What Happens If You Skip a 409A Valuation: Penalties

Last Updated: March 2026

Section 409A penalties refer to the tax consequences imposed on employees, executives, and service providers when stock options or deferred compensation arrangements fail to comply with IRC Section 409A, most commonly because options were granted with a strike price below the fair market value of the underlying stock on the grant date. A 409A violation triggers immediate income inclusion on all deferred amounts, a 20% federal excise tax on top of ordinary income rates, and an interest charge on the underpaid tax going back to the year of deferral. Sofer Advisors, led by David Hern CPA ABV ASA, performs 409A valuations for startups, growth-stage companies, and private businesses that need an IRS safe harbor valuation to protect employees and founders from these consequences.

The penalties fall on the employee or service provider, not the company — which creates a specific and serious risk for equity compensation recipients. A company that fails to obtain a 409A valuation before granting options may unknowingly expose its own employees to a tax liability that exceeds the value of the options themselves. For startups, venture-backed companies, and any private employer issuing equity-based compensation under ASC 718, understanding 409A compliance is not optional. The cost of a 409A valuation is a fraction of the penalties it prevents.

Key Takeaways

  • A 409A violation triggers immediate income inclusion of all deferred amounts into ordinary income, plus a 20% federal excise tax, plus an interest charge calculated from the year of the original deferral.
  • The 20% excise tax under Section 409A is imposed on the employee or service provider, not the company, even though the company set the option strike price incorrectly.
  • California imposes an additional 20% state excise tax on 409A violations, meaning California employees can face a combined federal and state excise tax of 40% on top of ordinary income rates.
  • A 409A valuation performed by a qualified independent appraiser creates a safe harbor that shifts the burden of proof to the IRS to demonstrate the fair market value was unreasonable.
  • The IRS has limited correction programs under Notice 2008-113 for certain 409A violations, but correction is only available before the employee receives the benefit and is subject to strict timing requirements.

The consequences of a 409A violation fall on the employee — not the company that set the wrong strike price. An engineer who received $100,000 in options from a company that skipped a 409A valuation may owe more in combined federal and California excise taxes and income tax than the options are worth, before ever exercising them or receiving a dollar. The company faces no direct federal 409A penalty — but it does face withholding liability, payroll tax exposure, and the reputational and legal damage of employees who discover their equity was issued in a tax-noncompliant structure.

What Is a Section 409A Valuation?

Section 409A of the Internal Revenue Code governs nonqualified deferred compensation arrangements, including most private company stock option plans. The statute requires that stock options granted to employees or service providers be priced at or above the fair market value of the underlying stock on the grant date. If the strike price is set below fair market value, the option is treated as a deferred compensation arrangement that fails Section 409A.

Before Section 409A was enacted in 2004, companies frequently priced options informally, sometimes using book value, last-round pricing, or management estimates. The Enron-era reforms that produced Section 409A created strict rules requiring a defensible, documented fair market value determination at grant.

The IRS recognizes three methods for establishing FMV under the 409A regulations. The most reliable is an independent appraisal by a qualified appraiser — someone with significant knowledge, experience, education, or training in performing business valuations. Sofer Advisors’ 409A valuations are performed by David Hern CPA ABV ASA, whose ASA and ABV credentials satisfy the IRS qualified appraiser standard and whose reports create the safe harbor that protects employees from penalty exposure.

A 409A valuation is not a one-time event. The IRS requires a new valuation whenever a material event occurs that would reasonably affect fair market value — a new funding round, a material acquisition or disposition, a significant revenue change, or a period of more than 12 months since the last valuation. Companies that grant options without updating their 409A between material events risk retroactive penalty exposure.

What Are the 409A Penalties for Non-Compliance?

The penalties for a 409A violation are severe and are imposed on the individual employee or service provider, not the company. The three-layer penalty structure creates a tax cost that can far exceed the economic value of the option.

Layer 1 — Immediate income inclusion: All amounts deferred under the noncompliant arrangement are included in the employee’s ordinary gross income in the year the deferral is no longer subject to a substantial risk of forfeiture. This means options that have vested but not been exercised are immediately taxable at ordinary income rates.

Layer 2 — 20% federal excise tax: On top of ordinary income tax, the employee owes a 20% excise tax on the entire amount included in income under Section 409A. This excise tax is in addition to federal income tax, not a substitute for it.

Layer 3 — Interest charge: The employee owes an underpayment interest charge on the amount that should have been recognized in the year of deferral, calculated at the IRS underpayment rate plus one percentage point.

To illustrate the combined impact, consider an employee with $500,000 in vested options granted below FMV. At a 37% federal marginal rate plus the 20% excise tax plus applicable state income tax, the employee could owe $285,000 or more in federal tax alone, before receiving a dollar of proceeds from the options. The realistic combined tax rate in high-tax states exceeds 75% of the option spread.

Who Pays the 409A Penalty — Employee or Company?

The 409A penalty is imposed directly on the employee or service provider who received the noncompliant compensation. This is one of the most counterintuitive aspects of Section 409A and one of the most important for both companies and employees to understand before any option grant.

The company bears no direct federal penalty under Section 409A itself. However, the company faces significant indirect consequences:

  • Withholding liability: Companies are required to withhold income taxes on amounts included in income under Section 409A. A company that fails to withhold correctly faces its own penalties under the withholding rules.
  • FICA and payroll taxes: The company must also address FICA tax obligations on Section 409A income inclusions, creating additional payroll tax exposure.
  • Talent retention risk: Employees who discover their options are noncompliant may demand remediation, price adjustments, or departure, creating legal and HR exposure for the company.
  • Investor and audit scrutiny: Companies with 409A violations face heightened scrutiny during due diligence, financing rounds, and financial statement audits.

Firms like Carta and Andreessen Horowitz (a16z) have extensively documented the 409A compliance requirements for venture-backed startups. For middle-market companies, closely held businesses, and pre-revenue startups outside the venture ecosystem, Sofer Advisors provides the same standard of 409A valuation with the credentialing and documentation that satisfies the IRS safe harbor requirements.

What Happens When Stock Options Are Priced Below FMV?

When a company grants stock options with a strike price below the fair market value of the underlying stock on the grant date, those options are treated as nonqualified deferred compensation that violates Section 409A from inception. The violation is not curable simply by later repricing the options — the IRS position is that the violation occurred at grant.

The practical sequence of events typically follows this pattern:

  • The company grants options at a strike price of, for example, $1.00 per share.
  • The actual FMV on the grant date, determined by an independent appraisal, was $2.00 per share.
  • The $1.00 spread per option is a below-FMV grant and constitutes a deferred compensation arrangement.
  • When the options vest, the spread is included in the employee’s ordinary income immediately, even if the employee has not exercised the options and received no cash.
  • The 20% excise tax and underpayment interest apply on top of income tax.

The company’s own 409A valuation report is the primary evidence that determines whether options were priced at or above FMV. A defensible, credential-backed report from Sofer Advisors creates the IRS safe harbor — meaning the IRS must prove the valuation was unreasonable to challenge it. Without a safe harbor valuation, the company and its employees bear the full burden of proving that the strike price reflected fair market value.

Does California Impose Additional 409A Penalties?

California imposes its own additional excise tax on 409A violations that significantly increases the total tax burden for California-based employees. The California excise tax mirrors the federal structure but adds an additional 20% state excise tax on the same income included under Section 409A.

For a California employee, the combined penalty tax structure is:

Tax Component Rate
Federal ordinary income tax Up to 37%
Federal 409A excise tax 20%
California ordinary income tax Up to 13.3%
California 409A excise tax 20%
Combined effective rate on option spread Can exceed 90%

The California excise tax applies in addition to — not instead of — the California ordinary income tax on the included amount. The combined federal and California excise taxes alone total 40%, before any ordinary income tax is applied.

This is why companies with California employees face the highest urgency around 409A compliance. An employee in California who holds $200,000 in vested options granted below FMV could owe more than the options are worth in combined taxes, penalties, and interest.

Can You Fix a 409A Violation?

The IRS provides limited correction opportunities for certain 409A violations under Notice 2008-113. These correction programs are available for specific types of violations and are subject to strict timing requirements — generally, correction must occur before the year in which the employee would otherwise be required to include the amount in income.

The correction programs cover several categories:

  • Operational failures: Errors in administering a compliant plan (paying deferred amounts at the wrong time or in the wrong form) that can be corrected by returning or adjusting the payment within the same calendar year.
  • Plan document failures: Certain plan language that fails to satisfy 409A requirements may be corrected under the document correction programs, subject to IRS-specified procedures.
  • Below-FMV stock options: A specific correction program allows companies to raise the exercise price of discounted options to at least FMV, subject to conditions including employee consent and compensation adjustment.

The below-FMV option correction is the most relevant for companies that discover a 409A compliance gap. You can raise the exercise price if: the correction is made by December 31 of the year following the year of grant, the employee consents, and appropriate compensation adjustments are made. After that window closes, correction becomes significantly more complex or unavailable.

Sofer Advisors supports companies through 409A compliance reviews and can identify whether options granted in prior periods had an adequate FMV basis, helping legal and tax counsel determine whether a correction is available and what it requires.

Frequently Asked Questions

What are the penalties for 409A non-compliance?

A 409A violation triggers three layers of penalty for the employee or service provider: immediate income inclusion of all vested deferred amounts at ordinary income rates, a 20% federal excise tax on the total included amount, and an underpayment interest charge running from the year of the original deferral. These penalties are imposed on the individual, not the company, even though the company set the option strike price. In California, an additional 20% state excise tax applies, bringing the combined excise tax alone to 40% of the affected amount.

Who pays the 409A penalty?

The 409A excise tax and income inclusion are imposed directly on the employee or service provider who received the noncompliant compensation, not on the company that granted the options. The company bears indirect consequences including withholding liability, FICA tax obligations, and reputational and legal exposure during due diligence or financing events. Companies with California employees face the highest total combined penalty burden because California mirrors the 20% federal excise tax with its own separate 20% state excise tax.

What happens if stock options are priced below fair market value?

Options granted with a strike price below the FMV of the underlying stock on the grant date are treated as deferred compensation that violates Section 409A. When the options vest, the spread between strike price and FMV is included in the employee’s ordinary income immediately, even before the employee exercises the options or receives any cash. The 20% federal excise tax and underpayment interest apply in addition to ordinary income tax, creating a combined tax burden that can exceed the value of the options themselves.

What is the 20% excise tax under Section 409A?

The 20% federal excise tax is an additional tax imposed on amounts included in income due to a 409A violation, on top of regular federal income tax. It is not a penalty in the administrative sense — it is a statutory tax built into Section 409A. The excise tax applies to the total amount included in income, not just the benefit received. At a 37% marginal rate plus 20% excise tax, an employee faces a minimum 57% federal tax rate on the noncompliant amount before state income taxes are considered.

How much does a 409A valuation cost?

A 409A valuation from a qualified independent appraiser typically costs $2,500 to $9,000 depending on company stage, revenue, capital structure complexity, and the appraiser’s methodology. Sofer Advisors performs 409A valuations with a next business day response from engagement inception, typically delivering reports within 2 to 4 weeks. The cost of a 409A valuation is a fraction of the penalties it prevents — a $4,000 valuation protects employees from potential six-figure excise tax exposure on option grants.

Can you fix a 409A violation after it occurs?

The IRS provides limited correction programs under Notice 2008-113 for certain 409A violations, but correction is only available before the year the employee would otherwise include the amount in income. For below-FMV stock options, correction requires raising the exercise price to at least FMV by December 31 of the year following the grant year, with employee consent and appropriate compensation adjustments. After this window closes, correction becomes significantly more complex. Companies that discover a 409A gap should immediately consult tax counsel to evaluate whether correction is still available.

How often do you need to update a 409A valuation?

The IRS requires a new 409A valuation whenever a material event occurs that would reasonably affect the company’s fair market value. Material events include a new equity financing round, a material acquisition or disposition, a significant change in revenue or profitability, or any other event a reasonable investor would consider relevant to value. Even without a material event, a 409A valuation is considered stale after 12 months. Companies granting options more than 12 months after their last 409A must obtain a new valuation before the grant date to maintain safe harbor protection.

What is the 409A safe harbor valuation?

The 409A safe harbor is the IRS’s recognition that an independent appraisal by a qualified appraiser creates a presumption of reasonable FMV. When a company obtains a safe harbor 409A valuation, the IRS bears the burden of proving the valuation was unreasonable to challenge the option pricing. Without a safe harbor valuation, the company bears the burden of proving its strike price reflected FMV. The safe harbor requires the appraiser to have significant knowledge, experience, education, or training in performing business valuations — the standard that ABV and ASA credential holders like David Hern satisfy.

Does California impose additional 409A penalties?

Yes. California Revenue and Taxation Code Section 17501 mirrors the federal 409A penalty structure and imposes an additional 20% California excise tax on amounts included in income due to a 409A violation. This is separate from and in addition to the federal 20% excise tax, meaning California employees face a combined 40% excise tax on top of both federal and state ordinary income taxes. California’s additional surcharge makes 409A compliance especially critical for companies with California-based employees, officers, or founders holding equity compensation.

What triggers a 409A audit?

The IRS most commonly identifies 409A issues during routine employment tax audits, M&A due diligence disclosures, whistleblower reports, or examination of company option grant records. Discrepancies between reported W-2 income and option grant records, grants made just before a major liquidity event, and options priced at round numbers inconsistent with independent appraisal results are common audit triggers. Companies that cannot produce a contemporaneous 409A valuation report for each grant date face the highest exposure because they cannot establish safe harbor protection retroactively.

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Executive Summary

Section 409A penalties impose a three-layer tax on employees who receive noncompliant equity compensation: immediate income inclusion, a 20% federal excise tax, and underpayment interest. The penalty falls on the employee, not the company, even though the company sets the option strike price. California adds a separate 20% state excise tax, making the combined excise burden 40% before ordinary income taxes. A 409A valuation by a qualified independent appraiser creates an IRS safe harbor that shifts the burden of proof and protects employees from these consequences. Limited IRS correction programs exist under Notice 2008-113, but timing requirements are strict. Prevention through a current, credential-backed 409A valuation is far less costly than remediation.

What Should You Do Next?

Sofer Advisors performs 409A valuations that meet the IRS qualified appraiser standard, backed by David Hern CPA ABV ASA’s dual ASA and ABV accreditations. Our 409A reports create the safe harbor protection your employees need, with typical engagements delivered in 2 to 4 weeks at $2,500 to $9,000. With 180+ five-star Google reviews, Inc. 5000 recognition in 2024 and 2025, and a next business day response policy, Sofer Advisors is the firm founders and CFOs trust for defensible, audit-ready equity compensation valuations.

SCHEDULE A CONSULTATION to discuss your company’s 409A valuation needs and ensure your option grants are protected by a current, qualified safe harbor appraisal.

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About the Author

This guide was prepared by David Hern CPA ABV ASA, founder of Sofer Advisors – a business valuation firm headquartered in Atlanta, GA serving clients across the United States. David holds dual accreditations as an Accredited Senior Appraiser (ASA) and is Accredited in Business Valuation (ABV), credentials recognized by the IRS, SEC, and FINRA. He also holds the Certified Exit Planning Advisor (CEPA) designation. With 15+ years of valuation experience, David has served as an expert witness in 11+ cases across multiple jurisdictions and built Sofer Advisors into an Inc. 5000-recognized firm with 180+ five-star Google reviews. The firm’s full W2 employee team maintains subscriptions to all major valuation databases and operates under a next business day response policy.

For professional business valuation services, visit soferadvisors.com or schedule a consultation.

This article provides general information for educational purposes only and does not constitute legal, tax, financial, or professional advice–consult qualified professionals regarding your specific circumstances.