409A valuations estimate the fair market value (FMV) of private companies’ common stock. This independent appraisal is a major compliance requirement for companies issuing stock options. Although it helps the company in ensuring option grants are priced reasonably, it also safeguards the company against harsh taxes.
Why the IRS Cares About 409A Compliance
The IRS pays attention to 409A valuations as an element that determines how and when stock options are taxed. Stock undervaluation might allow employees to postpone or decrease taxes and the IRS regards this as an error. Those not in compliance with Section 409A may face tax and interest without regard to the usual grace periods. The agency tends to scrutinize valuations to detect any possible manipulation or inconsistency.
Top Red Flags That Attract IRS Scrutiny
Inconsistent Valuations Across Reporting
When the FMV in the 409A report differs sharply from valuations in cap tables, or financial statements, it is a major red flag. Here’s an example. Say a recent funding round values the company at $80 million. However, the 409A report reports a much lower figure. This may lead to the IRS wanting to know the reasons behind this difference.
Outdated Valuation Reports
Using an expired 409A valuation (typically one older than 12 months or predating a major event like a financing round) undermines credibility. The IRS expects valuations to reflect current conditions, not outdated data.
Using Internal or Unqualified Valuators
Startups relying on internal teams or inexperienced individuals to perform valuations raise concerns. Independent third-party firms with domain expertise are expected, especially for venture-backed or late-stage companies.
Unrealistic Assumptions or Projections
If financial forecasts in the valuation are overly optimistic or suspiciously conservative without solid justification, the IRS may infer intent to manipulate FMV. Assumptions must be clearly documented and backed by data.
Lack of Discount for Lack of Marketability (DLOM)
Private company shares are illiquid, and valuations should reflect this. Omitting or undervaluing the DLOM inflates the share price, triggering potential scrutiny. The discount must be applied reasonably to account for restricted trading.
Ignoring Recent Financing Rounds
If a priced equity round recently occurred but the valuation fails to incorporate it (or doesn’t explain why) it raises red flags. The IRS expects this data to factor into FMV unless distinctions in share classes or investor rights are clearly detailed.
Even outside typical valuation parameters, events such as terrorism and violence in global markets can shift investor sentiment and affect how the IRS assesses financial assumptions. This underscores the need for companies to remain alert to external risk factors when finalizing their reports.
Best Practices to Avoid Scrutiny
Work with a reputable third-party valuation provider. You should renew your 409A at least once a year or after major events such as funding rounds. Keep thorough documentation for all financial assumptions. Ensure consistency across your cap table, investor materials, and board communications. As American companies embrace a sustainable future, transparency in financial reporting has now become a core element of a successful future.
Finally, it helps to understand everything to know about 409A valuations, from how reports are structured to how regulators interpret them. A strong knowledge base minimizes exposure to compliance issues and prepares companies for investor and IRS inquiries alike.
Endnote
A justifiable 409A valuation protects both the company and its stakeholders. Companies should not perceive it as a mere formality but as a strategic compliance measure. Consulting experienced advisors ensures accuracy. Plus, they can also help avoid costly errors.
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