“(a) Rules Relating to Constructive Receipt.— 

“(1) Plan Failures.— 

“(A) Gross Income Inclusion.— 

“(i) In general.—If at any time during a taxable year a nonqualified deferred compensation plan—

“(I) fails to meet the requirements of paragraphs (2), (3), and (4), or

“(II) is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in gross income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. 

“(ii) Application only affected participants.— Clause (i) shall only apply with respect to all compensation deferred under the plan for participants with respect to whom the failure relates.

“(B) Interest and Additional Tax Payable with Respect to Previously Deferred Compensation.—

“(i) In general.— If compensation is required to be included in gross income under subparagraph (A) for a taxable year shall be increased by the sum of— 

“(I) the amount of interest determined under clause (ii), and

“(II) an amount equal to 20 percent of the compensation which is required to be included in gross income.

“(ii) Interest.— For purposes of clause (i), the interest determined under this clause for any taxable year is the amount of interest at the underpayment rate plus 1 percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which first deferred or, if later, the first taxable year in which such deferred compensation is not subject to a substantial risk of forfeiture. 

“(2) Distributions.— 

“(A) In general.— The requirements of this paragraph are met if the plan provides that compensation deferred under the plan may not be distributed earlier than— 

“(i) separation from service as determined by the Secretary (except as provided in subparagraph (B)(i)),

“(ii) the date the participant becomes disabled (within the meaning of subparagraph (C)), 

“(iii) death, 

“(iv) a specified time (or pursuant to a fixed schedule) specified under the plan at the date of the deferral of such compensation, 

“(v) to the extent provided by the Secretary, a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation, or

“(vi) the occurrence of an unforeseeable emergency.

“(B) Special Rules.— 

“(i) Specified employees. —In the case of any specified employee, the requirement of subparagraph (A)(i) is met only if distributions may not be made before the date which is 6 months after the date of separation from service (or, if earlier, the date of death of employee). For purposes of the preceding sentence, a specified employee is a key employee (as defined in section 416(i) without regard to paragraph (5) thereof) of a corporation any stock in which is publicly traded on an established securities market or otherwise. 

“(ii) Unforeseeable emergency.— For purposes of subparagraph (A)(vi)— 

“(I) In general.— The term ‘unforeseeable emergency’ means a severe financial hardship to the participant resulting from an illness or accident of the participant, the participant’s spouse, or a dependent (as defined in section 152(a)) of the participant, loss of the participant’s property due to casualty, or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant.

“(II) Limitation on distributions.— The requirement of subparagraph (A)(vi) is met only if, as determined under regulations of the Secretary, the amounts distributed with respect to an emergency do not exceed the amounts necessary to satisfy such emergency plus amounts necessary to pay taxes reasonably anticipated as a result of the distribution, after taking into account the extent to which such hardship is or may be relieved through reimbursement or compensation by insurance or otherwise or by liquidation of the participant’s assets (to the extent the liquidation of such assets would not itself cause severe financial hardship).

“(C) Disabled.— For purposes of subparagraph (A)(ii), a participant shall be considered disabled if the participant—

“(i) is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, or

“(ii) is, by reason of any medically determinable physical or mental impairment which can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, receiving income replacement benefits for a period of not less than 3 months under an accident and health plan covering employees of the participant’s employer. 

“(3) Acceleration of Benefits.— The requirements of this paragraph are met if the plan does not permit the acceleration of the time or schedule of any payment under the plan, except as provided in regulations by the Secretary.

“(4) Elections.— 

“(A) In General.— The requirements of this paragraph are met if the requirements of subparagraphs (B) and (C) are met.

“(B) Initial Deferral Decision.—

“(i) In general.— The requirements of this subparagraph are met if the plan provides that compensation for services performed during a taxable year may be deferred at the participant’s election only if the election to defer such compensation is made not later than the close of the preceding taxable year or at such other time as provided in regulations.

“(ii) First Year of Eligibility.—In the case of the first year in which a participant becomes eligible to participate in the plan, such election may be made with respect to services to be performed subsequent to the election within 30 days after the date the participant becomes eligible to participate in such plan. 

“(iii) Performance-Based Compensation.— In the case of any performance-based compensation based on services performed over a period of at least 12 months, such election may be made no later than 6 months before the end of the period. 

“(C) Changes in Time and Form of Distribution.— The requirements of this subparagraph are met if, in the case of a plan which permits under a subsequent election a delay in a payment or a change in the form of payment—

“(i) the plan requires that such election may not take effect until at least 12 months after the date on which the election is made,

“(ii) in the case of an election related to a payment not described in clause (ii), (iii), or (vi) of paragraph (2)(A), the plan requires that the first payment with respect to which such election is made be deferred for a period of not less than 5 years from the date such payment would otherwise have been made, and

“(iii) the plan requires that any election related to a payment described in paragraph (2)(A)(iv) may not be made less than 12 months prior to the date of the first scheduled payment under such paragraph. 

“(b) Rules Related to Funding.—

“(1) Offshore Property in a Trust.— In the case of assets set aside (directly or indirectly) in a trust (or other arrangement determined by the Secretary) for purposes of paying deferred compensation under a nonqualified deferred compensation plan, for purposes of section 83 such assets shall be treated as property transferred in connection with the performance of services whether or not such assets are available to satisfy claims of general creditors— 

“(A) at the time set aside if such assets (or such trust or other arrangement) are located outside of the United States, or 

“(B) at the time transferred if such assets (or such trust or other arrangement) are subsequently transferred outside of the United States.

This paragraph shall not apply to assets located in a foreign jurisdiction if substantially all of the services to which the nonqualified deferred compensation relates are performed in such jurisdiction.

“(2) Employer’s Financial Health.— In the case of compensation deferred under a nonqualified deferred compensation plan, there is a transfer of property within the meaning of section 83 with respect to such compensation as of the earlier of— 

“(A) the date on which the plan first provides that assets will become restricted to the provision of benefits under the plan in connection with a change in the employer’s financial health, or

“(B) the date on which assets are so restricted, whether or not such assets are available to satisfy claims of general creditors.

“(3) Income Inclusion for Offshore Trusts and Employer’s Financial Health.— For each taxable year that assets treated as transferred under this subsection remain set aside in a trust or other arrangement subject to paragraph (1) or (2), any increase in value in, or earnings with respect to, such assets shall be treated as an additional transfer of property under this subsection (to the extent not previously included in income).

“(4)Interest on Tax Liability Payable with Respect to Transferred Property.—

“(A) In General.— If amounts are required to be included in gross income by reason of paragraph (1) or (2) for a taxable year, the tax imposed by this chapter for such taxable year shall be increased by the sum of— 

“(i) the amount of interest determined under subparagraph (B), and 

“(ii) an amount equal to 20 percent of the amounts required to be included in gross income. 

“(B) Interest.— For purposes of subparagraph (A), the interest determined under this subparagraph for any taxable year is the amount of interest at the underpayment rate plus 1 percentage point on the underpayments that would have occurred had the amounts so required to be included in gross income by paragraph (1) or (2) been includible in gross income for the taxable year in which first deferred or, if later, the first taxable year in which such amounts are not subject to a substantial risk of forfeiture.

“(c) No Interference on Earlier Income Inclusion or Requirement of Later Inclusion.— Nothing in this section shall be construed to prevent the inclusion of amounts in gross income under any other provision of this chapter or any other rule of law earlier than the time provided in this section shall not be required to be included in gross income under any other provision of this chapter or any other rule of law later than the time provided in this section. 

“(d) Other Definitions and Special Rules.— For purposes of this section:

“(1) Nonqualified Deferred Compensation Plan.— The term ‘nonqualified deferred compensation plan’ means any plan that provides for the deferral of compensation, other than—

“(A) a qualified employer plan, and

“(B) any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. 

“(2) Qualified Employer Plan.— The term ‘qualified employer plan’ means— 

“(A) any plan, contract, pension, account, or trust described in subparagraph (A) or (B) of section 219(g)(5)(without regard to subparagraph (A)(iii)),

“(B) any eligible deferred compensation plan (within the meaning of section 457(b)), and 

“(C) any plans described in section 415(m).

“(3) Plan Includes Arrangements, Etc.— The term ‘plan’ includes any agreement or arrangement, including an agreement or arrangement that includes one person. 

“(4) Substantial Risk of Forfeiture.— The rights of a person to compensation are subject to a substantial risk of forfeiture if such person’s rights to such compensation are conditioned upon the future performance of substantial services by any individual. 

“(5) Treatment of Earnings.— References to deferred compensation shall be treated as including references to income (whether actual or notional) attributable to such compensation or such income. 

“(6) Aggregation Rules.— Except as provided by the Secretary, rules similar to the rules of subsection (b) and (c) of section 414 shall apply.

“(e) Regulations.— The Secretary shall prescribe such regulations as may be necessary  or appropriate to carry out the purposes of this section, including regulations— 

“(1) providing for the determination of amounts of deferral in the case of a nonqualified deferred compensation plan which is a defined benefit plan, 

“(2) relating to changes in the ownership and control of a corporation or assets of a corporation for purposes of subsection (a)(2)(A)(v),

“(3) exempting arrangements from the application of subsection (b) if such arrangements will not result in an improper deferral of United States tax and will not result in assets being effectively beyond the reach of creditors,

“(4) defining financial health for purposes of subsection (b)(2), and
“(5) disregarding a substantial risk of forfeiture in cases where necessary to carry out the purposes of this section.”.

“(b) Treatment of Deferred Amounts.— 

(1) W-2 Forms.— 

(2) In general.— Subsection (a) of section 6051 (relating to receipts for employees) is amended by striking “and” at the end of paragraph (11), by striking the period at the end of paragraph (12) and inserting “, and”, and by inserting after paragraph (12) the following new paragraph:

“(13) the total amount of deferrals for the year under a nonqualified deferred compensation plan (within the meaning of section 409A(d))”

(B) Threshold.— Subsection (a) of section 6051 is amended by adding at the end the following: “In the case of the amounts required to be shown by paragraph (13), the Secretary may (by regulation) establish a minimum amount of deferrals below which paragraph (13) does not apply.”.

(2) Wage Withholding.— Section 3401(a) (defining wages) is amended by adding at the end the following flush sentence:

“The term ‘wages’ includes any amount includible in gross income of an employee under section 409A and payment of such amount shall be treated as having been made in the taxable year in which the amount is so includible.”.

(3) Other Reporting.— Section 6041 (relating to information at source) is amended by adding at the end the following new subsection:

“(g) Nonqualified Deferred Compensation.— Subsection (a) shall apply to—

“(1) any deferrals for the year under a nonqualified deferred compensation plan (within the meaning of section 409A(d)), whether or not paid, except that this paragraph shall not apply to deferrals which are required to be reported under section 6051(a)(13) (without regard to any de minimis exception), and 

“(2) any amount includible under section 409A and which is not treated as wages under section 3401(a).”.

(c) Clerical Amendment.— The table of sections for such subpart A of part I of subchapter D of chapter 1 is amended by adding at the end the following new item:

“Sec. 409A. Inclusion in gross income of deferred compensation under non qualified deferred compensation plans.”.

(d) Effective Date.—

(1) In general.— The amendments made by this section shall apply to amounts deferred after December 31, 2004. 

(2) Special Rules.—

(A) Earning.— The amendments made by this section shall apply to earnings on deferred compensation only to the extent that such amendments apply to such compensation. 

(B) Material Modifications.— For purposes of this subsection, amounts deferred in taxable years beginning before January 1, 2005, shall be treated as amounts deferred in a taxable year beginning on or after such date if the plan under which the deferral is made is materially modified after October 3, 2004, unless such modification is pursuant to the guidance issued under subsection (f).

(3) Exception for Nonelective Deferred Compensation.— the amendments made by this section shall not apply to any nonelective deferred compensation to which section 457 of the Internal Revenue Code of 1986 does not apply by reason of section 457(3)(12) of such Code, but only if such compensation is provided under a nonqualified deferred compensation plan—

(A) which was in existence on May 1, 2004,

(B) which was providing nonelective deferred compensation described in such section 457(e)(12) on such date, and

(C) which is established or maintained by an organization incorporated on July 2, 1974. If, after May 1, 2004, a plan described in the preceding sentence adopts a plan amendment which provides a material change in the classes of individuals eligible to participate in the plan, this paragraph shall not apply to any nonelective deferred compensation provided under the plan on or after the date of the adoption of the amendment. 

(e) Guidance Relating to Change of Ownership or Control.— Not later than 90 days after the date of the enactment of this Act, the Secretary of the Treasury shall issue guidance on what constitutes a change in ownership or effective control for purposes of section 409A of the Internal Revenue Code of 1986, as added by this section.

(f) Guidance Relating to Termination of Certain Existing Arrangements.— Not later than 60 days after the date of the enactment of this Act, the Secretary of the Treasury shall issue guidance providing a limited period during which a nonqualified deferred compensation plan adopted before December 31, 2004, may, without violating the requirements of paragraphs (2), (3), and (4) of section 409A(A) of the Internal Revenue Code of 1986 (as added by this section), be amended—

(1) To provide that a participant may terminate participation in the plan, or cancel an outstanding deferral election with regard to amounts deferred after December 31, 2004, but only if amounts subject to the termination or cancellation are includible in income of the participant as earned (or, if later, when no longer subject to substantial risk of forfeiture), and

(2) to conform to the requirements of such section 409A with regard to amounts deferred after December 31, 2004.

Link to U.S. Congress.Gov Tax Code: (https://www.congress.gov/108/plaws/publ357/PLAW-108publ357.pdf).

The post Internal Revenue Service (IRS): 409A Valuation first appeared on Five23.

To be honest, the penalties for 409A Valuation non-compliance are insane; hefty fines, irreversible reputation damage, and a potentially greater tax bill. But they are there for a reason. An inaccurate 409A Valuation can lead to another Enron. We all don’t want that. The IRS doesn’t want companies generating their own 409A Valuation because the likelihood of inaccuracies can by high. That is why there are Safe Harbor provisions for companies who obtain an 409A Valuation from third parties. It’s a win-win situation. The IRS doesn’t have to go through your 409A valuation with a magnifying glass, and in return, you get an accurate, non-biased value of your company. The Safe Harbor 409A Valuation is one of the best assets you can add to your company.

409A Safe Harbor Opportunities

IRS 409A Valuation (Link Here) has two opportunities for startups through which you can achieve a Safe Harbor 409A Valuation. If you meet the conditions of any of these three items, you are considered in “Safe Harbor”. Below is a description of each of the three opportunities:

Independent Appraisal

Binding Formula

Illiquid Startup Safe Harbor

Each of these opportunities are complex and unique. Each provides you with a clear path to achieving a Safe Harbor 409A Valuation. Let’s take a look at each:

Independent Appraisal Safe Harbor

When it comes to the matter of 409A Safe Harbor Valuations methods, the independent appraisal opportunity is among the most common and easiest to pursue. The IRS wants an independent 409A Valuation from a reputable firm that employs consistent, well-documented methodologies in their appraisals (like Five23). This is typically the easiest route to take in securing a Safe Harbor 409A Valuation. Find an independent, trustworthy valuation firm and pay them to do your 409A valuation. What’s so hard about that, right? Turns out, finding a quality fully-independent firm is more difficult than it seems.

Many companies turn to their cap table software providers for a 409A valuation package deal. This makes sense. Your cap table software has access to almost all the data you need to perform a safe harbor 409A valuation. However, even the leading cap table software providers stretch the boundaries on independence. And, in many cases you will run into a conflict of interest. Typically, your software provider doesn’t have the proper authority to provide you with an accurate 409A Valuation. They use old methods which do not require up-to-date financial data, which will eventually lead to an inaccurate 409A. If this is the case, you will find your valuation may be grossly mis-calculated. The IRS may find your company to be grossly mis-valued and take away your Safe Harbor exemption. At this stage you still may be on the hook for the inaccuracies.

Binding Formula Safe Harbor

The binding formula Safe Harbor applies to 409A Valuations based on the consistent use of one, generally-applicable repurchase formula in the company’s stock transfers. The legalese around this provision incomprehensible at best. The formula applies whether those transfers are compensatory or non-compensatory. It’s applied all of a company’s stock transfers and the stock transfers of at least 10% of the company’s shareholders. Additionally, the IRS specifies: any person or issuer holding more than 10% of the combined voting power across all classes of the issuer’s stock is void from this exception. Thus effectively making the provision unattainable for the vast majority of companies (any company which one shareholder owns 10%+ of the companies shares).

The big exception to the binding formula safe harbor presumption are “arm’s length transactions” related to the company’s stock. These are transactions for which both buyer and seller have no prior relationship and act independently of each other’s interests. The actual legislation covering this Safe Harbor presumption states that this generally-applicable formula should apply when used as part of a non-lapsing restrictions surrounding the company’s stock.

In essence, unless your company has a valuation of $100mm+ and more than 100 independent shareholders. You are not going to fall into this exemption opportunity.

Illiquid Startup Safe Harbor

The illiquid startup opportunity to Safe Harbor 409A Valuations is intended to accommodate the startup environment, where equity switches hands on a much more frequent basis. It applies only when both the service recipient and the service provider (typically the “employer” and “employee”, respectively) do not anticipate an IPO within 180 days or a change of control event within 90 days. A ‘Change of Control Event” could be a shift in voting power such that one person or entity holds more than 50%. It could be a liquidation; could be a substantial sale of assets; could be a board call. Point is, you’ll know it when you see it.

Under the illiquid startup presumption, your 409A Valuation must be performed by a “qualified individual”. The IRS specifies a qualified individual to be someone companies can reasonably rely upon based on some combination of knowledge, education, training, and experience (Five23 for example). They further specify this to mean five years of relevant experience.

Failing to Achieve a Safe Harbor 409A Valuation

As stated previously, you should view meeting 409A Safe Harbor requirements as a mandatory part of running your company. While it’s not actually required, the penalties of non-compliance aren’t worth the risk. Not even close. These penalties are exacted on each employee deferring compensation. The employees can be hit with a tax on their income, with the entire balance of their deferred compensation plan applied—for the current year and all past years for which their compensation was deferred. There’s a 20% excise tax on that. On top of that, the IRS charges interest on that 20%. That premium interest rate is roughly 1% plus the federal underpayment rate. Employees are hit with these tax penalties in tandem with whatever fees and fines they accrue in their efforts to pay off what they owe. Basically, get ready to pay a fortune to the government for failure to comply. Luckily, that is why there are Safe Harbor 409A Valuation, and they are cheaper and easier to get than you would imagine.

Safe Harbor 409A Valuation from Five23

At Five23, we pride ourselves on working closely with startups and investors to provide the best service possible. Our 409A Valuations are quick, straightforward, and painless. We give you a simple form to complete with minimal information required. From the time you start the process, we typically complete a 409A Valuation in just a matter of days. In addition, being an unbiased third party. We give provide the Safe Harbor 409A Valuation discussed in this article. 

If you’d like to get started with a 409A Valuation, you can view our packages here (all come with a 409A Valuation). If you’d like to learn more about Five23, please visit our website or send us an email to: contact@five23.io. We’d love to hear from you.

The post 409A Valuation Safe Harbor Guide (2019) first appeared on Five23.