409A Valuations: State-Tax Footnotes VCs Check in Texas

409A Valuations

Texas startups and founders issuing stock options must navigate 409A valuations to comply with federal tax rules, but the process also intersects with state tax considerations that venture capitalists (VCs) scrutinize closely. Inexperienced advisors may overlook footnotes in 409A reports highlighting Texas franchise tax implications, potentially raising red flags for investors or leading to compliance oversights.

Are you ensuring your 409A valuation footnotes address state-tax risks to satisfy VCs in 2025? At Kewal Krishan & Co, our expert tax advisors help Texas clients save an average of $50,000 annually, potentially totaling $775,000 over a decade through precise valuation and tax strategies. This blog examines 409A valuations under Internal Revenue Code (IRC) § 409A, focusing on state-tax footnotes VCs check in Texas under Texas Tax Code § 171, with detailed examples and compliance steps for 2025.

With Texas’s franchise tax on margin and no state income tax, these footnotes can reveal hidden liabilities or opportunities, influencing VC due diligence. Begin strengthening your valuation process today with insights from Our Tax Planning Services.

Understanding 409A Valuations and State-Tax Footnotes in Texas

A 409A valuation determines the fair market value (FMV) of a private company’s common stock for stock option grants, required under IRC § 409A to avoid deferred compensation penalties (up to 20% additional tax plus interest). Valuations must be performed by independent appraisers at least annually or after material events, using methods like income, market, or asset approaches.

In Texas, no state income tax means 409A primarily affects federal compliance, but VCs scrutinize report footnotes for state-tax risks, particularly Texas franchise tax (margin tax under Texas Tax Code § 171.002, 0.75% rate for most entities, no-tax-due threshold $2,470,000 in 2025). Footnotes often note:

• Nexus and Apportionment: If the company has Texas operations, franchise tax nexus (Texas Tax Code § 171.001); apportionment based on Texas receipts (§ 171.106), potentially affected by valuation if FMV influences revenue projections.
• Compensation Deductions: Option grants impact deductible compensation (TAC § 3.587), footnotes may highlight if valuation supports reasonable FMV for deductions.
• R&D Credit Offsets: OBBBA and Texas SB 2206 (June 22, 2025) enhance R&D franchise tax credits (Texas Tax Code § 171.651), footnotes may discuss if valuation incorporates R&D assets for credit eligibility.
• Penalties and Liabilities: Footnotes warn of underpayment risks if valuation understates revenue for margin (Texas Tax Code § 171.401, 5% penalty).

VCs check these for tax efficiency, as high franchise tax could reduce returns. Report valuations on Form W-2 for option exercises; franchise tax on Form 05-163 or Form 05-169. For details, see IRS Notice 2006-4 and Texas Comptroller’s Franchise Tax Rule.

Detailed Example: 409A Footnotes and VC Scrutiny

Consider a Texas fintech startup seeking VC funding, with a 409A valuation of $10 million common stock FMV in 2025. Revenue $3 million, 80% Texas-sourced.

• Valuation Report: FMV supports $0.10/share for options. Footnotes note: Franchise tax nexus due to Texas HQ (Texas Tax Code § 171.001), margin $2.1 million (70% revenue), apportioned $1.68 million (80%), tax $12,600 (0.75%). Highlights R&D credit eligibility ($5,000 offset if qualified under § 171.651).
• VC Check: Investors scrutinize footnote for tax drag; high apportionment signals risk if revenue grows, but credit offsets reassure. If footnote omits nexus, raises due diligence flags.
• Federal Impact: Options at FMV avoid 409A penalties (20% tax + interest); exercises reported on Form W-2.
• Savings: Proper footnote disclosure builds VC confidence; credit saves $5,000 franchise tax.

If valuation understates FMV, IRS penalties (IRC § 409A), and VCs may demand revaluation, delaying funding.

Alternative Scenario

For a startup below $2,470,000 revenue: Footnote notes no-tax-due threshold, reassuring VCs of low liability; but warns of future tax as revenue grows.

Step-by-Step Guide for Taxpayer Compliance

To prepare a 409A valuation with state-tax footnotes for VC review in Texas 2025, follow these steps:

1. Engage Independent Appraiser: Hire qualified valuer for FMV determination (IRC § 409A, safe harbor per Reg § 1.409A-1(b)(5)).
2. Gather Data: Provide financials, projections, and Texas operations details for nexus/apportionment (Texas Tax Code § 171.106).
3. Incorporate Footnotes: Ensure report includes Texas franchise tax exposure, R&D credits, and risks (TAC § 3.587, Texas Tax Code § 171.651).
4. Review for VC Due Diligence: Confirm footnotes address tax efficiency, penalties, and offsets.
5. Grant Options: Issue at FMV to avoid penalties; document in board minutes.
6. File Franchise Tax: Report on Form 05-163/05-169 by May 15, 2026, including R&D credit if applicable.
7. Report Federal: Include option exercises on Form W-2; no direct 409A filing but retain valuation for audits.
8. Retain Records: Keep valuation report and financials for three years (IRC § 6001).

For VC-backed startups, explore Our Business Tax Services.

Common Pitfalls to Avoid

• Ignoring Nexus: Omit franchise tax footnote, misleading VCs on liabilities (Texas Tax Code § 171.001).
• Valuation Method Errors: Non-safe-harbor methods risk IRS challenge (Reg § 1.409A-1(b)(5)).
• Credit Ineligibility: Claim R&D without qualifying activities, triggering disallowance (Texas Tax Code § 171.651).
• Underreporting Margin: Exclude revenue sources, incurring penalties (Texas Tax Code § 171.401).

Why Work with a Tax Expert?

409A valuations in Texas require integrating IRC § 409A with Texas franchise tax rules, where incomplete footnotes can deter VCs or lead to penalties. Generic advisors may neglect state-specific risks or OBBBA credits, costing thousands. Kewal Krishan & Co specializes in Texas valuation compliance, ensuring VC-ready reports with accurate footnotes. Our expertise mitigates pitfalls, as demonstrated in Our Tax Litigation Services.

Conclusion

409A valuations in Texas for 2025 must include state-tax footnotes on franchise tax nexus, margin calculations, and credits to satisfy VC due diligence, enhancing funding prospects in a no-income-tax state. Proper preparation and disclosure are key—consult experts now to craft audit-ready valuations.

Call to Action

Schedule a consultation with Anshul Goyal, CPA EA FCA, a licensed U.S. CPA and Enrolled Agent, admitted to practice before the IRS, specializing in tax litigation and cross-border tax for U.S. businesses and Indians in the U.S. Contact us at Kewal Krishan & Co to prepare your 409A valuation.

About Our CPA

Anshul Goyal, CPA EA FCA, is a licensed U.S. CPA and Enrolled Agent, representing clients in IRS tax litigation and assisting with cross-border tax compliance for U.S. businesses and Indians in the U.S. His expertise ensures tailored strategies that maximize savings and ensure compliance.

Disclaimer

This blog provides general information for educational purposes only and does not constitute tax, legal, or financial advice. Tax laws change frequently, and individual circumstances vary. Consult a qualified tax professional before making decisions. The author and firm disclaim liability for actions taken based on this content.

FAQs

1. What is a 409A valuation?

FMV appraisal for stock options to comply with IRC § 409A.

2. Why do VCs check footnotes?

To assess state-tax risks like Texas franchise tax liability (Texas Tax Code § 171.002).

3. What’s the 2025 no-tax-due threshold?

$2,470,000 revenue (Texas Tax Code § 171.002).

4. How do R&D credits work?

Offset franchise tax for qualifying activities (Texas Tax Code § 171.651).

5. When is franchise tax due?

May 15, 2026, for 2025 reports.