Section 409A
Definition
A section of the IRS tax code that governs deferred compensation, including stock options. Section 409A requires that stock options be granted at or above fair market value (as determined by a 409A valuation). Options granted below FMV trigger immediate taxation on vesting plus a 20% penalty tax, making 409A compliance critical for both companies and employees.
Real-World Example
A startup grants options at $1/share but the actual FMV (which they failed to properly determine) was $3/share. The IRS determines a 409A violation. Each option holder owes ordinary income tax on the spread at vesting, plus a 20% penalty tax, plus interest. On 10,000 options, this could mean $10,000+ in penalties alone.
Common Mistake
As an employee, assuming the company has properly handled 409A compliance. If you join a startup and your options are later found to be below FMV, YOU bear the tax penalty — not just the company. Ask whether the company has a current 409A valuation from a reputable firm.
Why It Matters
Section 409A violations create serious tax consequences for employees, not just companies. Verifying that your employer has a proper 409A valuation protects you from penalties that could wipe out most of your equity value.
Related Terms
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