Stock options granted as compensation normally get favorable tax treatment — options can either be non-qualified, which means that the value is not taxed until exercise, or incentive, which means that the value is not taxed until the stock is sold. However, in order to gain either benefit, the exercise price of the options cannot be less than the fair market value of the stock at the time of grant. If the exercise price is lower, the tax on the value must be paid at the time of the grant; furthermore, the grant is also subject to a penalty tax of 20% under Section 409A — the issuer (the company) has the responsibility of reporting the option as violating Section 409A and withholding the appropriate tax, and can be subject to penalties if it fails to do so. In order to avoid Section 409A penalties, the company must make sure that the exercise price is not less than the fair market value at the time of grant. First, the company must solidify when the grant date occurs. According to the IRS, the grant occurs on the date when the issuer (company) completes the corporate action necessary to create the legal right constituting the option. A few facts must be established (or at least are determinable) in order to have a proper grant: 1) the maximum number of shares that can be purchased; 2) the minimum exercise price; 3) the class of stock that the option grants. Typically these things occur when the Board of Directors adopts the stock option plan; however, the Board at that time can effectively set a future grant date (but once a grant occurs, it may not retroactively set a new grant date). Second, a company can ascertain the fair market value of the stock in a number of ways. If the company is publicly traded, it is usually determined from the actual stock price on the market. However, for private companies that do not have that benefit, they must use a “reasonable valuation method”; moreover, it is the burden of the taxpayer to prove the reasonableness of the valuation method. Section 409A does give a couple of safe-harbor methods, which include: – independent appraisal – use of a formula that meets IRS guidelines (such as book value, multiple of earnings, etc.) that is used consistently for all transfers of stock (except for a transfer of all or substantially all of the issuer’s stock) – or for relatively new, illiquid startups, a valuation report prepared by a person reasonably determined to be qualified to perform the valuation (based on their knowledge, experience, education, or training), which report takes into factors such as value of assets, present value of future cash flow, recent transactions in stock control premium, objective market value of similar entities, discounts for illiquidity, etc.) The company should take the above steps to ensure that the exercise price of stock option grants is not below the fair market value; otherwise, both the option holder and the company could be subject to significant taxes and penalties for noncompliance.