A 2004 statute, not a single rule, created 409A valuation

The record

The deferred-compensation valuation regime behind most startup option pricing traces to a single statute: Section 409A of the Internal Revenue Code, added by the American Jobs Creation Act of 2004, Pub. L. 108-357, enacted 22 October 2004, and generally applicable to amounts deferred after 31 December 2004. The statute's own text makes noncompliant deferred compensation immediately includible in gross income, plus interest and a 20 percent additional tax. In January 2005 the IRS issued Notice 2005-1, its first interim guidance, stating explicitly that it was the first part of an expected series and that the Treasury Department intended to fold its principles into more comprehensive regulations later that year.

What the sources establish

The distinction between these layers matters: the statute is the binding law Congress enacted; the notice was interim guidance the IRS itself called incomplete; and the final Treasury regulation, 26 CFR 1.409A-1, is what now governs valuation in practice. That regulation states that for stock not readily tradable on an established securities market, fair market value means a value from the reasonable application of a reasonable valuation method, and it names three methods presumed reasonable: an independent appraisal under section 401(a)(28)(C) dated within 12 months of the transaction; a formula tied to a nonlapse restriction; and a written report, prepared reasonably and in good faith by a qualified person, for illiquid stock of a start-up corporation, defined in the regulation as stock of a company with no material trade or business conducted for ten years or more and no publicly traded equity.

Scope and revision

Not every valuation method carries the same weight under the regulation. The start-up presumption does not apply once a company reasonably anticipates a change in control within 90 days or a public offering within 180 days of the valuation being applied, and the Commissioner may rebut any of the three presumptions on a showing that the method or its application was grossly unreasonable. Notice 2005-1's interim status means it was superseded in substance by the final regulations the Treasury issued afterward; a valuation practice citing only the 2005 notice, rather than the current section 1.409A-1(b)(5)(iv), is citing guidance the IRS itself described as provisional.

The decision in front of you

This is editorial: a founder or option holder relying on a company's 409A valuation should confirm which presumption, if any, the valuation claims, since an appraisal outside the 12-month window or a valuation performed while a sale or offering was reasonably anticipated may not carry the presumption of reasonableness at all.

• Which of the regulation's three presumed-reasonable methods does the valuation report identify, and is it timely under that method's terms?
• Was the company, at the time of the valuation, reasonably anticipating a change in control or public offering that would void a start-up presumption?
• Does the valuation source cite the current Treasury regulation or only the superseded 2005 interim notice?

A statute, a notice and a regulation are not interchangeable citations; only the regulation currently in force describes the safe harbors a valuation can actually rely on.