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In 2005, our company was formed through the acquisition of numerous existing Web sites. At its inception, a valuation was done by management and later, in 2006, by a third-party valuation firm. Both used the current-valuation method (not the option pricing method) and were/are considered compliant for the purposes of 409(a).
Since that time, a Big 4 audit firm has provided us with information and a point of view that this is wrong. Their position is that the only acceptable method of stock-option valuation is the option-pricing method, as indicated by the AICPA Practice Guide, which was issued in April 2004. (It has been represented by the audit firm and others that the SEC accepts only the practice guide.)
The option valuation meets the IRS requirements but, of course, if we change it to conform to GAAP requirements (per the audit firm), and then there are adverse personal tax consequences for individuals. We are okay with the impact on the financial statements of the company, but it doesn’t seem right.
I believe that the option pricing was done in good faith and supported, but by the current-value method, not the option-pricing method.
Have any other members had experience with using different valuations for book and tax? It is clear that the best practice is a dual report with the same valuation for both book and tax, but in hindsight, what can a company do to support a different position for tax?
Any insight into this issue would be much appreciated.
Anonymous
Response:
The situation you describe unfortunately is not unusual. I suspect your accounting firm can confirm this. I know of one situation in which a public offering was held in "limbo" for more than six weeks and unable to proceed, since neither the SEC nor the public accountants would budge from their position that the valuation was wrong....and neither was willing to change. The public accounting firm was unwilling to change their previously signed-off opinion, and the SEC was unwilling to accept it.
So...going forward, your safe harbor is a third-party valuation. No one said it was better, necessarily, just safer. The AICPA practice guide is pretty specific and does not at all like the current value method (good faith being irrelevant). What you do right now is really in the hands of the accountants and the SEC (if you are public, that is; you didn't actually say).
To your question, as far as I know (please check your tax experts, lawyers, and/or accountants) the IRS has never carried through on the implicit threat to align the value used by the SEC and accountants with a 409(a) valuation. Everyone fears that event, but it has not happened, and it may never. Who's to say?
Anonymous
Response:
Here is a response from a friend who is one of the leading experts in this area. He is on the Advance Issue Task Force on valuation that communicates with the FASB. I can provide contact information if the FEI member wants it.
Mike Adhikari (madhikari@att.net )
It sounds as if this company actually slid by in using the current-value method. From what is described, the valuation firm should not have applied the current-value method. This method is applicable only for companies with an imminent liquidation or acquisition event. The only other eligible companies are those at such an early stage of development that no material progress has been made on its business plan; no significant common equity value has been created in the business, above the liquidation preference on the preferred shares; and there is no reasonable basis for estimating the amount and timing of any such common equity value above the liquidation preference that might be created in the future. The current-value method may have been applicable in 2005, when management did the valuation at inception. But the third-party valuation firm probably shouldn’t have followed in that path in 2006, especially if there had since been a round of financing. I’m not sure whether there was a round in the interim, but it seems to be implied.
While there can be exceptions, we always do the analysis and write the report so that it is in compliance with both 123(r) financial and 409(a) tax purposes. None of our clients have issued different valuations for book and tax. As such, when a company gets into the predicament of a divergence, I’m not sure what can be done.
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