409A Penalties: What Happens If You Don't Get a 409A Valuation

Short answer: if you grant options without a supportable fair market value and the price turns out to be too low, your option holders can owe tax on paper gains they cannot sell, plus a 20% penalty tax, every year the problem persists. The company does not pay the 409A penalty directly, but it pays in other ways: payroll reporting, gross-ups, repricing, audit findings and a harder conversation with every acquirer.

This page is about consequences. The mechanics of avoiding them — the three presumptions of reasonableness and how each one is qualified for — are covered in our 409A safe harbor guide. Think of that page as the fix and this one as the reason the fix matters.

What are the penalties for a 409A violation?

A 409A violation makes vested deferred compensation under the failed arrangement taxable immediately, adds a 20% additional federal income tax on that amount, and charges premium interest at the IRS underpayment rate plus one percentage point. For a discounted stock option, the taxable amount is the vested spread, taxed before exercise or sale.

The rules come from Internal Revenue Code Section 409A(a)(1). When a nonqualified deferred compensation plan fails the statute's requirements, three consequences apply to the service provider:

• Immediate income inclusion. All compensation deferred under the plan for the current and prior years becomes taxable as ordinary income, to the extent it is vested and was not already included. For an option, that means the spread between the stock's value and the exercise price on the vested shares — even though no cash has changed hands.
• A 20% additional tax. Section 409A(a)(1)(B)(i)(II) adds a tax equal to 20% of the amount required to be included. This is not a replacement for ordinary income tax; it sits on top of it.
• Premium interest. Interest is charged at the underpayment rate plus one percentage point, calculated as if the income had been taxed when it was first deferred or, if later, when it vested. It is modest when the income is reported in the year it vests and grows quickly when the failure is discovered years later.

Two features make the Section 409A penalty unusually painful for option holders. First, it can recur. Under the IRS's proposed income-inclusion regulations (Proposed Treasury Regulations Section 1.409A-4, which taxpayers may rely on), the amount deferred under a discounted option is measured at the end of each year. If the stock keeps rising, the newly vested spread and the increase in spread on previously taxed shares are taxed again, with a fresh 20% additional tax, until the option is exercised or expires. Second, states can pile on. California imposes its own additional tax on 409A income, reduced from 20% to 5% for tax years beginning in 2013, so a California employee faces a 25% combined penalty rate before ordinary federal and state income tax.

If the problem is found on audit rather than reported voluntarily, ordinary underpayment interest and potentially an accuracy-related penalty can apply to the unpaid tax as well. Those are general tax-law consequences, not 409A-specific ones, but they land on the same employee.

Why a Stock Option Priced Below Fair Market Value Triggers 409A

Stock options are not automatically subject to Section 409A. Treasury Regulations Section 1.409A-1(b)(5)(i)(A) excludes a nonqualified stock option from the definition of deferred compensation if, among other conditions, its exercise price can never be less than the fair market value of the underlying common stock on the grant date. Incentive stock options that meet Section 422 are excluded separately.

Grant the option at a discount and the exclusion is gone. The option becomes deferred compensation, and a typical startup option — exercisable whenever the holder chooses over a ten-year term — does not have the fixed payment date or permissible payment event that Section 409A requires. The plan fails from the day of grant, and the tax consequences begin as the option vests.

That is why the 409A valuation exists. It is the evidence the board relies on when it sets the exercise price at fair market value. Our guide to how the 409A sets your strike price walks through that link from common stock value to option pricing. The penalty regime only bites when the price the board chose is later shown to have been too low.

What happens if you don't get a 409A valuation?

Nothing happens automatically, because no rule requires the appraisal itself. But without one, your board's fair market value carries no presumption of reasonableness. If the IRS later concludes options were priced below fair market value, the company must prove otherwise, and option holders face the full 409A penalties.

In practice, what happens without a 409A depends on which of three situations you are in:

1. The price was right by luck. If the exercise price was in fact at or above fair market value, there is no 409A violation. The difficulty is proving it. Years later, with no contemporaneous valuation, you are reconstructing value from memory and hindsight — and hindsight after a successful financing rarely favors a low number.
2. The price was too low. Every option granted below fair market value is a discounted option. Each holder faces the income inclusion and 20% additional tax as their options vest, and the company has reporting obligations it probably missed.
3. Nobody has looked yet. This is the most common case, and the exposure is latent. It tends to surface at the worst moment: a financial statement audit, a tender offer, or an acquirer's due diligence.

A stale valuation creates the same 409A compliance risks as having none. The independent appraisal presumption only covers grants made within 12 months of the valuation date, and it is lost earlier if a material event — a priced round, a significant acquisition offer, a large change in revenue — makes the report's conclusion unreliable. See our guides to when to update a 409A and what counts as a material event.

Who pays the 409A penalty, the company or the employee?

The employee pays. Section 409A imposes the income inclusion, 20% additional tax and premium interest on the service provider who holds the deferred compensation, not on the company. The company still faces reporting and withholding obligations, possible liability for under-withholding, and the practical cost of gross-ups, repricing and damaged employee trust.

“Service provider” is broader than employees. Non-employee directors, advisors and most independent contractors who hold discounted options are exposed in the same way. For the company, the obligations are concrete:

• Reporting. Amounts includible under Section 409A are reported for employees on Form W-2 in Box 12 with code Z, and for non-employees on the applicable Form 1099.
• Withholding. Under IRS Notice 2008-115, the employer must withhold regular income tax on the includible amount for employees. It is not required to withhold the 20% additional tax or premium interest, which the employee reports on their own return. An employer that fails to withhold can be liable for the tax it should have withheld.
• Gross-ups. Many companies choose to make affected employees whole. A gross-up is taxable compensation itself, so covering a $10,000 penalty costs noticeably more than $10,000.
• Lost ISO status. An option priced below fair market value generally cannot qualify as an incentive stock option, subject to a narrow good-faith exception in Section 422(c)(1). Employees who were promised ISO treatment lose it.
• Accounting. Stock-based compensation expense under ASC 718 is measured at grant-date fair value. If the common stock value was understated, the expense may be understated too, which auditors will flag.

So while the statute taxes the employee, the business ends up absorbing much of the cost — financially and in credibility with the team it was trying to reward.

A Worked Example: What a 409A Violation Costs One Employee

Consider a Series A software company whose board grants an engineer 20,000 options at $1.00 per share without a valuation. A later independent analysis concludes the common stock was worth $1.80 on the grant date, so the grant is a discounted option. It vests 25% per year. The table shows the amounts that become includible under the proposed income-inclusion rules as the company's common stock value rises.

Over three years the engineer reports $52,500 of ordinary income without exercising a single option or receiving any cash. At an assumed 32% federal bracket, that is about $16,800 of regular federal tax plus $10,500 of 20% additional tax. A California resident would add state income tax and a further $2,625 of California's 5% additional tax. Premium interest is small here because the income is reported as it vests; it grows sharply if the problem is only discovered in an audit several years later.

Compare that with a correctly priced option. A nonqualified option granted at fair market value is generally not taxed until exercise, and a qualifying ISO is generally not taxed for regular income tax purposes until the shares are sold (though the alternative minimum tax can apply at exercise). The engineer's cash tax bill before a liquidity event would be zero. The numbers are illustrative and simplified; actual amounts depend on each person's tax position.

Compliant vs Non-Compliant Option Grants: Side by Side

The table summarizes how the same grant plays out when it is priced on a current independent 409A valuation versus when it is priced below fair market value.

How 409A Compliance Risks Surface: IRS, Auditors and Acquirers

Most 409A problems are not discovered by the IRS. They are discovered by the people who read your equity records closely:

• Acquirers. In an M&A process, buyer's counsel requests every 409A report and compares grant dates and exercise prices against them. Grants with no valuation, or grants made more than 12 months after the last one, go on the issues list. The usual outcome is a special indemnity or escrow funded from the sellers' proceeds. Our 409A exit planning guide covers how to prepare.
• Financial statement auditors. Auditors testing ASC 718 expense review the valuation supporting each grant. Unsupported values produce audit adjustments and, sometimes, a finding that the company needs to address its option pricing.
• Secondary and tender offers. A sale of common stock at a price far above the latest 409A value invites the question of whether the 409A was ever right, and may itself be a material event.
• The IRS. Examinations of individuals or employers can reach option grants, particularly where large gains were realized. Our article on how the IRS evaluates a 409A valuation covers what examiners look for.

Many of the underlying errors repeat from company to company: granting before the report is signed, relying on a preferred price, or letting a valuation lapse. Our list of common 409A mistakes covers them in detail.

How to Fix a 409A Problem Before It Compounds

If you suspect some grants were priced without adequate support, the order of operations matters. Every year of delay can add another year of income inclusion and narrow the correction options.

1. Stop the bleeding. Pause new grants until you have a current independent valuation. Every grant made without one adds to the exposure.
2. Establish what fair market value was. A qualified appraiser can prepare a retrospective analysis of common stock value at each past grant date. This tells you which grants, if any, were actually discounted. Some may turn out to be fine.
3. Correct unexercised discounted options. IRS Notice 2008-113 permits certain inadvertent operational failures to be corrected with reduced or no 409A consequences. For a discounted option, that generally means raising the exercise price to fair market value before the option is exercised, ideally within the same tax year as the grant; limited additional relief is available for non-insiders in the following year. Companies often compensate holders for the higher price with a cash payment or additional options, which must also be structured with care.
4. Deal with what cannot be corrected. Where correction deadlines have passed, the remaining choices — reporting the income, amending the options to a compliant fixed payment schedule where the rules allow it, tender offers, or gross-ups — carry strict timing rules. This step needs experienced tax counsel.
5. Put a process in place. Renew the valuation at least every 12 months and after any material event, record in board minutes which valuation supports each grant, and never grant before the report is final.

The cheapest fix is the one you never need. A current independent valuation typically costs a small fraction of a single employee's penalty exposure; see our breakdown of what a 409A valuation costs.

How Safe Harbor Shifts the Burden — and What It Does Not Cover

Safe harbor does not make a valuation immune from challenge. It changes who has to prove what. Under Treasury Regulations Section 1.409A-1(b)(5)(iv)(B)(2)(i), a valuation by a qualified independent appraiser, as of a date no more than 12 months before the grant, is presumed reasonable. The IRS can overcome that presumption only by showing the valuation or the method was grossly unreasonable. Without a presumption, the burden sits with the company.

The presumption can be lost if the valuation is more than 12 months old, if it ignored material information that existed on the valuation date, or if a later material event made it unreliable for new grants. It also does not cure a board that sets a price below the appraised value. Our safe harbor guide explains all three presumptions, including the illiquid startup method, and how each one is qualified for. For the reviewer's side of the same question, see what makes a 409A audit-defensible.

The Bottom Line on 409A Penalties

409A penalties are among the harshest in the tax code because they tax income no one has received, add a 20% additional tax on top, and can repeat every year until the option is exercised. They fall on the people a startup most wants to reward, and they tend to be discovered at the worst possible time. The good news is that they are almost entirely avoidable: price every grant on a current independent valuation, refresh it every 12 months and after material events, and fix any past gaps early while correction relief is still available.

This article is general educational information about IRC Section 409A and related tax rules. It is not tax, legal or accounting advice, and the example figures are illustrative. Correction and reporting rules are technical and time-sensitive; consult a qualified tax advisor and valuation professional about your company's specific facts.