What happens when you fail to comply with Section 409A? Short answer: THE COMPANY GETS SUED!
The long answer is perhaps not best for a blog entry but some additional color here may be of use. Founders and executives often ask us what real consequences a company might face if it fails to comply with Section 409A. Failing to comply with Section 409A can take many forms but we generally see it in two flavors: ineffective reports from third parties (work that fails to meet the standards set for in the AICPA Practice Guide or work performed by non-independent parties) and companies decided to not have the analysis performed at all.
But who suffers if the proverbial 409A ball is dropped? Interestingly, it is not the company or the company’s board but the employees—the recipients of the deferred compensation covered by Section 409A (e.g., stock options)—that must face the pain. The recent case of Wilson v. Safelite Group Inc. shows who took it in the rear and how that person responded (in a very predictable fashion).
In an oversimplified nutshell, failing to comply with Section 409A happens when a company issues deferred compensation (of course what we are really talking about in the context of venture-backed startups is stock options, which are a form of “deferred compensation”) at less than fair market value.
So, back to Wilson v. Safelite Group. Dan Wilson was President and Chief Executive Officer of Safelite Group, Inc. Dan chose to defer compensation worth more than $9 million. The IRS audited Dan and took the position that some of Wilson’s deferrals under Section 409A were defective! Because of that, Dan owed taxes of $2,630,000, excise taxes of $1,470,000 (20% penalty), interest of $150,000 and any investment gains that had accrued. Ouch!
So Dan did what I think every former CEO would do, he sued Safelite for money damages! Of course, he did—his wallet was approximately $4,000,000 lighter without accounting for his own attorneys’ fees. Dan sought damages from his former employer on the basis of breach of contract and negligent misrepresentation. In his complaint, Wilson asserted that Safelite’s failure to comply with Section 409A constituted a breach of contract and that Safelite negligently misrepresented to him that they had taken care of Section 409A matters. Turns out, they muffed it!
In the end, Dan lost his suit against his former employer. But the important as it relates to stock options is that complying with Section 409A is not difficult to do. Hire an independent valuation firm and make sure they reasonably apply and reasonable methodology!
The decision at the appellate level can be found here: https://law.justia.com/cases/federal/appellate-courts/ca6/18-3408/18-3408-2019-07-10.html
Contact us today to get your Section 409A done right, the first time!