Introduction

Stock option backdating has erupted into a major corporate scandal, involving potentially hundreds of publicly-held companies, and may even ensnare Apple’s icon, Steve Jobs.

While the focus of the Securities and Exchange Commission (“SEC”) centers on improper accounting practices and disclosures, thereby violating securities laws, a major yet little explored consequence to the scandal involves potentially onerous taxes on those who received these options.

Stock Options

Basically, a stock option is a contract right to purchase an amount of stock at a set price for a period of time. For instance, if a stock was worth $10 a share, a stock option may grant an option holder the right to purchase $1,000 shares at $10 a share for a period of 5 years.

If the stock increased to $11 a share, the holder could exercise the option, pay $10/share to acquire the stock, then turn around and sell it for $11/share, earning $1/share in profit ($1,000 in total).

If the stock dropped below $10/share, the stock would be “under water”; therefore, the option would not be exercised, since the stock price is lower than the cost of exercising the option.

Variations of Backdating Options

Unlike the abusive corporate tax shelter ploys which often involve complex manipulation of a transaction to achieve tax results that are inconsistent with the economic reality of the deal, stock option backdating is a relatively crude device: A corporation merely changes the date that a stock option was actually granted to an earlier time when the stock price was lower.

Thus, the option becomes “in the money”, meaning there was a built-in profit on the underlying stock, on the grant date. In some cases, the date of exercise, rather than the date of grant, was changed to an earlier date to convert ordinary income into capital gains.

In general, companies engaging in a classic backdating transaction chose a date when the stock price was at a low point and chose that favorable date as the grant date. Some companies set the grant date at the lowest point within a 30-day window ending on the actual grant date, thereby virtually guaranteeing a below market price option.
In other situations, when a company believes its stock would dramatically increase in value based on a future event, options are granted just prior to the favorable event. This is called “spring-loading” the stock options.
Another type of backdating occurs when the company will announce bad news that could temporarily depress its stock price. The company waits until the stock drops, then issues the options at a low point in the stock’s price. This practice is called “bullet-dodging.”

Example

To illustrate the effect of backdating options, consider Mike who is offered a job as CEO of Acme Corporation, a public company, on September 1st, when Acme’s stock is worth $20/share.

As part of his compensation, Mike is offered a salary of $1,000,000 and 1,000,000 stock options that will vest immediately. The board of directors approves the compensation package on November 1st, when Acme’s stock is worth $30/share.

Note: The stock option grant date is usually the date on which the board approves the grant, thus, the option price on the grant date is now $30/share.

However, by backdating the grant date to the date when Mike was offered the stock options (September 1st), the option price is lowered to $20/share and Mike receives built-in gain on the “spread” between the exercise price and the fair market value of the stock of $10/share or $10,000,000.
Assuming Acme backdated the stock options to September 1st, what are the tax consequences to Mike and the company?

Excessive Compensation

IRC Sec. 162(m) states that a public corporation may claim a tax deduction for compensation paid to its CEO and its four other highest-paid executives, but only if strict requirements are met.

The salary paid cannot exceed $1,000,000, excluding performance-based compensation, such as stock options, provided the exercise price equals or exceeds the fair market value as of the date of grant.

In our example, IRC Sec. 162(m) has been violated since Mike received stock options at an exercise price of $20/share when Acme’s stock was worth $30/share. Therefore, Acme may not deduct Mike’s compensation in excess of the $1,000,000 salary, which could cause a restatement of earnings of $10,000,000.

Also, Mike has ordinary income on the date the options are exercised and could be subject to much harsher rules under IRC Sec.409A instead (discussed below).

IRC Sec. 409A

IRC Sec. 409A, was enacted after the Enron scandal and targets deferred compensation schemes, including in-the-money options granted before October, 2004 and vesting after December 31, 2004.

If IRC Sec. 409A applies, Mike is taxed on the spread ($10,000,000) at the time his stock options vest, not when he exercises them. In our example, Mike’s options vested immediately, so he owed $10,000,000 in ordinary income on the date he received the stock grant.

But that’s not all. Violating IRC Sec. 409A triggers a 20% excise tax penalty in addition to the immediate income tax, plus interest (currently about 9% per annum, plus a 1% per year interest penalty) and potentially an accuracy-related penalty of an additional 20%!

Note: IRS has a new initiative (IR 2007-30) allowing employers to pay the additional taxes incurred by rank and file employees caused by the company’s backdating of stock options during 2006.

IRS intends the program to minimize compliance burdens on employees who are not corporate insiders while collecting the additional taxes due.

Under the IRS initiative, employers will not report the additional taxes on the employee’s W-2 and the employee will not be obligated to pay the additional taxes. Employers must submit a notice of intent to participate in the program by February 28, 2007.(Check to see whether the initiative has been extended).

Impact on ISOs

When an incentive stock option (“ISO”) is issued under IRC Sec. 422, the employee does not pay taxes on the date of grant or exercise, although he is subject to the alternative minimum tax on the spread once the option is exercised.

If the employee holds the stock for at least one year after the date of exercise and two years after the date of grant, he is entitled to the federal long-term capital gains tax rate of 15% on the spread.

In-the-money options, however, violate the ISO rules under IRC Sec. 422, which means the stock options were taxable as ordinary income on the date of exercise and the employer is required to withhold income and payroll taxes on the income received by the employee, including applicable penalties for the failure to withhold.

Exercise Date

Another variation on the stock option backdating scheme has emerged. Instead of merely backdating the grant date to achieve a lower exercise price, the SEC has begun investigating whether executives have backdated the exercise date.
There are two potential tax advantages in this scheme: First, the earlier the date of exercise, the sooner the 12-month period will be reached for the favorable 15% long-term capital gains rate. In addition, by choosing an exercise date in which the stock had a low value, the executive converts potential ordinary income into capital gains. Here’s how:

Scenario One: Assume Mike receives 100,000 options on January 1, 2006 with an exercise price of $20/share and exercises them on July 1, 2006 when the stock is worth $50/share. Mike will have $3,000,000 of ordinary income on the date of exercise (100,000 x the spread of $30/share).

Scenario Two: If Acme backdates the date of exercise to January 1st when the stock was worth $25/share, Mike’s ordinary income is lowered to $500,000, because the spread is now only $5/share.

Assume that on January 2 of the following year, Acme’s stock is worth $55/share, and Mike sells the stock.

Scenario One: Mike will have paid taxes on $3,000,000 of ordinary income (taxed at a maximum of 35% federal) and will have $500,000 of short-term capital gains in the following year (taxed at ordinary income rates), since the stock rose $10/share since the date of exercise (100,000 x 5/share = $500,000).

Scenario Two: Mike will have $500,000 of ordinary income, but will receive $3,500,000 taxed at long-term capital gains rates, since he sold the stock more than 12 months from the date the options were granted.

The Lesson: Backdating the date of exercise, rather than the date of grant, provides the employee with a double tax benefit and does not run afoul of IRC Secs. 162(m), 409A, or the ISO rules under IRC Sec. 422, since these code provisions address in-the-money options on the date of grant, not exercise.

Conclusion

The stock option backdating scandal shows no signs of abating and the newly-discovered backdating of the date of exercise may give corporate American another black-eye.

Expect IRS to aggressively pursue this cheating since it amounts to tax fraud and evasion, pure and simple, and is relatively easy to prove.