to outsource such valuations.

  • Accounting Standards Codification topic 718 (Compensation – Stock Compensation) (“ASC 718”): According to Generally Accepted Accounting Principles (“GAAP”) and International Financial Reporting Standards (”IFRS”), companies must record an expense on their books in the amount of the fair value of any Options granted at the times of the grants.

    Generally, an independent valuation of the Options is required under accounting standards. Such valuations come under heavy scrutiny by financial statement auditors because, historically, a large percentage of audit deficiencies arise from fair value accounting issues, including stock options.

    Accordingly, it’s important to work with a valuation provider who has experience working on financial statement-related valuations. With that experience, your valuation provider can anticipate the questions that might be asked about the valuation, address them proactively, and ensure that the valuation will be accepted into the audit smoothly and with minimal intervention by the company’s management.

    Often, a 409a valuation can, with minor modifications, be used to meet this reporting requirement as well.

With technology and biotechnology companies in particular, these valuations can become particularly complex because of the existence of complex capital structures (such as multiple classes of preferred shares and multiple tranches of Option grants) or investor terms (such as caps and antidilution rights). Accordingly, it’s critical to work with a provider that has experience working with these structures and the expertise to perform the correct valuation procedures.

If you have a 409a or stock option audit reporting task, relevant valuation expertise can help you meet your reporting requirements with minimal distraction and manage the risk around those grants. Contact contact us at High Score Strategies to set up a consultation.


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