Apogee Business Valuations, Inc.

409A Valuations of Private Company Deferred
Compensation Plans – FAQ's

Question:
When did Section 409A become law?

Answer:
Section 409A was added to the Internal Revenue Code as part of the American Jobs Creation Act of 2004.

Question:
What does Section 409A apply to?

Answer:
Section 409A applies to “nonqualified deferred compensation plans.” A plan provides for the deferral of compensation if the service provider (broadly defined to include individuals, personal service corporations, or other non-corporate entities) has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to (or on behalf of) the service provider in a later year. Thus, the application of § 409A is not limited to arrangements between an employer and employee. It may apply to arrangements between a partner and a partnership, or between an independent contractor and a company. There are also rules related to certain trusts, deferred compensation plans located outside the United States, and for benefits in connection with a decline in the financial health of the plan sponsor.

Question:
When are nonqualified deferred compensation plans included in a recipient’s income?

Answer:
All amounts deferred under a nonqualified deferred compensation plan, for all taxable years, are currently includible in gross income (unless previously included in gross income) to the extent not subject to a substantial risk of forfeiture, unless certain requirements are satisfied.

Question:
What is a substantial risk of forfeiture?

Answer:
Compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial.

Question:
What are the implications of Section 409A?

Answer:
Section 409A significantly impacts the need for private companies to support their determination of fair market value in setting exercise prices for nonqualified deferred compensation plans, such as stock options and other stock based compensation. Section 409A will not apply to nonstatutory options that are not discounted at and do not include any extra deferral features. One requirement for avoiding Section 409A is to provide for the grant of an option with a strike price that is at least equal to the fair market value of the underlying employer stock on the date of the grant. Under IRS Notice 2005-1, if, under the terms of the option the amount required is or could become less than the stock’s fair market value on the date of the grant, then the grant of the stock may provide for the deferral of compensation for purposes of Section 409A.

Question:
What if a plan fails to comply with
Section 409A?

Answer:
Generally, if at any time during a taxable year a nonqualified deferred compensation plan fails to meet the requirements of Section 409A, namely, the deferred amount is found to be less than fair market value, then the recipient is required to include the deferred amount in income, plus the amount is subject to a penalty equal to 20% of the compensation required to be included in income, plus statutory interest on the amount of the underpayment of tax.

Question:
Are there exceptions or safe harbors
rules that can avoid failing to comply with Section 409A?

Answer:
There are exceptions and safe harbor provisions in the Treasury Regulations and IRS notices discussed below. These rules are largely based on a presumption that fair market value has been determined on a reasonable basis using recognized methods and adequate documentation. For purposes of determining the fair market value of the stock at the date of grant, any reasonable valuation method may be used. Such methods include, for example, the valuation method described in Section 20.2031-2 of the Estate Tax Regulations.

Question:
When is Section 409A effective?

Answer:
Section 409A became effective January 1, 2005, however the new law applies to any nonqualified deferred compensation plan that either vests (becomes nonforfeitable) after December 31, 2004, or is substantially modified after October 31, 2004.

On October 23, 2006 the IRS issued Notice 2006-79, providing transition relief under section 409A of the Internal Revenue Code.

Final regulations will not become effective until January 1, 2008.
Generally extending through 2007 the transition relief provided for 2006 in the preamble to the proposed regulations except with respect to certain discounted stock rights.
It provides additional transition relief for certain payment elections in linked plans and certain collective bargaining arrangement.
It extends the amendment date for certain plans that took advantage of transition relief provided for 2005.

The notice provides a detailed explanation for each of the above points. Nothing in this notice is intended to limit the scope or applicability of the transition relief provided in Notice 2005-1 and the proposed regulations.

The IRS issued final regulations in April of 2007. These regulations generally follow the proposed regulations, but the service did make some changes. The final regulations can be accessed from the links below.

Recently the IRS issued further relief in Notice 2007-86, Notice 2007-89 and Notice 2007-100. Notice 2007-86 and 2007-100 generally extended earlier transitional relief with written plan requirements. Notice 2007-89 provided guidance for employers and payers as to reporting and wage withholding requirements for 2007. See these Notices shown in the links below.

Question:
Can the employer pay the Section 409A taxes on behalf of the employee?

Answer:
On February 8, 2007 the IRS released Announcement 2007-18, 2007-9 IRB that allows employers to pay additional Code section 409A taxes for the employee who exercised discounted stock options and stock rights during 2006. The announcement excludes insiders or corporate executives. The employer must notify the IRS by February 28, 2007 , and notify the employee no later than 15 days after informing the IRS. All the required information and payment must be submitted to the IRS by June 30, 2007 . The notice explains how to calculate the 20% tax and interest. Payment of the employee’s taxes constitutes additional compensation to the employee in the year the taxes are paid.

Question:
What should you do?

Answer:
We strongly encourage you, and your professional advisers, to read the tax law directly. The Code, regulations, and notices are available at the following links:

•  Code Section 409A
•  Final Regulation 409A
•  Notice 2005-1
•  Notice 2006-4
•  Notice 2006-79
•  Notice 2007-86 & 2007-89
•  Notice 2007-100
•  Announcement 2007-18
•  Regulation 20.2031-2

Question:
How can Apogee Business Valuations and The Financial Valuation Group help?

Answer:
We are objective, independent appraisers and financial consultants that can assist you in complying with Section 409A and the determination of fair market value of your Company stock.

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