What is a 409A valuation and when is it needed?

Remain compliant when granting options to US taxpayers and organisations.

A 409A valuation is a type of valuation that determines the fair market value (FMV) of a company’s share price. 

If you have an EMI scheme, you’re probably familiar with the HMRC valuation process and your company’s AMV and UMV. 

A 409A valuation is a US equivalent that’s needed when a company grants options to US taxpayers. 

The granting company doesn’t have to be based in the US or even a US taxpayer, but if the recipient (individual or company) has a tax liability in the US, a 409A valuation is needed to protect both the granting company and recipient against any IRS audits or tax penalties. 

When is a 409A valuation needed? 

Much like how an HMRC-approved valuation is needed when granting EMI options to UK employees, a 409A valuation is needed when granting any type of stock option to US taxpayers. 

A 409A valuation is valid for 12 months (compared to 90 days for HMRC valuations) unless there’s a material change to the company’s FMV in that time – such as a funding round.

For the purpose of this FAQ, we’ll only use scenarios where a UK company will need a valid 409A valuation. 

UK company granting options to US employees: When a UK company is issuing any type of stock option to their US-based employees. 

UK company granting options to any US taxpayer: This includes companies, contractors, consultants and subsidiaries. 

For UK parent companies with US subsidiaries and vice-versa, it’s likely that a 409A valuation will be completed every 12 months as standard practice. 

Why is a 409A valuation needed?

In all scenarios, the 409A valuation determines the company’s FMV and sets the exercise price for recipients, which allows them to purchase shares in the future at the current price. 

This 409A valuation also protects both parties from any tax penalties or IRS audits. 

For example, if you didn’t receive a 409A valuation and granted 1,000 options with an exercise price of $2 to a US employee, the IRS may investigate your company in the future and determine that the FMV at the time of grant was actually $4.

And of course, the company may have grown since the grant date, so the current FMV would be even higher – let’s say $8. 

The employees would then be liable for paying tax on the difference between the incorrect exercise price ($2) and the current share price ($8) across their vested options. If all of their 1,000 options have vested, they would owe income tax on the $6,000 difference. 

Depending on their tax bracket, this would be $1,200 at 20% and $2,000 at 33%. 

Plus, the IRS add a 20% penalty on the $6,000 price difference, so the employee would owe a further $1,200. 

Having a valid 409A valuation gives the granting company ‘safe harbour’ status. This means that if the IRS were to look into the granting company, it would be on the IRS to find any wrongdoing with regard to the valuation through facts, figures and documents. 

Not to mention the protection it gives option holders in the event of an IRS audit. Without safe harbour status, the option holders would be taxed immediately and have to foot the 20% penalty – which isn’t a good look for the granting company. 

In short, a 409A valuation gives a stock option scheme protection and fairness – ensuring recipients get maximum value and minimal risk from their options. 

 

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