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.
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."
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?
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).