You may have heard the term “safe harbor” 409a valuation, but what is it, and why does it matter? A safe harbor valuation is one in which the IRS must accept the results of fair market value appraisals unless it can show they are ‘grossly unreasonable’. Section 409A of the Internal Revenue Code (IRC) are regulation defining the fair market value (FMV) of an equity interest of an entity that is not publicly traded. This article will cover what safe harbor 409A is and its uses, its benefits.
Safe harbor 409A Valuation and LLC
Safe harbor 409A valuation is based on a number of presumptions, as described in the Internal Revenue Code. If you are thinking about forming an LLC, you should make sure you understand the safe harbor 409A valuation and its meaning.
Overview of limited liability companies (LLC)
LLCs are entities that are characterized by their limited liability protection and tax benefits. In essence, LLC protects its owners from personal liability, and LLC itself is a separate tax entity from its members. It combines the features of a corporation with that of a partnership or sole proprietorship. However, the regulations of LLCs are different in every state.
What is s 409a valuation?
The IRC section 409A provides private companies with fair market value (FMV). In simple words, this valuation allows for determining the cost that is required to purchase a share. 409A set the strike price, which is an amount that is justified to buy an equity interest in the company. 409A is a separate legal entity from the actual company and contains the guidelines for determining the FMV of an equity interest in a company. Therefore, business owners or investors should choose an appropriate method according to the guidelines. An appraiser also needs to comply with all of the rules and regulations set under this law.
Importance of getting 409a valuation
The act of valuation of an entity has to be performed by an approved appraiser that is qualified and licensed by the state and the federal government. The benefits associated with this 409A valuation are as follows:
Sense of Security for Investors - It is a part of a business’s plan to ensure that an investor or the owner should not be in danger of breaking any laws while structuring the return on investment (ROI). These legal provisions are there to protect the business owners and their investors.
Standardization - This 409A valuation method gives an insight into understanding how other companies are valued, and this allows standardization of appraisal methods across different industries. Thus, making it easier to invest as well as raise money and allowing the cost of investment to be determined.
Avoiding Penalties As 409A valuation is required to be performed, it helps in avoiding penalties as it is a legal requirement to comply. Every company is required to provide the fair market value of their equity interest using a qualified appraiser.
Safe harbor 409a valuation
Safe harbor 409A valuation is a legal provision that helps in creating a somewhat informal valuation of an LLC under the condition of company existence being less than ten years. Read on to know more about safe harbor 409A valuation.
What does safe harbor 409a valuation mean?
Safe harbor 409A valuation is a part of IRC section 409A, a legal provision set by the federal government that helps determine the value of an LLC. If your 409A is handled in a certain way, it qualifies for safe harbor status. This safe harbor allows the company to trust a third-party valuation that abides by certain fairly objective standards.
However, a company must “update” its 409A valuation every 12 months to keep the safe harbor. Therefore, if a company does not update its safe harbor, it can be penalized with tax evasion.
Importance of getting safe harbor valuation
The importance of safe harbor 409A valuation lies in providing financial protection to a business owner. Here are some of the reasons why most business owners believe it is necessary to pay attention to safe harbor valuation:
Structuring an investment plan - When a business owner is setting a plan for the return on its investments, it is important to understand the safe harbor 409A valuation. This prevents financial damage that can be caused by non-compliance with the law (i.e., fines, penalties, etc.).
Cost Reductions - Since safe harbor 409A valuation is performed for businesses running for less than 10 years, it helps in cutting costs since the IRS does not need to do a lot of work and must only accept the fair market value.
Protecting Tax Evasion - The part of this law that makes it difficult for tax evasion is the fact that safe harbor valuation is mandatory, and it is done only by a qualified appraiser.
Why do LLCs need a safe harbor valuation?
One of the reasons why most business owners want to use safe harbor valuation is that it is a part of the IRS’ Section 409A, which provides financial protection to a business owner. The best time to get a safe harbor 409A valuation is during the onset of the LLC or before it goes public. It is advised to get the safe harbor valuation done on time to avoid potential penalties.
How to get a safe harbor 409a valuation for LLC?
There are three ways in which safe harbor 409a valuation methods are conducted in the US. These methods are as follows:
Independent Appraisal Safe Harbor - The 409A Safe Harbor evaluation method is one of the most common independent appraisal presumptions. The IRS wants an independent 409A assessment from a reputable firm that uses consistent and well-documented methods in its assessments. This is usually the easiest way to get a Safe Harbor 409A valuation. It is suggested to find an independent accounting agency and pay them to do your 409A assessment.
Binding Formula Safe Harbor - The adoption of the binding formula applies to 409A assessments based on the consistent use of a generally applicable repurchase formula in the transfer of company stock. The formula is applicable in both situations, transfer of share in compensatory or non-compensatory with at least 10% of the company’s shareholders. The IRS specifies any person or issuer owning more than 10% of the combined gets the voting rights in all of the issuer’s share stock.
Illiquid Startup Safe Harbor - In this, the safe harbor 409A valuation for LLC is intended to correspond to the start-up environment where capital changes hands much more frequently. It only applies if both the service recipient and the service provider do not expect an IPO within 180 days or a change of control event within 90 days. A control change event is what you would expect. It could be a voting change where one person or company owns more than 50%.
How can LLC avoid 409a valuation penalties?
An LLC can avoid penalties and maintain its safe harbor status by following the procedure for updating the 409A valuation. Here are a few tips on how a company can avoid penalties:
Follow IRC 409a valuation guidelines - Many people assume that the IRS does not have a set of rules for 409A valuation. In reality, there is a set of guidelines for valuations, and however you follow these guidelines, you can maintain your safe harbor status.
Get experts to help with valuation - It is always recommended to hire a qualified business valuator to help you with the safe harbor valuation. This is because the IRS wants an independent valuation that is fairly objective and unbiased.
Always maintain safe harbor status - The best way to maintain safe harbor status if you are running your company is to update the valuation every year. This helps in keeping the company compliant with the law and keeps penalties out of sight.
Conclusion
Safe harbor valuation is an important part of the IRS’s 409A regulations. LLCs are required to follow safe harbor status and avoid penalties that come with non-compliance. It is advisable for LLCs to follow the 409A valuation guidelines, hire a qualified appraiser, and update valuations annually in order to stay compliant with the law.