Deferred Compensation Rule Heads for Final Deadline

By now, leaders of private medtech companies should be intimately familiar with the terms of a new section of the Internal Revenue Code—Section 409A—which regulates company use of nonqualified deferred compensation.¹ Executives who haven't already taken action to bring their companies into compliance with the standards set up under these new regulations could find themselves struggling to meet the final implementation deadline of December 31, 2008.² Failure to meet the standards could cause major financial pain for both companies and their employees.

Creation of IRS's new regulations was prompted by the perceived abuses of deferred compensation arrangements that came to light during corporate scandals earlier in this decade, including those involving such companies as Enron, Tyco International, and Worldcom, to name a few.

Simply put, the new rules regulate a wide array of nonqualified deferred compensation arrangements, including stock appreciation rights, restricted shares, phantom stock, and other deferred compensation programs. This article focuses on one important aspect of 409A: the more-stringent standards for determining the fair market value (FMV) of stock options issued by private companies.

Why This Matters

Until 409A came along, one of the chief ways that medical technology start-ups and emerging growth companies could compete with larger, more financially robust businesses for top-notch talent was to issue stock options at bargain rates. Many prospective employees were willing to take less in current compensation in exchange for a potential big gain from the stock options if the company succeeded. Although the requirement to use FMV for pricing such incentive stock options has always existed, most companies exercised a fair amount of leeway in determining their true FMV.

The advent of Section 409A means that the practice of granting stock options at below true FMV is officially out the window as a tool for recruiting, retaining, and incentivizing employees. Key elements and implications of the new rules include the following.

The New Standard

To ensure that company grants of stock options meet the requirements of 409A, the new rules state that FMV must be determined through “the reasonable application of a reasonable valuation method.” If this standard is met, then the stock options will be presumed exempt from the financial penalties prescribed by the new regulations.

In order to define valuation methods considered acceptable to the Internal Revenue Service (IRS), Section 409A provides the following three solutions, which are referred to as ‘safe harbor' methods.

Illiquid Start-Up Presumption. This methodology applies to privately-held companies less than 10 years old (referred to in the statute as ‘illiquid start-ups'). The valuation of a start-up company's illiquid stock must be in written form, and will be considered reasonable if the valuation is performed by a person with significant knowledge and experience or training in performing similar valuations.

Also, the CEO must be able to specify whether the stock is subject to any put or call rights, and whether the company anticipates an initial public offering, sale, or change of control within the 12 months following the equity grant to which the valuation applies. CEOs who can't answer ‘no' to these questions must use another valuation methodology.

Finally, the valuation must take into account the value of tangible and intangible company assets, cash flows, control premiums, and discounts for lack of marketability of the stock, among other factors. A valuation applying these factors will be considered reasonable only if it is less than 12 months old.

Binding Formula Presumption. This valuation is based on the consistent application of a single formula used in all transactions in a company's stock whether or not compensatory, including (but not limited to) sales of stock to third parties, loan covenants, and regulatory filings.

Independent Appraisal Presumption. A valuation performed by a qualified independent appraiser using traditional appraisal methodologies will be presumed reasonable if it values the stock as of a date that is no more than 12 months before the applicable stock option grant date.

“Under 409A there is now an expectation that companies are going to go through a rigorous and defined valuation analysis to determine the stock value,” says Alexander Lifson, former director of the employee benefits group at Deloitte Tax LLP (Boston). “Companies can retain an outside appraisal firm or the valuation can be done with internal personnel or a related party, such as someone at a venture firm who sits on the board. But it still has to be done by people with the credentials and expertise to do it.”

Company leaders should be aware, however, that if they lose a battle with the IRS over Section 409A, company employees who received stock options will be hit with severe financial penalties. Income taxes on the difference between the discounted price and fair market value will become due at the time of vesting rather than when options are exercised, as is currently the case. Also, IRS will assess a 20% excise tax, along with any accrued interest if the taxes are being collected for prior tax years.

Companies that continue to grant discounted stock options will need to withhold payments for the income and employment taxes that will be applicable at the time of option vesting. Failure to do so may result in financial penalties for the company.

For most companies, the impact of Section 409A will probably not be as significant as the effects of the Sarbanes-Oxley Act of 2002. Nevertheless, buyers have started asking for written assurances that companies are complying with these regulations, as well as for full indemnification for failures to comply with 409A.

Advice to Consider

As always, getting expert advice is the first step toward determining the best route for any specific company. “My main advice to clients is that if you're going to continue to grant stock options, you have to either have an outside appraisal expert or someone similar,” says Lifson. “You can't ignore this issue and continue to grant options as you have in the past.”

“The nice thing about this regulation is that we're actually being told what to do,” says Jonathan Levitt, founder and principal of Outside GC LLC (Boston), a firm that provides in-house legal services to companies on an on-demand basis. “A really simple road map for solving this problem is to hire an independent, qualified valuation expert to do the FMV analysis.”

Companies that choose to have an outside firm determine the FMV of its stock options should go with an organization that knows how to accurately value companies of its type, both in terms of the specific industry and the business stage. Working with a firm that has expertise in the appropriate marketplace and knows how to value such a business can be critical to obtaining a supporting valuation.

Another key item on executives' to-do list should be to add appropriate information about Section 409A to the descriptions of their companies' stock-option plans. This language should inform employees about the risk related to the company's FMV analysis and make them aware that the IRS could reassess the value of their options. The information provided should be designed to release the company from legal exposure in the event that unhappy employees sue over unexpected tax bills.

Burden of Proof

Companies that consistently and reasonably apply one of the previously mentioned safe harbor methodologies for determining the FMV of their stock options will shift the burden of proof to the IRS to prove that the valuation method is grossly unreasonable. On the other hand, companies that do not use one of the safe harbor methods will continue to shoulder the burden of proof that the stock price they have set represents true and accurate FMV.

For company leaders who are not already familiar with the requirements of IRC Section 409A, time has run out. December 31, 2008, is the final deadline, and all medical technology companies should be fully compliant with the new rules as they turn the corner into the new year.

References

1. Federal Register, “ Application of Section 409A to Nonqualified Deferred Compensation Plans,” 72 FR 19234–19325 (April 17, 2007[cited 16 December 2008]); available from Internet: http://frwebgate3.access.gpo.gov/cgi-bin/PDFgate.cgi?WAISdocID=62623923432+15+2+0&WAISaction=retrieve.

2. “ Notice of Additional 2008 Transition Relief under Section 409A,” Notice 2007-86 (Washington, DC: Internal Revenue Service, 2007); available from Internet: http://www.irs.gov/pub/irs-drop/n-07-86.pdf.

Bas van der Brugge is a principal of Mirus Capital Advisors Inc. (Burlington , MA ), where he leads the company's valuation services group.

© 2008 Canon Communications LLC

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