Companies often reward employees, partners, directors or contractors (generally referred to as “employees”) by granting them restricted stock, restricted stock units or stock options. Providing equity ownership1 (generally referred to as “stock”) to employees is seen as more closely aligning the employee’s interests with the company’s interest and does not affect the employer’s cash flow, however it does typically dilute ownership of current owners.
Under tax rules for compensation, an employee is almost always taxed on the fair market value (FMV) of the shares on the date the shares are transferred to the employee. In a public company, this is a reasonably easy rule to follow because the shares are likely to be traded enough that the FMV of the stock is generally defined as the FMV on the date of transfer (often the average of the high and low value for the day or the last trading price of the day) or defined as the FMV on the last trading value before the date of transfer.
FMV is less obvious for a private company and has to be determined to properly comply with reporting rules.
General U.S. tax rules
The IRS has general guidance on how to determine the FMV of an item for tax purposes, such as when an asset is transferred as part of an estate upon the death of the original holder. Revenue Procedure 59-60 provides guidance and factors to be considered in determining the actual FMV for this purpose, and this guidance is still used by valuation teams in taking steps to value assets.
Starting with the general valuation guidance, the IRS then has regulations that discuss how and when equity compensation is included in the employee’s income, based on the type of plan and also whether section 409A applies to the grant.
- Section 83 governs restricted stock, capital and non-safe harbor profits interests, and the exercise of nonqualified stock options (similar rules apply to incentive stock options).
- Section 409A governs the FMV used for the grant (rather than exercise) of stock options (and stock appreciation rights or SARs).
The two sets of rules are slightly different but end up using essentially the same approach in most cases.
SECTION 83 VALUATIONS
When an employer transfers stock to an employee or other service provider (such as a director or contractor) in connection with the performance of services, the employer must include the FMV of the asset in employee income using the FMV of the share on the date transferred (if vested) or on the date vested (if subject to a substantial risk of forfeiture on grant).2
The regulations provide that so long as a good faith valuation method is used, the IRS will generally presume that the value used for taxing the employee on the shares is the FMV. However, the IRS reserves the right to challenge a grossly unreasonable valuation.
Using inconsistent valuation methods for different purposes or for grants to different employees is likely to suggest that the method is not a good faith attempt at determining the FMV. Likewise, using the same value even after company facts have changed considerably raises questions about whether the valuation method (or lack of a method) is grossly unreasonable.
To make administration of an equity compensation arrangement easier, the regulation allows an employer to use a written formula, (the regulation provides for reasonable “book value” or a reasonable multiple of earnings), so long as the formula is used consistently at all times when a FMV of the stock is needed for the plan (at grant, at repurchase, etc.).
A valuation expert can use limited valuation discounts in determining the value of a share of stock. The typical discounts are a lack of marketability discount or a minority interest discount. Under section 83, a company cannot discount for the fact that the share is subject to a substantial risk of forfeiture (such as a forfeiture clause if the employee voluntarily quits before the vesting date). Any “lapse restriction” (a restriction that is expected to lapse) is ignored for valuation purposes.
Although the good faith method provides much latitude, it is very difficult to reasonably argue for a FMV of zero for most transfers of employer ownership to employees, even from companies that are very small or growing. Thus, where an internal valuation indicates a value of zero, it is generally best to look harder and perhaps assign a value above zero in determining the amount to be included in compensation income on transfer of shares to employees. If a company has some expectation of future worth, this expectation is generally factored into the valuation method and generally pulls the value above zero (investors would not generally be willing to put money into a truly worthless company, and employees would be unlikely to have any use for stock that the company and employees expect to consistently remain worthless).
Example: Employer, a private company that is small but expects to grow considerably, gives top employees restricted stock grants that vest three to five years after the date of grant. The plan provides that the company will use a seven times earnings multiple (and this multiple has been checked with a valuation expert when the plan is implemented to make sure the multiple is reasonable) to set the value of the stock. Under the multiple, at the time of grant, the FMV of a single share of stock is 26 cents.
If an employee chooses to make a section 83(b) election, within 30 days of the grant date, to be taxed on the current FMV of the shares (rather than waiting and being taxed on the FMV at the date of vesting), the employer would report the number of shares times the 26 cents per share value as compensation on the Form W-2 and the employer would receive a current deduction equal to the same amount. For employees who do not make the section 83(b) election, the company will use the FMV under the same earnings multiple at the time the various shares vest in determining the Form W-2 income and thus the employer deduction.
While not strictly supported or required for grants subject to section 83, many companies borrow the FMV discussion in the section 409A regulations when determining the FMV for all equity compensation.
SECTION 409A VALUATIONS
Section 409A governs the taxation of deferred compensation. Stock options that satisfy several conditions are regarded as “stock rights” that are excludable from section 409A rather than “deferred compensation” subject to section 409A.
The section 409A regulations provide valuation rules for stock option and SAR grants. So long as a stock option or SAR grant meets the section 409A “stock right” rules, the grants are not subject to the stringent section 409A requirements. (In general, being subject to the stringent section 409A requirements either means losing flexibility in payment timing or having a “409A failure” which accelerates taxation and causes an additional 20 percent tax.)
The “stock right” exception applies to stock options and SARs that are based on the employer’s own stock (or the stock of a parent owning more than 50 percent - generally – of the employer), using an exercise price (or threshold level, for SARs) at least equal to the FMV of the underlying shares on the date of grant.
In determining that the exercise price (or threshold level) is at least equal to the FMV of the underlying shares on the date of grant, the regulation provides an extensive discussion of factors to be considered in determining the FMV. As with section 83, reasonable minority interest and lack of marketability discounts can be used.
Under the section 409A discussion of FMV rules, the IRS provides several different “presumptions of reasonableness.”
Independent appraisal: The most commonly used presumption of reasonableness provides that if the employer uses an independent valuation firm, the independent valuation reported value of the shares can be used as the FMV for up to 12 months, unless the method or application of the method was grossly unreasonable. The independent valuation of private stock annually for this purpose is commonly referred to as a “409A valuation”.
Formula: Another presumption borrows from the section 83 rules and provides that if (1) the plan uses a written formula that will be consistently used for valuations under the plan and (2) the stock valuation method will also be used if any shares of such class of stock are transferred to the issuer or any owner holding more than 10 percent of the stock of the company, then that formula can be used for FMV.
Start-up company: There is also a special valuation presumption for illiquid stock of young companies (around less than 10 years and not related to any older company) under which a calculation done by an in-house person is presumed reasonable, if at the time the valuation is done the company does not reasonably anticipate a change in control or IPO within 90 days.
Many companies use the independent appraisal presumption. However, if a company has had significant changes during a year that affect the value of the company, the company needs to consider whether they should update the 409A valuation.
If a company does not use the independent appraisal presumption and instead uses either another presumption or follows the general section 409A valuation discussion, the equity valuation must be updated for any new facts (positive or negative) that affect the company value before any new grants are made to employees.
Even in instances where enterprise value may be identified in a reasonable method, companies must also consider the complexity of their capital structure. When stock options, preferred shares, restricted shares and other levels of capital exist, it is not as simple as dividing enterprise value by shares outstanding. The FMV of an individual right is going to differ by its particular rights (e.g. voting, dividends, liquidation preferences, etc.).
As with the section 83 valuation rules discussed above, it is generally difficult to argue that stock transferred to an employee under a plan really has a FMV of zero. In addition, a US stock option plan really cannot exist without an exercise price above zero.
Within these rules, the IRS has been reasonably tolerant of good faith attempts to determine the FMV of stock for an equity compensation plan. However, where a company has investors purchasing shares at a known value and then uses a lower value when transferring shares to employees, or the company is buying shares back from employees at value higher than is being used for other company purposes, this can suggest that the price being used may be unreasonable and should be questioned. Using a skilled professional to meet the independent appraisal safe harbor method certainly provides comfort that assumptions and methods are reasonable to prevent any unintended tax consequences.
Equity compensation can be a valuable tool for private companies to tie executives’ compensation to company performance, but determining the value of that equity takes more consideration without the readily available market setting a price.
Paying compensation in stock also has unique tax timing (both income and payroll tax) and financial statement implications that are beyond the scope of this article. Needless to say, employers choosing to use equity compensation must carefully consider all aspects when implementing such plans to prevent unintended consequences from outweighing the economic benefits.