Is An Independent, Third Party Valuation Required By Section 409A To Grant Stock Options?
I was recently asked if a company had to obtain an independent, third party appraisal in order to grant stock options in compliance with Internal Revenue Code Section 409A, which generally requires that stock options be granted at fair market value or be subject to a 20% excise tax. The answer is no, a third party appraisal is not required.
"The final regulations adopt the provisions in the proposed regulations relating to the valuation of stock not readily tradable on an established securities market, subject to the modifications discussed in this section III.C.4.c. Accordingly, a valuation of stock based upon a reasonable application of a reasonable valuation method is treated as reflecting the fair market value of the stock. To meet this standard, it is not necessary that a taxpayer demonstrate that the value was determined by an independent appraiser. Where the taxpayer can otherwise demonstrate that the valuation was determined by the reasonable application of a reasonable valuation method, the standard will be met."
See the Final Regulations. That is not to say that an independent appraisal may not be advisable or worthwhile. In fact, if done in the manner specified in the final regulations, a valuation will create a presumption that the valuation of the stock reflects the fair market value of the stock, which presumption is only rebuttable by a showing that the valuation is grossly unreasonably.
"The final regulations adopt a presumption in specified circumstances that, for purposes of section 409A, a valuation of stock reflects the fair market value of the stock, rebuttable only by a showing that the valuation is grossly unreasonable. The presumption applies where the valuation is based upon an independent appraisal, a generally applicable repurchase formula (applicable for both compensatory and noncompensatory purposes) that would be treated as fair market value under section 83, or, in the case of illiquid stock of a start-up corporation, a valuation by a qualified individual or individuals applied at a time that the corporation did not otherwise anticipate a change in control event or public offering of the stock."
The Tax Problem With Using Nonrecourse Loans To Buy Restricted Stock
Executives frequently desire to start their capital gains holdings period with respect to their equity compensation awards immediately upon receipt of the awards. This generally cannot be accomplished if the executive receives stock options (the exception being the receipt of an immediately exercisable stock option, which is exercised and a Section 83(b) election is filed if the shares are subject to vesting).
The goal of starting the capital gains holding period upon receipt of an equity compensation award can be accomplished with a restricted stock award provided the stock is fully paid for and vested upon receipt or a Section 83(b) election is filed. However, if a loan is used to pay for the stock, and the loan is non-recourse, the goal of starting the capital gains holding period may very well be thwarted because the IRS will likely deem the transaction to be the grant of an option--not the receipt of stock--until the note is paid down (and treat the pay down of the note as the exercise of the option, with the tax consequences that accompany that).
Treasury Regulation Section 1.83-3(a)(2) provides as follows:
“In addition, if the amount paid for the transfer of property is an indebtedness secured by the transferred property, on which there is no personal liability to pay all or a substantial part of such indebtedness, such transaction may be in substance the same as the grant of an option. The determination of the substance of the transaction shall be based upon all the facts and circumstances. The factors to be taken into account include the type of property involved, the extent to which the risk that the property will decline in value has been transferred, and the likelihood that the purchase price will, in fact, be paid. See also Sec. 1.83-4(c) for the treatment of forgiveness of indebtedness that has constituted an amount paid.”
Reporting Requirements for Foreign Direct Investment In United States
"All investments in U.S. business enterprises in which a foreign person (in the broad legal sense, including a company) owns a ten-percent-or-more voting interest (or the equivalent) are subject to reporting. This includes foreign ownership of real estate, improved and unimproved, except residential real estate held exclusively for personal use and not for profit making purposes. Reporting to the Bureau of Economic Analysis (BEA) is required pursuant to the International Investment and Trade in Services Survey Act, as amended (citations and penalties are described on page 6 of this document)."
See here.
From the IRS: When 'Too Good to Be True' Very Well May Be: Funding Business Startups with Plan Assets
"With recent events in the financial markets putting a squeeze on business credit, many aspiring entrepreneurs may search for novel ways to acquire business capital. One that has gained IRS’s attention, and coverage in the press, is to withdraw money from existing retirement accounts and then channel it into a new retirement plan. On October 1, 2008, the IRS released initial guidelines on the acceptability of these arrangements."
For more, read here.
Not A Single IPO In September...
As reported in the Wall Street Journal, with credit to ThomsonReuters. We need capital market reform to make it less difficult for issuers to get out, but that's just my personal opinion....
Is the Carried Interest Tax "Break" a Goner?
It would appear that everyone is expecting that this tax "break" or "loophole" will be closed.
There were a number of articles to this effect written today, including one in CNNMoney, and another at GlobeSt.com.
It will be crucial to the venture capital industry and the real estate industry that any modification to the tax law to take away the carried interest tax "break" for larger institutions (where there is perceived executive compensation excesses) does not inadvertently or intentionally capture venture capital and real estate partnerships as well.
We will keep you posted.
Business Methods Patent Case From U.S. Court of Appeals for the Federal Circuit
This case could have a significant impact on this area of the law. The case restricts the patent protection available to business methods.
What Will Happen To Capital Gains Tax Rates On Early Stage Investments?
Senator Obama has said that he will "eliminate all capital gains taxes on investments made in small and start-up businesses." Suffice it to say, this would seemingly create a fair amount of excitement in the early stage and venture investment communities around the country, although it is still unclear how this would interplay with potential increases in the carried interest tax and the potential phase out and phase in of various other tax benefits and provisions. The National Venture Capital Association recently released a new position paper on the carried interest tax, which can be found here.
Additional stories on Senator Obama's plan can be found at peHUB and earth2tech.
Sequoia Capital on Startups and the Economic Downturn
National Venture Capital Association Declares Capital Market Crisis for Start-Up Community
The National Venture Capital Association has declared a capital market crisis for the start-up community as a result of no venture backed companies going public in the second quarter of this year.
Zero IPOs for Venture Backed Companies in the Second Quarter
The New York Times reported today that in the second quarter of this year not a single venture backed company completed an initial public offering. This is the first time this has happened since 1978.
Senate Passes AMT Patch Without Carried Interest Tax Increase
A text of the bill can be view here.
IRS Issues Final QSB Stock Gain Rollover Regulations
The IRS has issued final regulations relating to the deferral of gain under Section 1045 of the Internal Revenue Code on a partnership's sale of qualified small business ("QSB") stock and a partner's sale of QSB stock distributed by a partnership. The regulations also provide rules for a taxpayer (other than a C corporation) who sells QSB stock and purchases the replacement QSB stock through a partnership. Shortly after issuing these final regulations, the IRS issued corrections.
In general, Section 1045 allows a taxpayer to roll over gain on the sale of QSB stock, and does so under fairly liberal rules. With the reduction in long term capital gains taxes to 15%, the QSB stock rollover benefit under Section 1045 has been the predominent benefit of QSB stock. (From a choice of entity standpoint, this favors C corporations.) This will change if capital gains rates are raised in the future.
