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Crackdown on Executive Stock Option Tax Shelters
Introduction   On February 22, 2005, IRS announced a settlement initiative for taxpayers using an illegal tax shelter, known as the "executive stock option scheme" in which employee stock options were transferred to entities controlled by family members and then sold for cash.

The Scheme   The scheme essentially involved the "sale" of employee stock options or restricted stock rights to an entity controlled by the taxpayer's family, in return for a promissory note payable in 30 years. The entity would then sell the stock for the fair market value and the tax on the transaction would be deferred until the promissory note became due 30 years later.

Note: This scheme could apply to a wide variety of appreciated assets and is not just limited to employee stock options or restricted stock.

Tax laws require executives to include in income and pay tax on the difference between the amount they pay for the stock and its value when the stock option is exercised. Corporations are entitled to a deduction for the compensation when the options are exercised.

Thus, instead of realizing compensation income taxed at ordinary income tax rates upon exercise of the employee stock option, taxes were deferred during the term of the promissory note.

Example   The basis structure of the tax shelter works like this: Taxpayer sells stock with a basis of $1.00 for $1,000,000 to an entity controlled by his family. If the taxpayer exercised the option, he would have received compensation income taxable at ordinary income rates.

The entity "buys" the stock by issuing a promissory note due and payable in 30 years. The entity then sells the stock for $1,000,000, thus avoiding gain on the transaction. The entity has use of the $1,000,000 in cash without the payment of tax for 30 years.

Note: The company also must defer the compensation deduction it receives when the taxpayer exercises his stock option for 30 years.

Corporate Involvement   IRS has identified at least 42 corporations that were involved in the scheme and had unreported income of more than $700 million.

According to IRS Commissioner, Mark Everson, "These transactions raise questions not only about compliance with the tax laws, but also, in some instances, about corporate governance and auditor independence. These deals were done for the personal benefit of executives, often at the expense of shareholders.

We believe a new climate under Sarbanes-Oxley, together with the tougher independence standards for auditors recently proposed by the Public Company Accounting Oversight Board make this sort of thing less likely going forward...however, we want to give executives and corporations a chance to clean up past transactions."

Settlement Deadline   Corporate executives who engaged in these transactions will have until May 23, 2005, to accept an IRS settlement offer. The offer also extends to corporations that issued the options to executives and directors as part of their compensation. IRS Announcement 2005-19 outlines the details of the settlement offer.

Under the terms of the settlement, taxpayers must report 100 percent of the compensation, pay interest and a 10 percent penalty. This is one-half of the maximum 20 percent applicable penalty. Employment taxes must also be paid.

The parties will be allowed to deduct their out of pocket transaction costs (typically promoter and professional fees) and the employer will be allowed a deduction for the compensation expense reported by the taxpayer.