Can the IRS reject a 409A valuation report?

Yes, the IRS can challenge the fair market value behind your option grants. But “reject” is slightly misleading because the IRS does not review and approve 409A reports when they are issued.

Your board adopts an exercise price based on the facts available at the time. If the issue later appears in an examination, the question becomes whether the valuation method and the way it was applied were reasonable as of the grant date.

An independent appraisal can qualify for safe harbor when it is no more than 12 months old and reflects all material information. That creates a presumption that the value is reasonable. To rebut it, the IRS must show that the method or its application was grossly unreasonable.

Safe harbor can still fail. Red flags include:

• Ignoring a recent arm's-length financing or secondary transaction
• Using forecasts that conflict with the information management actually had
• Applying a generic discount without company-specific support
• Omitting material securities or rights from the capital structure
• Relying on a report after material facts changed or after 12 months passed
• Backdating the analysis to support grants already made

An audit-ready PDF is not magic. The contemporaneous facts, model, conclusion, board action, and grant records all have to tell the same story.

Read how 409A safe harbor works and what helps a valuation hold up in an audit. The audit section of the founder's guide explains what reviewers usually test.