Compliance
What the IRS Asks For When It Examines Your 409A Valuation
The IRS publishes what its examiners look for in equity compensation audits. A defensible 409A is a dated file of documents that agree, not just a number.
By 409.AI Team - 2026-08-12
Most founders think of a 409A valuation as a number. The IRS thinks of it as a file.
That difference decides how an examination goes. When a revenue agent picks up equity compensation, the question isn't "does this company have a 409A." It's whether the company can produce a dated, internally consistent set of documents showing that the strike price on a specific grant matched fair market value on the day the board approved it. A valuation report that nobody can tie to a grant date is close to worthless in that conversation.
The IRS publishes what its own examiners are trained to look for. Almost nobody in startup land reads it.
The playbook is public
In June 2024, the IRS released [Publication 5992, the Equity (Stock)-Based Compensation Audit Technique Guide](https://www.irs.gov/pub/irs-pdf/p5992.pdf), its first refresh of that guide since 2015. It sits alongside [Publication 5528, the Nonqualified Deferred Compensation Audit Technique Guide](https://www.irs.gov/pub/irs-pdf/p5528.pdf), which covers the deferred compensation side of Section 409A. Both are listed in the IRS's public [Audit Techniques Guides index](https://www.irs.gov/businesses/small-businesses-self-employed/audit-techniques-guides-atgs).
Two things about these guides are worth getting straight before you rely on them.
First, they're internal training material, not law. Each carries a disclaimer saying it isn't an official pronouncement of the Service's position and can't be cited or relied on as such. You can't win an argument by quoting one back at an agent.
Second, that's exactly why they're useful. They tell you the order in which an examiner opens the file, what they compare against what, and which mismatches make them keep pulling. The equity compensation guide covers options, restricted stock, RSUs, stock appreciation rights, phantom stock, and ESPPs, and its documented examination techniques run to compensation committee minutes, plan documents, payroll records, and W-2s. The deferred compensation guide describes interviewing the people who actually run executive compensation, then working through deferral election forms and ledger accounts.
Notice what the equity guide leans on first: SEC filings. Items 10, 11 and 12 of a Form 10-K identify who received equity and under what plan. That's a public company starting point, and it's a tell. For a private startup there are no filings to cross-check against, so the examiner works from what you hand over. Your internal paper trail isn't one input among several. It's the whole record.
The only question the audit is really asking
Section 409A doesn't apply to most stock options, and that's the point. A stock right sits outside 409A if the exercise price is never less than the fair market value of the underlying stock on the date of grant, along with a few other conditions in the regulations. Grant at or above FMV and the option is exempt. Grant below it and the option becomes deferred compensation that almost certainly fails 409A, because an option can be exercised whenever the holder wants, which is the opposite of a fixed payment schedule.
So the examination collapses to one question with two halves. What was fair market value on the grant date, and what proof do you have?
If you're fuzzy on why that number differs from the headline price investors paid, [409A versus fair market value](https://409.ai/articles/409a-valuation-vs-fair-market-value) is the place to start.
Who has to prove what
Here's the part that decides most outcomes before anyone looks at your methodology.
Treasury Regulation [1.409A-1(b)(5)(iv)(B)](https://www.law.cornell.edu/cfr/text/26/1.409A-1) sets out valuation methods that are presumed reasonable. Use one, and the burden flips: the IRS can only dislodge your number by showing that the method or its application was "grossly unreasonable." That is a hard standard for an examiner to meet, and it's the reason the safe harbors exist.
The independent appraisal method is the common route. The valuation has to be performed by a qualified independent appraiser as of a date no more than 12 months before the grant, and the stock can't have materially changed in value since. The illiquid start-up method is the alternative: a written report, prepared by someone with significant knowledge, experience or training in comparable valuations, available to companies under 10 years old with no publicly traded stock, no change in control reasonably anticipated within 90 days, and no IPO expected within 180 days. Significant experience is generally read as at least five years in business valuation, financial accounting, investment banking, private equity, secured lending or a comparable field.
Skip the safe harbor and the presumption disappears. Now you're the one proving your number was reasonable, using the regulation's list of factors, against an agent who already thinks it was low. Companies rarely win that from a spreadsheet a board member built in an afternoon. Our walkthrough of [what's inside a 409A report](https://409.ai/articles/decoding-a-409a-valuation-report-walkthrough) covers what a defensible one contains.
Five documents, requested together
The mistake is treating the valuation report as the deliverable. It's one exhibit. In practice these get pulled as a set, and they have to agree with each other:
The written report itself, with its valuation date on the cover. The appraiser's qualifications and methodology, because "independent" and "qualified" are conditions of the safe harbor, not adjectives. The board minutes or written consents approving each grant, showing the date the board acted and the fair market value it adopted. The grant agreements, option plan and cap table, which have to reflect the same strike price and the same date. And the payroll and reporting trail, including any Section 409A income reported in box 12 of Form W-2 under Code Z, plus deferral election forms where an actual nonqualified plan is involved.
An examiner doesn't read these one at a time. They read them against each other, looking for dates that don't line up.
Where it usually breaks: a worked example
A company gets a 409A dated January 15, common stock at $1.10. The board grants 200,000 options on February 20 at $1.10. That's clean: inside 12 months, nothing material has changed.
A Series B closes on April 3 at a $60 million post-money valuation. In June, the board grants another 200,000 options and reuses the January report, because it's still less than 12 months old.
That second grant is the problem. The 12-month rule isn't the only condition. The stock also has to not have materially changed in value since the valuation date, and a priced round is the clearest material change there is. Say a fresh appraisal would have put common at $4.40. The spread is $3.30 a share on 200,000 options, or $660,000 of discount baked into a single grant.
The consequences land on the employee, not the company. Income is included as the options vest rather than when they're exercised, so 50,000 shares vesting in year one puts roughly $165,000 into that year's income. On top of ordinary tax comes the additional 20% tax under Section 409A, about $33,000 on that slice, plus premium interest running at one percentage point above the underpayment rate from the year the amount should have been included. It recurs every year the vested options stay unexercised, and later appreciation gets swept in too. A few states, California among them, add their own charge on top.
Nobody sets out to issue discounted options. They issue them by reusing a report through an event that moved the value. New rounds are the obvious trigger; [tender offers and secondary sales](https://409.ai/articles/tender-offers-secondary-sales-409a-valuation) do it just as effectively, because a real price paid by a real buyer for your common stock is evidence of what it's worth. Our guide to [how often you actually need a new 409A](https://409.ai/articles/409a-valuation-frequency-how-often-should-you-get-one) walks through the triggers.
The other classic failure is administrative. The board "approves" grants in a Slack thread in March and signs the written consent in September, backdated to March. Now the grant date on the paper doesn't match anything, and the one document that's supposed to fix the FMV to a moment in time is the document that looks manufactured. If your minutes are the weak link, the fix costs nothing and takes an afternoon.
If you find the problem first
Finding a bad grant during diligence is not the same as being caught with one. The IRS has correction programs: Notice 2008-113 for operational failures, which is what a discounted grant usually is, and Notice 2010-6 for document failures. Relief narrows the longer you wait, with the most generous treatment for failures corrected in the same taxable year and progressively less in the year after.
These are not self-serve. They have eligibility conditions, employee notification requirements and filing attachments, and getting the mechanics wrong can be worse than the original error. Bring in tax counsel. Our piece on [dealing with incorrect 409A valuations](https://409.ai/articles/dealing-with-incorrect-409a-valuations) covers how these get spotted, and the one on [missed deadlines and correction procedures](https://409.ai/articles/409a-valuation-deadline-correction-procedures) covers the timing side.
Worth saying plainly: none of this is tax advice for your situation. Section 409A is unforgiving in the details, and the facts that matter are the ones on your cap table.
What audit-ready actually means
Reframe the deliverable. You're not buying a number, you're building a file that a stranger can reconstruct years later without your help, at a point when the employees who received those grants may be looking at real money.
Test it yourself. Pick your three largest option grants from the last two years. For each one, find the board consent, the valuation report it relied on, and the grant agreement. Check that the strike price matches across all three, that the report predates the consent by less than 12 months, and that nothing material happened in between. If any of those takes more than ten minutes to locate, your paper trail has a hole in it, and an examiner will find it faster than you did.
Most companies pass that test. The ones that don't usually discover it in an acquirer's diligence, when the cost of fixing it comes out of the purchase price. For the fundamentals behind the file, start with [what a 409A valuation is](https://409.ai/articles/what-is-a-409a-valuation-a-comprehensive-guide) and [what happens inside the process](https://409.ai/articles/inside-the-409a-valuation-process).
If you want the safe harbor version, 409.ai's [409A valuation](https://409.ai/products/409a) is drafted and reviewed by valuation experts and delivered as a written report built to be handed to an examiner, an auditor or an acquirer without a covering explanation.