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The Tax Prophet Newsletter   Issue # 48 April, 2007

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In This Issue:
Introduction
Example
Excessive Compensation
IRC Sec. 409A
Impact on ISOs
Exercise Date
Conclusion


Tax Consequences of
Stock Option Backdating


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.

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%!


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.

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.


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.



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All contents copyright 2007 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet is a registered trademark of Robert L. Sommers.