You’re Fired: the Hidden Costs of Botched 409A Valuation Compliance – Part III

May 3, 2013 at 1:41 pm Leave a comment

The real money on the table from a poor-quality 409A valuation lays ahead and underlies the ultimate purpose for the 409A valuation report: tax compliance. That is the province of the IRS…and, in the case of California, the Franchise Tax Board – neither warm to tax evaders, as governments are cash starved in a weak economy, and their penalties and interest prove it. For the taxing entities, the penalty is 20% to the IRS on the taxable income and is triggered from vesting date, not exercise date, and 20% to the FTB, plus underpayment interest at a combined 6%.

It seems reasonable that the trigger for a challenge to a 409A valuation will be the audit of a high income shareholder following a liquidity event for the company (who received large grants of stock options – see Sutardja for an example of one such optionee) – in other words, years after the original valuation and strike price were set. This takes on significance because the clock on the underpayment interest starts at the time of vesting, so it is not improbable that there may be 5 to 10 years of accrued interest that will be due, in addition to penalties. Furthermore, it may be difficult to find the valuator who initially performed the valuation, leaving the document to defend itself. As you will see below, non-compliance cost our hypothetical taxpayer at least $1,000,000 or 40% of the proceeds – probably substantially more with the imputed interest on the underpayment as well as tax and legal fees.

Let’s look at the math:

Item Assumptions: Notes:
(1) Strike price $ 5.00
(2) FMV at grant $ 7.00 (a)
(3) FMV at exercise (M&A event) $ 10.00
(4) Shares exercised 500,000
(5) Federal income tax rate 39.6% (b)
(6) CA State income tax rate 12.3% (b)
(7) Federal 409a penalty 20.0% (c)
(8) CA FTB 409a penalty 20.0% (c)
(9) Medicare 1.45%
(10) Taxable income $ 2,500,000 (3) minus (1) times (4)
Taxes and Penalties:
(11) Federal income tax $ 990,000 (5) times (10)
(12) Federal 409a penalty $ 500,000 (7) times (10)
(13) CA income tax $ 307,500 (6) times (10)
(14) CA 409a penalty $ 500,000 (8) times (10)
(15) Medicare $ 36,250 (9) times (10)
Legal and tax adviser fees ???
(16) Total tax and penalties   $ 2,333,750 Sum (11) through (15)
Balance to grantee*   $ 166,250 (10) minus (16)
Maximum implied return   6.7%

(a) As later determined by the IRS
(b) Assumes highest tax bracket in 2013
(c) On amounts includable in taxable income
* Before underpayment interest due from vesting date (3% to each of the IRS and FTB, 6% combined).

It is rational to assume that the respective taxing authorities would not stop with this taxpayer if such bounty is available from other shareholders. Likely targets include all senior level executives and employees who received sizable option grants – and therefore, have potentially large tax bills. There may be additional charges to the company (and perhaps restatements) to the extent the taxing authorities determine that the shareholder is under withheld relative to the implied income from the mispriced options.

The Bottom Line
IRC 409A is a mine field for those who play at its boundaries, potentially being left with an indefensible opinion gotten during their watch. While serious financial costs for the employee/optionee accrue, the management, Board, and company are likely to suffer even more punitive consequences.

Also on the table, but difficult to quantify, are the lost gains to the optionees resulting from strike prices that were set higher than necessary because of errors (including errors in judgment) in the valuation analysis. The bottom line is that it’s not only important to get a competent, defensible opinion, but also one that optimizes the outcome for all constituent parties (including accountants and taxing authorities).

Hopefully, you leave this discussion with a better understanding of how a poorly prepared valuation can destroy lots of bank accounts, not to mention lives and livelihoods. Those who get the message will begin to probe and challenge the quality of the valuators and valuations being offered in their defense when the accountants and IRS call.

Part I of this series describes some ways to test the credentials of a valuation firm and avoid a poor-quality valuation. The discussion in Part II quantifies the magnitude of expected fees for defending a poor-quality valuation. And read more about What Makes a Good 409A Valuation.

John Heath is Executive Vice President, Valuations & Financial Advisory Services of The Brenner Group. John joined The Brenner Group® in 1994 and manages the firm’s Valuations and Financial Advisory Services Groups. John has more than thirty-five years of experience in corporate finance, and has assisted more than 600 companies with financing, public underwritings, mergers, acquisitions, and valuations. Prior to joining The Brenner Group, John held executive management positions at Smith Barney, The First National Bank of Chicago, and Price Waterhouse. He received an MBA in Finance from The Wharton School of Business, and a BA degree from the University of Pennsylvania. John is a member and Accredited Senior Appraiser of the American Society of Appraisers and a member of the Appraisal Issues Task Force.

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Entry filed under: Financial Advisory, Interim Management, Valuations.

You’re Fired: the Hidden Costs of Botched 409A Valuation Compliance – Part II Revised Guidance from AICPA on Valuing Privately-Held Stock

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