What Happens If You Grant Options Without a 409A

The uncomfortable truth: the penalties hit your employees

Here's what most founders don't realize until it's too late. When you grant stock options without a current 409A valuation — or with an expired one — the compliance risk doesn't land on the company. It lands on the people holding the options.

Under IRC §409A(a)(1)↗, employees holding options that were granted below fair market value face three penalties simultaneously:

Immediate taxation. All vested deferred compensation becomes taxable in the year the option vests — even though the employee hasn't exercised, sold, or received any cash.

20% additional federal penalty tax. Applied on top of the regular income tax. This is a punitive tax, not a withholding issue. It can't be waived, negotiated, or deferred.

Interest charges. Calculated from the original vesting date at the IRS underpayment rate. The longer the gap between vesting and discovery, the larger the interest.

In California, add another 5% state penalty under California Revenue and Taxation Code §17501↗.

Run the math on a real scenario. An early employee receives a $50,000 option grant at a strike price of $0.50/share. The correct FMV was $1.25/share — but there was no 409A to establish it. The mispriced amount is $37,500. Federal penalty tax: $7,500. State penalty (California): $1,875. Ordinary income tax on the vested amount. Interest charges from the vesting date. Total exposure can exceed $20,000 — on an option the employee hasn't exercised and may never exercise.

The employee did nothing wrong. They accepted an offer letter with equity. The compliance failure was the company's. The tax bill is the employee's.

How this actually gets discovered

The IRS doesn't typically show up at your door and audit your equity grants unprompted. The problem surfaces through your own business milestones — at the worst possible times.

During a fundraise. Series A or Series B investor counsel conducts equity diligence as a standard part of the process. They request the 409A report supporting each option grant. When there's no report — or a gap between the report date and the grant date — it gets flagged. At minimum, it delays the close. At worst, it triggers a purchase price adjustment or a requirement that the company remediate the affected grants before the investment closes.

During an audit. Your auditor needs the 409A to calculate stock-based compensation expense under FASB ASC 718↗. When the supporting valuation doesn't exist, the auditor can't rely on the grant prices. Additional audit procedures kick in. The timeline extends. The cost increases. If the auditor concludes the grants were materially mispriced, it may require a restatement of stock-based compensation expense.

During an M&A transaction. Acquirer's counsel performs a full equity compliance review. Every grant is traced back to a 409A. Every 409A is checked for timeliness, independence, and proper methodology. Gaps create contingent liabilities that the acquirer quantifies and either deducts from the purchase price or places in escrow. A company with 50 affected employees and $5M in aggregate option value during the gap period could face a $1.5M+ purchase price reduction. (See 5 Biggest 409A Mistakes Founders Make for more on how these situations compound.)

The pattern is consistent: the compliance gap exists silently for months or years, then surfaces at the moment when the financial and reputational stakes are highest.

The "nobody checks" myth

Some founders assume that early-stage option grants fly under the radar. No auditor. No sophisticated investors yet. No IRS scrutiny at this size.

This is technically true — today. But the grants don't go away. Every option you issue without a current 409A creates a permanent compliance record that follows the company forward. When you do raise a round with diligent counsel, or when you do get audited, or when you do negotiate an acquisition — the entire grant history gets reviewed. Not just the recent grants. All of them.

The IRS statute of limitations for 409A violations runs from the date of vesting, not the date of the grant. If an employee's options vest over four years, the exposure window extends for years beyond the original grant. The "nobody checks" assumption only holds until someone does — and by then, the correction is far more expensive than the original valuation would have been.

If you've already granted without a 409A: what to do right now

If options have already been granted without a current valuation, the situation is recoverable — but the sooner you act, the less painful the correction.

Step 1: Stop granting immediately. Do not issue any additional options until a current 409A is in place. Every new grant issued without a valuation adds to the exposure.

Step 2: Get a current 409A. Engage a qualified, independent appraiser to produce a valuation as of the current date. This re-establishes safe harbor going forward — every grant issued after this valuation (and within the 12-month window) is protected.

Step 3: Assess the prior grants. Work with your corporate counsel to determine whether correction is needed for grants issued during the gap. The IRS provides correction frameworks under Notice 2008-113↗ and Notice 2010-6↗ for 409A failures. The options range from repricing to additional reporting to employee tax gross-ups. The right remedy depends on the size of the gap between the granted strike price and the actual FMV during the gap period.

Step 4: Document everything. Whatever correction path you and your counsel choose, document it thoroughly. Future investors, auditors, and acquirers will ask about the gap. A documented remediation plan signals competent governance. An undocumented gap signals the opposite.

The critical insight: if the company's value hasn't materially changed during the gap period, the risk may be low — the granted strike price may still be defensible even without formal safe harbor protection. But "may be defensible" is a judgment call, not a guarantee. The entire purpose of a 409A is to replace judgment calls with documented, independent analysis that shifts the burden of proof to the IRS.

The cost of prevention vs. the cost of correction

A 409A valuation costs a fraction of what traditional firms charge. An annual plan with continuous coverage means as-needed refreshes throughout the year, so material events never leave you exposed. A retroactive correction program — engaging counsel, assessing each affected grant, filing corrective documentation, potentially grossing up affected employees — costs tens of thousands of dollars. A purchase price reduction in an M&A transaction costs hundreds of thousands.

The economics are unambiguous. Get the 409A before the first grant. Refresh it annually. Never let it lapse. (See What Happens to Your Options If Your 409A Lapses for the expiration scenario.)

Express 409A delivers audit-ready, signed valuations in 48 hours. If you've already granted options and need to get compliant fast, we can assess the situation and deliver the documentation you need. Every report includes lifetime audit support — if the IRS or an auditor ever questions a grant, we respond directly.