The 409A Valuation Problem for NSOs: Why Under-FMV Strikes Are Section 409A Failures

A founder granted 50,000 NSOs to a new VP of engineering in September 2025 with a strike of $2.40. The company’s 409A valuation at that time was $4.80. The legal team missed it; the founder had used a six-month-old 409A number from before a recent tender offer bumped the valuation. The new hire exercised 12,000 options in December, assuming a spread of $0 at grant and modest spread at exercise. The company’s tax filing preparer caught the issue: the grant was below-FMV at grant, violating IRC §409A.

The consequences cascaded. The vested portion of the grant (36,500 shares) had an inclusion amount on the 2025 tax return equal to the spread between current FMV and strike at each vest date, starting in 2024 when the first tranche vested. Plus 20% additional tax under §409A(a)(1)(B)(i)(II). Plus interest at the underpayment rate plus 1 percentage point under §409A(a)(1)(B)(ii). The new hire faced an unexpected ordinary income event on shares he had not sold, along with tax treatment that kept him in §409A purgatory for the life of the grant.

IRC §409A, enacted in 2004, imposes a regime on nonqualified deferred compensation. Stock options are ordinarily treated as exempt from §409A if granted with a strike at or above fair market value at grant. A strike below FMV at grant pulls the option into §409A and triggers the penalty regime.

The §409A framework

What §409A covers

IRC §409A applies to “nonqualified deferred compensation.” Broadly, this means compensation that is earned in one year but paid in a future year, and that is not otherwise exempt under §401 (qualified plans), §83 (restricted stock), or other specified exclusions.

Stock options are potentially deferred compensation because the option allows the employee to defer receipt of the underlying shares. The Treasury regulations carve out stock options from §409A treatment if:

1. The strike is at or above FMV at grant.
2. The option is on service-provider stock (of the employer or a parent/subsidiary).
3. The option has no additional deferral feature beyond the exercise mechanism.

If any condition fails, the option is deferred compensation under §409A.

The consequence of §409A failure

If §409A applies and the option is in violation (a “plan failure”), the service provider recognizes ordinary income equal to the value of the option at the moment of vesting, plus a 20% additional tax, plus an interest penalty. All of this applies in the tax year of vesting, regardless of whether the option has been exercised.

The mechanism is roughly:

• Compute the spread at each vesting date.
• Report that spread as ordinary income in the vesting year.
• Add 20% additional tax under §409A(a)(1)(B)(i)(II).
• Add interest at the federal underpayment rate plus 1% under §409A(a)(1)(B)(ii).
• Continue to report any incremental spread in subsequent years as additional inclusion.

This is a severe outcome. The tax is owed on paper gains that have not been realized through sale.

The FMV-at-grant requirement

What FMV means

For private companies, FMV is typically established by a §409A valuation. The valuation is an independent appraisal of the company’s common stock, refreshed at least annually and upon material events.

For public companies, FMV is the market price on the grant date. The regulations specifically allow an averaging method across some window of recent trading days, but most companies use a specific day’s price.

The safe harbor for §409A valuations

Treasury Regulation §1.409A-1(b)(5)(iv) establishes a safe harbor for private company valuations. A valuation qualifies for the safe harbor if:

1. It is performed by an independent appraiser.
2. The valuation is applied consistently to all grants and transactions.
3. The valuation date is not more than 12 months before the grant date (or another valuation event).
4. The company’s facts and circumstances have not materially changed since the valuation date.

A 409A valuation that meets the safe harbor is presumed reasonable. The IRS bears the burden of showing the valuation was grossly unreasonable to challenge it.

Material changes

The “material changes” concept is where many §409A errors occur. A tender offer at a price higher than the current 409A can be a material change that invalidates the prior valuation. A Series D financing at a price substantially above the prior preferred round is another. A significant change in financial performance, competitive position, or strategic direction can also invalidate.

After a material change, the company should obtain a new 409A valuation before issuing new grants. Continuing to use the pre-change 409A for post-change grants risks a below-FMV error.

Common failure patterns

Stale 409A

The most common error is using a 409A that was valid when obtained but that has become stale. 409As are valid for 12 months or until a material event. Companies that delay refreshing their 409A after a financing or tender offer create exposure.

Post-hoc repricing

Repricing options below current FMV is always a §409A problem. The repriced option has a strike below current FMV at the time of repricing. Unless the repricing qualifies for a specific exception (such as a “qualified substitution” in a corporate transaction), the repriced option is a §409A failure.

Some companies implement repricings via an exchange: the old option is cancelled and a new option is granted at current FMV. The exchange is treated as a new grant for §409A purposes, avoiding the below-FMV trap.

Below-market exchange

A contingent exchange of options in a corporate transaction must meet §424 requirements to avoid being a §409A issue. A stock-for-stock exchange in a tax-free merger typically meets §424. An acquisition for cash or for acquirer stock in a non-qualified transaction may not.

Administrative error

Simple human error (wrong date used, wrong share count, wrong strike) can produce below-FMV grants. These are usually discoverable through the company’s grant review process, but errors do slip through.

The correction mechanisms

IRS Correction Program

The IRS has provided guidance (Notice 2008-113 and subsequent) on correcting §409A operational failures. Corrections in the year of the error, where the amount involved is limited, can be corrected without penalty. Corrections in later years carry some residual penalty.

The mechanics of correction involve:

• Identifying the failure.
• Paying any delinquent tax.
• Modifying the option terms to bring them into compliance.
• Documenting the correction.

Modification to cure

The most common cure is to reprice the option up to current FMV. The employee’s strike increases, effectively reducing the embedded value. The modification is treated as a new grant under §424, starting the ISO clocks (if ISO) or the §409A analysis (if NSO) from the modification date.

Increasing the strike requires the employee’s consent because it reduces the value of the grant. Companies often offer consideration (a bonus, a new refresh grant, a cash payment) in exchange for consent to the strike modification.

Cancellation and regrant

The option is cancelled and a new option is granted at current FMV. This fully cures the §409A failure going forward, but may have its own tax implications (a cancellation can trigger §83 income on the spread of the cancelled option in some circumstances).

The discount option gamble

Some early-stage startups offer “discount options” at a strike below current FMV as a recruiting tool. This is almost never done correctly. The §409A consequences are severe and largely fall on the employee rather than the company.

If a discount option is used, the employee should understand the §409A exposure and plan for the consequences. A discount option that is not cured is a tax trap with 20%-plus penalty treatment.

The 409A audit and the IRS

The IRS has periodically audited §409A compliance at startups, particularly around IPO events. A company going public undergoes intensive review of its equity plan, including all historical grants. A below-FMV grant that slipped through in early years may surface during the S-1 review process.

Companies discovered to have §409A issues before IPO typically undergo correction programs. The cost of correction can run into the millions for companies with many affected grants. Employees bear some of the cost via strike modifications or ordinary income recognition.

Frequently asked

Does §409A apply to ISOs?

Generally no. ISOs that meet §422 requirements are exempt from §409A. If an ISO fails §422 and is treated as NSO, the §409A analysis applies.

What if my grant is above FMV at grant?

No §409A problem. The regulations carve out grants with strike at or above FMV. Grants with strike at exactly FMV are fine.

Can I exercise my grant if the company identifies a §409A issue?

Usually yes, but the exercise may have different tax treatment than expected. The §409A failure is a separate issue from the exercise; the failure produces income recognition at vesting regardless of exercise.

Does §409A apply to RSU grants?

Generally no. RSUs that pay out at a specific vesting date or within a short window after vesting are typically treated as “short-term deferrals” exempt from §409A under §1.409A-1(b)(4). RSUs with additional deferral features can trigger §409A.

What is the statute of limitations on §409A issues?

The IRS generally has three years from the filing of the affected return. Returns for prior years are open if the failure is discovered in a current year where the amounts are still being reported.

Before you grant options, confirm the current 409A valuation and verify the strike-versus-FMV relationship. The 409A valuations article covers the company-side implications in more depth.