IRS Provides Guidance on Valuation of Employee Stock Options

An IRS Chief Counsel Advice (CCA)¹ released on January 15, 2016, takes the position that employees' stock options were subject to section 409A,² resulting in additional tax for the employees. An employee who receives an option subject to section 409A owes income tax on the spread between the strike price and the value of the stock as the option vests—even before the option is exercised—including an additional 20 percent federal income tax. As a result, the marginal federal income tax rate on the option spread could be as high as 59.6 percent.

Employee options must be granted with a strike price at least equal to the fair market value of the underlying stock on the date of grant to be exempt from section 409A. Given the high stakes, a common question is how to determine fair market value of the stock on the option grant date. What information should be taken into account? Should a third party valuation be obtained? When is stock considered to be publicly traded, such that valuation is by reference to the market price? The CCA provides insight into how the IRS considers some of those questions.

Background

As noted above, one of the requirements for an employee option to be exempt from section 409A is that the strike price of the option must equal or exceed the fair market value of the underlying stock at the time of granting the option. 

Stock that is "readily tradable on an established securities market," must be valued by reference to actual third party transactions in the stock. Permissible alternatives include the last sale before or the first sale after the grant, the closing price on the trading day before or the trading day of the grant, or another reasonable method.

The fair market value of stock that is not readily tradable on an established securities market must be determined using a "reasonable application of a reasonable valuation method." This method should take into account all material information, including the value of the company's assets, anticipated future cash flows, and recent arm's-length transactions in the company's stock. The valuation must be updated at least every twelve months. A safe harbor is available, providing a presumption of reasonableness, if the company obtains an independent appraisal as of a date no more than twelve months before the option grant.

Chief Counsel Advice

At issue in the CCA was which set of valuation rules applied. Apparently the company had established a valuation that would apply for purposes of granting the options, and presumably the company thought it set a strike price equal to fair market value. However, two days before the options were granted, the company's stock began trading on an over-the-counter market. Trades issued on the first three days (including the grant date) were made on a "when issued" basis, meaning that buyers purchased contracts to purchase common stock at a particular price when the stock was issued. These trades were contingent on actual issuance of the stock, at which time the trades would settle.

The employees being audited by the IRS took the position that the company's stock was not readily tradable on an established securities market, and therefore that the company's valuation (made without regard to the "when issued" contracts) should be used for the options they received. The IRS, however, concluded that stock traded on a when-issued, over-the-counter market is readily tradable on an established securities market for purposes of section 409A. It noted that "established securities market" includes not only a national securities exchange but any over-the-counter market in which quotations of stocks and securities are regularly disseminated by identified brokers and dealers. Furthermore, the IRS determined that "readily tradable" requires only the ability to buy and sell stock through a third party, not actual transactions in the stock. Thus, it was irrelevant that no stock was bought or sold on the over-the-counter market on or before the grant date. The price was effectively set by the "when issued" contracts.

The IRS asserted that, because the "when issued" price on the first three days of trading (including the grant date) was more than the exercise price set on the grant date, the options were in-the-money when issued and therefore not exempt from section 409A.

Moreover, the IRS argued that, even if the stock was not readily tradable on an established securities market, such that the stock could be valued under the "reasonable application of a reasonable valuation method" standard, the company's valuation was not reasonable because it did not take into account prices on the over-the-counter market. To be reasonable, the IRS stated, a valuation method must take into account information that becomes available after the valuation is calculated but on or before the grant date that may materially affect the value of the company. In this situation, the recent arm's length transactions had to be considered, even though they took place after the company's valuation was calculated.

Observations

The CCA does not reveal the difference between the "when issued" price on the grant date and the strike price. It could have been a large or trivial amount. Either way, the tax consequences to the employees could be huge: immediate tax on the spread of vested options as it grows each year, plus an additional 20 percent federal income tax.

The CCA also does not discuss the method the company used to value the stock for purposes of the option grants, but suggests that the company did not get an independent valuation. Would the employees have been better off if the company had done so? Generally, there is a safe harbor under which the valuation established by an independent appraisal is presumed reasonable. However, such a valuation cannot be used where the stock is readily tradable on an established securities market. Furthermore, the IRS can rebut the presumption of reasonableness upon a showing that the method or application of the method was "grossly unreasonable." The IRS would likely argue that failing to take into account third party transactions in the stock (including "when issued" contracts) makes use of a valuation grossly unreasonable.

Regardless of the valuation method, the CCA emphasizes that if there is a lag in time between a valuation and the grant date, the company must take into account third party transactions in the stock between the valuation date and the grant date. Left unanswered by the CCA is what to do if a third party transaction is anticipated as of the grant date but has not yet occurred. For example, what if a third party has entered into a binding agreement to purchase stock (similar to a "when issued" contract)? A nonbinding letter of intent? What if discussions have started but nothing is in writing? Because valuation depends on the facts and circumstances, and given the high stakes for employees, a company should consider these points in determining its value when granting stock options to employees.

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¹ CCA 201603025 (released Jan. 15, 2016). A Chief Counsel Advice is nonprecedential guidance.

² Internal Revenue Code of 1986, as amended.

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