Loopholes, Exploits, and Regulations: A brief history of 409A

A brief history of 409A valuations and how the Section 409A of the Internal Revenue Code came about. Enron, Stock Options, Loopholes, and Regulations.

There are two things that are certain:

Death and Taxes.

And if you’re running a startup, both concepts can feel a little too close to home.

  • Your job is to avoid the former.
  • My job is to help you wrangle the latter.

And part of that means keeping up with all current regulations. It's understandable that you might need professional help with this, because regulations are always changing.

The main reason regulations change is that people find a way to skirt the intent of the law. In fact, you could say that's the reason we have regulations at all. The initial intent of a society might be that we all contribute for the common good necessary for everyone to benefit. But people don't want to do that voluntary, and so taxes are enacted. And naturally, people find a way to avoid paying the tax whenever they can. And government responds by enacting new regulations to force people to pay. It's a never-ending cycle.

Regulations have Loopholes. Loopholes are Exploited. Exploits lead to Regulations.


So the history and context would help to explain the taxes and penalties of Internal Revenue Code Section 409A (or "IRC 409A”) and why startups need a “409A valuation” report when offering non-cash compensation.

A Brief History

While originally taxes were only on income, in 1937 the Payroll Tax was first applied. That has persisted through today, so if you are an employer, when you pay your employee, both of you pay taxes. Normally that's easy enough to calculate, because you just take the appropriate percentage of the cash you pay them. It becomes even easier if you have a payroll provider, since they generally handle the relevant taxes for you (we use JustWorks and they're fantastic).

You're a smart employer, and the government has just told you that whenever you pay money to your employee, you are both going to be taxed on it. So what do you do? You try to pay your employee with something that isn't money. Loophole exploited. Naturally, the IRS has established regulations to cover for this exploit.

If you're compensating your employees with shares or Options, you are now required to calculate the "cash-equivalent amount" (a loose translation of "Fair Market Value"), and pay taxes accordingly. To avoid paying taxes on paper money (i.e. shares), you can grant your employees the option to buy your shares, but at a price no cheaper than the Fair Market Value of your shares, so that the taxes and penalties of IRC Section 409A do not apply to you.


The question becomes: what's the Fair Market Value of the shares when you grant them?

And the answer wasn't always clear.

Let's go back two decades to 1998, when Google was still searching for investors. They had raised a $1M seed round from Jeff Bezos and a number of other angel investors. Soon after, the company issued some Options (presumably) to its first employees. So what was the Fair Market Value of this Common Stock (which employees would receive as options)? At the time, the country's top advisors, lawyers, and investors would often use generalized rules of thumb to set the strike price of options. “Set the Strike price as 10% of the Preferred Stock" was the common and preferred practice at the time.

It was, literally, close enough for government work.

A rough estimation was used for Fair Market Value because it wasn't rigorously defined. In fact, many parts of the tax code regarding stock options were not rigorously defined at that point in time. And that left some loopholes, through which Enron would drive several large trucks in 2001.

December 2001: Enron’s Greed

Prior to and after its bankruptcy, Enron executives were granted large - devastatingly large - options to purchase the company’s stock under their deferred compensation plan. The execs then accelerated payments to themselves under their deferred compensation plans, to ensure that they would be able to access to the money and get paid out before the company went bankrupt.

What was supposed to happen, of course, was that the government gets paid first. Standard practice for any bankruptcy proceeding has a well-defined order of payout that is the same: Employees first, Uncle Sam next, everyone after. But Enron execs managed to jump the line via their deferred compensation in stock options. When Enron officially filed for bankruptcy on December 2nd, 2001, it became clear that the loopholes had been seriously exploited. And so, the exploits had to be regulated.

June 2004: The Government's Move

While Enron was perhaps the most well-publicized exploit of the stock option loopholes in the tax code, it was far from the only instance. With limited enforcement of principles like the constructive receipt tax doctrine, there had been years of companies taking advantage of loopholes in the tax law. And so in the summer of 2004, the US government passed the American Jobs Creation Act to, amongst other things, patch those loopholes. It included creating Section 409A of the Internal Revenue Code, specifically intended to prevent payment-acceleration practices like the ones Enron had exploited.

Section 409A deals with this in a few ways, but one of them is by creating a very strict valuation definition when it comes to shares and options. The old "rules of thumb" no longer apply, and you can't get away with estimating value at 1/10th of preferred stock just because it worked in 1998 (you could also start a successful company without a website in 1998, but hey, times have changed). Now, you have to follow the current tax provisions if you want to remain in compliance and not face penalties.

And the penalties for non-compliance can be severe.  All compensation deferred for the taxable year and all preceding taxable years can become includible in gross income for the taxable year. You can then be forced to pay accrued interest on the taxable amount, as well as an additional penalty of 20% of the deferred compensation.

That's bad news.

The good news is that 409A does not apply to incentive stock options (ISOs) and non-qualified stock options (NSOs) granted at Fair Market Value. However, if a company issues options at a valuation BELOW fair market value, section 409A -- and all of the aforementioned penalties -- will apply.

Consequently, the risk to the recipients (most often employees and advisors) is receiving stock options with a strike price below that of the stock's fair market value. If you give your employees the option to buy something that is worth $1.00 per share, the only way to avoid penalty is to make sure you're giving them the option to buy the shares at $1.00 per share - and not a penny cheaper.


GET YOUR 409A AND GO BACK TO BUILDING YOUR COMPANY

All of which brings us back to our earlier question: "What's the Fair Market Value of the shares when you grant?"

The answer to that is found (with a fair amount of room for interpretation) by following the guidance set out in the AICPA Equity Task Force Guide. Or, you can reach out to us, and we can get your a valuation report within 4 business days. We’re here to help, so you can go back to building your venture.

Loopholes, Exploits, and Regulations: A brief history of 409A