Do non-U.S. companies need a 409A opinion?
There is some confusion on whether non-U.S. startups need to obtain a 409A opinion. Carta says that it can both ways and simply suggests to consult with your U.S. lawyers. Surprisingly non-U.S. startups, must consider U.S. tax law when issuing equity to employees who are US citizens and/or U.S. tax residents (“U.S. employees”). Most importantly, a non-U.S. equity grant should comply with Section 409A of the US Internal Revenue Code (“409A”).
Why care? 409A non-compliance catch up time at Exit
Many non-U.S. startups with U.S. employees find out at “exits” that they have outstanding tax penalties from the U.S., and are forced to allocate reserves for tax penalties and reduce money that should go to founders and investors. All this could be a tax nightmare for a non-U.S. startup who was simply looking to incentivize its U.S. employees by issuing them equity.
Who does 409A apply to?
Say you are a U.K. or German. startup with a subsidiary in the U.S., and want to issue equity to your U.S. employees, it may be alarming to find that the issuance of equity to your U.S. employees, may require your startup to comply with 409A. This is because 409A applies to all U.S. citizens or U.S. tax residents, regardless of whether or not the issuing company is a U.S. entity and non-compliance brings about significant tax consequences. For instance, if company X which is a U.K. company recruits Y, a U.S. citizen to work in the U.K. or in its subsidiary in the U.S., and offers equity to Y under its U.K. plan, company X will be required to comply with 409A as it relates to Y. 409A also applies to nonresidents who perform services and earn deferred compensation in the U.S. With this in mind, non-U.S. startups with U.S employees, must scrutinize their equity-based incentive plans carefully to ensure that they do not fall short of 409A.
What does 409A require?
409A regulates the taxation of a wide-range of “deferred compensation” plans in which an employee is awarded compensation in one taxable year, but which is payable in another taxable year. Generally, 409A provides that deferred compensation plans meet certain complex requirements and the failure to meet these requirements results in serious tax consequences. There are certain exclusions under 409A that apply to non-US deferred compensation plans including plans excluded under a tax treaty with the U.S. and broad-based non-U.S. retirement plans, etc. However, the focus of this piece is on equity-based compensation plans which are an important means of compensation for startups.
How does 409A apply to equity compensation plans?
A plan under which stock options are to be issued to employees will generally be required to comply with 409A. However, stock options will not be treated as deferred compensation under 409A if they meet certain conditions. The first is that a company which is issuing stock options, may never set the exercise price of the stock at a price below the Fair Market Value (FMV) of the company’s common stock at the time of the grant. The exercise price is the price at which the employee may purchase the company’s stock once the options vest. Following our illustration, if the FMV of company X is $0.05/share at the date of grant, then company X should not set the exercise price for Y’s shares lower than that, say at $0.04/share.
In addition, 409A requires that the number of shares subject to the option be fixed on the date of grant, the transfer or exercise of the option is subject to taxation under section 83 of the US Internal Revenue Code and the option does not include any additional deferral feature other than the deferral until the later of exercise/disposition of the option or the time or vesting.
How does a non-U.S. startup comply with 409A when issuing equity to U.S. employees?
To take advantage of the exemption, 409A primarily requires you to determine the FMV of your startup’s stock, before the options are issued. This way, your non-U.S. company will be sure that it does not set the strike price below the FMV of the company’s stock. To determine the FMV, the 409A rules require an appraisal by an independent party or the board (in the case an early stage company, prior to a financing). The appraiser may consider the value of tangible and intangible assets, the present value of future cash flows, market value of comparable businesses etc. in fixing the FMV of the company. It is important for the appraiser to comply with U.S. standards for determining FMV, as non-US valuation standards may differ from U.S. standards and expose the company to a violation of 409A. Note that a 409A valuation report is valid for a period of 12 months or until a “material event”, such as a financing occurs.
It is good practice to add an addendum to the non-U.S. employee stock option plan, which explains the 409A rules. The addendum to each foreign equity agreement to be signed by a U.S. employee, should state that the equity agreement is subject to and complies with 409A. This requires the review of the addendum and the employee stock option plan itself by U.S. lawyers and local counsel in the UK or Germany.
What happens if 409A is not complied with?
At this point, you are probably wondering what the risks are if you do not comply with 409A. Non-compliance with 409A exposes both the U.S. employee and the non-U.S. startup to significant tax consequences and penalties. This is because, the difference between the strike price and the FMV of the company’s equity will be regarded as income, because it considered as an added benefit for the U.S. employee each time the options vest, even if the employee has not exercised the option. Using the company X illustration above, the difference between the FMV and the strike price i.e. $0.01/share will be treated as income for Y and, Y will be taxed on that income at higher U.S. income tax rates. This will be in addition to any taxes the U.S. employee will have to pay and/or withhold to the country where the non-U.S. company is located. In addition, the U.S. employee may be required to pay federal tax penalties (20%), applicable state penalties and interest.
The non-US startup on its part, would be burdened with reporting the non-compliance on the employee’s tax form, withholding the income tax on the 409A income and could face penalties for failing to do so by the U.S. Internal Revenue Service. Some startups may also decide to bear the burden of paying off the tax obligation caused by the 409A violation, on behalf of the affected employee.
As a non-U.S. startup, it is important to ensure that your company has a valid 409A valuation report before stock options are issued to U.S. employees, to avoid hefty tax consequences. It is also important to seek proper legal advice on compliance with 409A whenever equity is to be issued to U.S. employees under a non-U.S. plan, to avoid a violation.