Safe Harbor???

So I participated in a conversation yesterday with an IRS representative that was intended to illuminate some common misconceptions regarding what the Service is looking for in 409a appraisals. The initial Code provision was added January 1, 2005 and the final regulations were published on April 17, 2007. In addition to the valuation requirements stipulated by the Code, there was official guidance that outlined “safe harbor” methods for companies and appraisers to follow. It was very, very limited and after what I learned yesterday from the IRS I am here to tell you: as it stands now, we should all be afraid. Very afraid.
I was eagerly anticipating the discussion, as I figured that by now (October 2008), the IRS would be ready to come forward with some new detailed how-to guidance in the 409a realm. After all, people have been doing these valuations since 2005 and since that time there has been a wide disparity in practice, ranging from the CFO or controller doing internal, back-of-the-envelope analysis to highly experienced valuation experts engaging in heated debate over appropriate “allocation methods.” Most would tell you that much of the guidance regarding option valuation for private companies has come from the financial reporting community. But guess what? That’s fair value, not fair market value, so it’s not relevant. Or wait, maybe it is relevant? Where there are two reports out on the same date that are rendered for different purposes (tax and financial reporting) that might indicate different values, we were told in our conversation yesterday that it was certainly possible that the two could be different. However, when a similar situation came up later in the discussion, it was said the different data points could create cause for investigation.
I’m not saying these are conflicting answers, and the IRS representative was extremely courteous in addressing the questions at all (as his answers were in fact his own personal opinions and not official positions of the IRS). To that point, the IRS is STILL developing its 409a review practices. We were told that they will start reviewing 409a appraisals on January 1, 2009. They will review appraisals going back to when the provision was implemented in 2005. Oh yeah, and did I mention they are beefing up their appraisal review processes? At the good old penalty review center, where they figure out whether appraisers did naughty things to help their clients and should be punished (under things like Section 6695a of the Pension Protection Act of 2006), the number of cases went from zero two years ago to 140 currently. Remember, this does not include 409a cases, because they haven’t even started reviewing those yet. Did I mention that appraisers found in violation can be barred from practicing before the IRS?
So let’s sum this up: the IRS has yet to release any hard and fast, detailed implementation guidance of any kind regarding 409a valuation—and yet thousands of these have been done to date AND the IRS is planning on reviewing these thoroughly and vigorously pursuing any appraisers found in violation. Not to mention the poor employees who will have to shell out taxes and penalties where deficiencies are discovered.
Scared yet? That said, it’s not all bad news. The conversation did yield some meaningful editorial commentary from the representative, whom I really do like. Basically, when pressed for best practices, the rep emphasized that the review pile will be somewhat divided into those reports which adhere to one or more of the professional standards (USPAP, AICPA, NACVA, etc.) and those that do not. Those that do not will receive greater scrutiny. Further, the IRS is leveraging the learning process of the financial reporting community, and as a result will likely embrace things like the equity allocation methods (i.e. OPM or PWERM). If you do these kinds of valuations, you know that’s huge. You also know that means every valuation under current value could be open season. We’ll have to see.