| The IRS recently threw down the gauntlet and | | | | one stone if you will. First, let's examine the code |
| placed pressure on private companies to get their | | | | and regulations driving this change. |
| valuations right at no matter what stage of | | | | Say Hello to the Culprits: IRC Section 409A |
| development they are. The Service has backed | | | | requires private companies which award stock |
| up this gesture by exposing private companies to | | | | options that have exercise prices below fair |
| substantial tax liabilities and penalties if they do | | | | market value to withhold income taxes on these |
| not. | | | | grants. Significant penalties on non-complying |
| Since the enactment of Section 409(A), non-public | | | | option grants have placed private or closely held |
| companies have struggled with how they should | | | | companies under increased pressure to be able to |
| establish that the exercise price of a stock option | | | | support and defend the fair market value |
| or a stock appreciation right (SAR) was | | | | determinations. |
| determined reasonably to be fair market value. Up | | | | FASB 123, Accounting for Stock-Based |
| to this point, most private companies did not | | | | Compensation, provides alternative methods of |
| worry about valuing their stock very often, if at | | | | transition for a voluntary change to the fair value |
| all. Private company valuations were needed | | | | method of accounting for stock-based employee |
| usually for an imminent transaction, for an ESOP, | | | | compensation. FASB 15X (Working Draft - issued |
| or for estate and gift tax purposes. One could | | | | October 21, 2005), Fair Value Measurements, |
| also throw in serious IPO candidates who obtain a | | | | established a framework for measuring fair value |
| valuation to avoid a "cheap stock" issue with the | | | | under a wide variety of accounting |
| SEC. | | | | pronouncements that require fair value |
| Many private companies do not qualify for any of | | | | measurements. |
| these scenarios; therefore they have not needed | | | | In developing FASB 15X, the Financial Accounting |
| valuations in the past. As a result, companies and | | | | Standards Board considered the need for |
| management that issue stock options could be | | | | increased consistency and comparability in |
| somewhat unenthusiastic about this development. | | | | estimates of fair value and enhanced disclosures |
| However, although a valuation in this situation can | | | | about the estimates. |
| appear fairly cumbersome and superfluous, it's not | | | | In most cases, when company management |
| all bad - just ask auditors. | | | | determines value and option pricing using an |
| Auditors have expressed a desire for this to be | | | | informal, internally generated valuation, the tax |
| done for years. They are cognizant of this | | | | burden will be on the company to prove to the |
| development because valuing stock options is a | | | | IRS that the fair market value of the equity is |
| financial reporting issue under FAS 123 and they | | | | reasonable. In light of the recent regulatory |
| want to know how a private company established | | | | changes announced over the past year, many |
| the strike price of its options. There is some | | | | private companies are proactively adopting one of |
| liability risk attributed to auditors when they sign | | | | the "presumptive" stock valuation methods set |
| off on this standard, and a professional valuation | | | | forth in the proposed regulations. |
| provides them with a level of reasonableness and | | | | Procuring a qualified independent appraisal will |
| reassurance that they desire. Considering this, | | | | cause the burden of proof to shift to the IRS and |
| there is a potential for tax and financial reporting | | | | may only be rebutted by the IRS if the application |
| synergy here. | | | | of the method is found to be grossly |
| With a good valuation report on hand, both issues | | | | unreasonable. |
| could be satisfied simultaneously - two birds with | | | | |