ASC 718 vs IRC 409a – What Are The Differences?

IRC 409A is a tax regulation, published and enforced by the IRS. ASC 718 (formerly FAS 123R) is an accounting standard published by the FASB and overseen by the public accounting firms (and the SEC, in the case of publicly traded companies).

IRC 409A establishes a requirement for the issuance of stock options to employees and others -- a requirement that must be met or the option recipients will be subject to severe tax penalties. This basic requirement is that stock options must be priced at or above the fair market value of the underlying security (that is, the security into which the options are exercisable, usually common stock). IRC 409A then defines methods by which a private company can show that it appropriately determined fair market value (basically, either a "do it yourself" approach for young companies or an independent appraisal for most other companies).

ASC 718 lays out the methodology by which the compensation expense for stock options is calculated under GAAP for inclusion in financial statements. ASC 718 utilizes a slightly different standard from IRC 409A (the fair value of the underlying common stock rather than the fair market value), but that difference are immaterial for most purposes.

Because there has been little enforcement activity by the IRS around IRC 409A, but most companies have had their ASC 718 work scrutinized by an audit firm, the focus of attention in stock option pricing has shifted from tax compliance to GAAP compliance.

The AICPA has published a practice aid (Valuation of Privately-Held-Company Equity Securities Issued as Compensation) that is used by audit firms in their review of valuation reports used to price stock options. Most high quality valuation reports follow this guidance to ensure GAAP compliance -- and tax compliance follows almost automatically in most cases.