Stock Options under SFAS 123 (R) and IRC 409A

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The American Jobs Creation Act of 2004 drastically changed the rules related to the taxation of nonqualified deferred compensation plans. Under the Internal Revenue Code Section 409A, all nonqualified deferred compensation is included in income in the year of deferral, unless certain requirements are met. This subjects the deferred amount to regular income tax plus a penalty equal to 20% of the amount of deferred compensation and interest.

Regulations issued in September 2005 broadly defined what constitutes "deferred compensation" and specifically included deferred equity plans, such as stock options, phantom stock, restricted stock, stock appreciations rights (SARs), supplemental executive retirement plans (SERPs) and severance agreements.

Deferred equity arrangements escape this treatment as long as the stated exercise price is equal to or above the Company's stock's fair market value per share . The grantor company has the burden of proof here, but may adopt a "Presumptive Method", to move the burden of proof to the IRS. Not only do presumptive methods shift the burden to the IRS, but they also raise the standard of proof to gross. For private companies, presumptive valuation methods include:

• The independent appraisal presumption
• The illiquid start-up company presumption
• The binding formula presumption

The independent appraisal presumption is the clearest presumption available under the proposed regulations and provides the best protection against adverse consequences of IRC 409A. Additionally, many boards of directors will likely be concerned about the potential liability for their company as well as for company employees in the event that discounted options are inadvertently granted or called into question by the IRS. Relying on outside experts minimizes such exposure for the company and company directors.

Lastly, company auditors are becoming more cautious with respect to stock valuations and option pricing. As new option expensing rules under FASB Statement No. 123(R) take effect, auditors have required more independent opinions of value.

For many companies, an independent business appraiser with experience valuing the common stock of companies with complex capital structures may be necessary to adequately meet the new requirements. Strategic Valuation Group can assist your company with the valuation of employee stock options and other securities impacted by 409A by providing independent valuation analyses and reports that determine the fair market value of company stock and eliminating the onerous consequences of failing to comply with IRC 409A.