Employee Stock Options: Tax Implications
Raquel Meyer Alexander, Mark Hirschey, and Susan Scholz
- Stock options have become an increasingly popular way to compensate
executives and employees, with Standard and Poor’s (S&P)
500 companies awarding more than $256 billion in stock options over
the past decade (BusinessWeek, September 11, 2006). Stock
options give employees the right to purchase employer stock at a
stated price at a future date. Because stock options are an employment
incentive tied to the company’s stock value, many believe
that options help align the employees’ interests with that
of the company. In addition, compensation through stock options
provides tax benefits to both the employer (through larger deductions)
and employees (through tax deferrals and lower tax rates).
the U.S. Department of Justice (DOJ), and the IRS are jointly
investigating instances of backdated stock options. Through backdating,
employers select grant dates that coincide with recent stock lows,
thereby increasing the value of options granted to employees.
Employers were actually issuing in-the-money options while leading
investors, regulators, and the IRS to believe that the options
were issued out-of-the money (or “underwater”) or
at-the-money. In addition to the joint DOJ and SEC investigation,
the IRS identified backdated stock options as a Tier 1 compliance
issue for its Large and Mid-Size Business Division (LMSB). IRS
auditors are now required to examine executive compensation at
all publicly traded companies.
stock options creates tax problems for corporations, their top
executives, and other employees. Backdating may lead to misreporting
corporate taxable income, misreporting employees’ wages,
and incorrectly withholding federal income taxes and Federal Insurance
Contributions Act (FICA) taxes. Because lower-level employees
may have unknowingly been affected by backdating, the IRS has
instituted a compliance resolution program for them. The program
does not extend to executives, other insiders, or the employer’s
corporate returns, however. Employers will owe back taxes, penalties,
and interest; executives may be subject to a 20% penalty and 8%
to 9% interest tax under IRC section 409A, as well as the ordinary
income and FICA taxes.
and employees should be aware of the tax treatment of backdated
stock options. Compensation deduction limitations under IRC section
162(m), nonqualified stock options, incentive stock options, and
the new penalties under IRC section 409A are discussed below.
The authors conclude with the latest wrinkles arising from stock
options, backdated exercise dates, and forward-dated grant dates.
For additional information on the financial-accounting, Sarbanes-Oxley
Act (SOX)–related, and legal implications of backdating,
Employee Stock Options: Accounting and Legal Implications.”
Expenses and IRC Section 162(m) Limitations
compensation expenses are generally deductible on corporate tax
returns; however, IRC section 162(m) limits compensation deductions
for five “covered” employees (the CEO and the next
four highest-paid officers) to $1 million each, annually. One
loophole of section 162(m) is that the limitation does not apply
to performance-based compensation. Stock option plans are generally
designed to be performance-based to escape the section 162(m)
limitation. Four criteria must be met to establish compensation
- A compensation
committee must prepare a written and objective plan based upon
future company performance no later than 90 days after service
begins. A plan can address any performance dimension, but continued
employment alone is insufficient evidence of performance criteria.
must approve the material terms of the performance plan.
- The compensation
committee must provide written certification that performance
goals are met prior to payment.
- The compensation
committee must include two or more outside directors.
conditions are required for stock options (and stock appreciation
rights) to qualify as performance-based compensation:
options must be granted by the compensation committee.
- The maximum
number of options awarded to any employee during a particular
time period must be stated in the compensation contract.
- The stock-option
exercise price must be equal to or greater than the stock’s
fair-market value at grant date.
any of these conditions would cause the stock options to be considered
non–performance-based compensation and, thus, IRC section
162(m) limitations would apply. Backdating grant dates violates
the first three conditions because the necessary documentation
and approvals were not complete. Backdating would violate the
last condition above for options issued in-the-money.
issuing backdated stock options would be subject to the annual
$1 million limit on tax-deductible compensation expenses for each
of their top five executives. To the extent that backdated stock
options were erroneously included as a deductible performance-based
compensation expense, corporate taxable income may be significantly
underreported. This would affect the corporate tax treatment only;
the executives’ personal tax liability would be unaffected.
The IRC section
162(m) limitation was established in 1993 to discourage excessive
executive compensation. Since 1993, the portion of executive compensation
attributable to stock options has increased dramatically. The
National Center for Employee Ownership reports that the number
of employees holding stock options was one million prior to the
passage of IRC section 162(m), but now exceeds 10 million (“Stock
Options: Who Gets What?” www.nceo.org/library/option_distribution.html).
Not surprisingly, many attribute the popularity of stock options
to the passage of section 162(m). Changes in the tax law may not
be the entire reason, however. In
1994, FASB backed off on a proposal to require stock option disclosures.
And in 1995, FASB was forced to rescind a decision that would
have required all stock options to be expensed after Congress
threatened to take over financial standards-setting if FASB required
the expensing of stock options. The continuing favorable accounting
treatment may have also contributed to the growth in stock options.
stock options. Stock option plans can generally
be classified into two categories: nonqualified stock options
(NSO) and incentive stock options (ISO). NSOs are available to
all employees and have fewer restrictions than ISOs. Because executives
primarily receive NSOs, most backdating investigations focus on
are generally nontaxable events. Upon exercise, an employee recognizes
ordinary income for the difference between the stock value and
the exercise price. This income is employment compensation, which
requires income and FICA tax withholding. An employer deducts
the corresponding compensation expense [subject to IRC section
162(m)], and remits FICA and Federal Unemployment Tax Act (FUTA)
taxes. After the NSO is exercised, the underlying stock becomes
the employee’s investment property with a basis equal to
the fair-market value (FMV) at exercise, and will be subject to
capital gain/loss rules. No corporate tax consequences exist when
employees dispose of stock acquired from NSOs.
Mary Jones receives an NSO to purchase Amex stock for $30,000.
At the option grant date, the stock’s FMV is $40,000. One
year later, Jones exercises the option when the FMV is $50,000.
Jones recognizes $20,000 of ordinary income when the option is
exercised and Amex records a compensation expense of $20,000.
Jones’ basis in Amex is $50,000.
and purely from a tax perspective, backdating increases corporate
deductions and the benefits that may be available as compared
to the deductions available at the actual grant date. The artificial
difference between the exercise price and the stock value from
backdating provides a larger—albeit fraudulent—employment
compensation deduction [subject to IRC section 162(m)]. Interestingly,
under current GAAP, the corporation’s book income may have
been bolstered by backdating (see the companion article for additional
A small subset
of NSOs with a “readily ascertainable fair market value”
are governed by alternative tax rules. Examples of such NSOs are
those composed of exchange-traded options. In these cases, employees
must recognize any discounted option value as ordinary income
upon grant, rather than upon exercise.
John Smith receives an NSO with a readily ascertainable FMV to
purchase Amex stock for $30,000. At the option grant date, the
FMV is $40,000. Smith recognizes $10,000 of ordinary income when
granted, and Amex records the corresponding $10,000 compensation
expense. Upon exercise, no additional income or deductions are
recognized. Smith’s basis in Amex is $40,000.
options with a readily ascertainable fair market value are backdated
to a date when the FMV was lower, employees would understate their
compensation in the year of grant. Withholdings, along with FICA
and FUTA tax liabilities, would be incorrect. For such NSOs, corporations
may again have forgone compensation deductions [subject to IRC
section 162(m) limitations] due to backdating. Upon the disposition
of the stock, the employee would have an incorrect basis, which
would allow an overstatement of income taxed at favorable capital
for determining whether NSOs have a readily ascertainable fair
market value can be more complex than determining the FMV or intrinsic
value under GAAP. While GAAP standards focus on whether an option
is in-, at-, or out-of-the-money, the tax standards related to
NSOs make no such distinction. (The IRC section 409A rules effective
for 2005 more closely mirror the GAAP standard.) Instead, Treasury
Regulations provide that an option has a readily ascertainable
FMV at grant if: 1) The option is actively traded; or 2) the option’s
FMV can be “measured with reasonable accuracy.” In
general, discounting alone is insufficient to provide options
a readily ascertainable fair-market value.
stock options. The attention of the DOJ, the SEC,
Congress, and the media has focused on executives’ backdating
activities with regard to NSOs. However, rank-and-file employees
may also be knowingly or unknowingly affected by backdated ISOs.
the most common form of qualified stock options. Because the value
of stock that can be purchased through ISOs is capped at $100,000
annually, ISOs are primarily used to compensate nonexecutive employees.
ISOs provide employees with favorable tax treatment because employees
do not recognize income on the grant date or on the exercise date
unless the employee breaks the ISO rules. When the strict rules
are broken, the ISO is taxed like an NSO. The ISO bargain element
is recognized only upon the sale of the stock. The gain is classified
as a capital gain, which typically has a lower tax rate than ordinary
income. [In the year of grant, the bargain element is an alternative
minimum tax (AMT) adjustment added to taxable income. Beginning
in the 2007 tax year, the AMT arising due to ISOs may qualify
for the newly enacted AMT refundable credit.] ISOs provide employers
no tax deduction.
ISO tax treatment, IRC section 422 requires that the exercise
price be equal to or greater than the underlying stock’s
FMV when granted. When backdating stock options creates a discount,
ISO treatment is lost and the options become NSOs. At the corporate
level, converting ISOs to NSOs has no tax effect at grant date.
Upon exercise, the corporation would receive a deduction related
to the NSO, as discussed above. Correcting a backdated ISO may
provide additional corporate tax deductions on amended returns.
affected by backdating would owe ordinary income taxes and FICA
in the year the option is exercised. In addition, the treatment
of the stock disposition would also be incorrect for backdated
Compensation and IRC Section 409A
409A dramatically changed the tax treatment of in-the-money stock
options. Section 409A requires that the FMV of all in-the-money
employee stock options be recognized as income at the time of
vesting, rather than upon exercise. For in-the-money stock options,
this generally means that affected employees must recognize ordinary
income for the difference between the stock price on the measurement
date and the option strike price as vesting occurs. Section 409A
will accelerate income recognition from the exercise date to the
vesting date. The readily ascertainable fair-market-value standard
for NSOs does not apply to the IRC section 409A rules.
the acceleration of income recognition, section 409A imposes an
additional 20% tax and an interest tax on all section 409A income.
The interest tax is calculated based upon the bargain element
(FMV minus option price) multiplied by the highest marginal rate,
35%. This amount is subject to the underpayment rate plus 1%.
The interest tax is 9% through March 31, 2007, and is compounded
daily until paid. Some companies have agreed to pay these taxes
on behalf of their affected employees. The payments are treated
as compensation income to the employee in the year paid.
409A does not affect options vested and earned before 2005. Options
issued in 2004 and exercised in 2006 or 2007 would, however, be
subject to these provisions. Also exempt are ISOs and all NSOs
granted with an exercise price that is less than the FMV of the
company’s underlying stock on grant date.
Forward-dating, or Misdating
firestorm was triggered by a study by Erik Lie (“On the
Timing of CEO Stock Option Awards,” Management Science,
May 2005) suggesting that as many as 2,000 companies may have
participated in grant-date backdating. A working paper by Dan
Dhaliwal, Merle Erickson, and Shane Heitzman (“Taxes and
the Backdating of Stock Option Exercise Dates,” University
of Arizona,ssrn.com/abstract=954974) found support for the theory
that exercise dates were also backdated to maximize the executives’
income while minimizing the executives’ taxes. Greg Geisler
(“Comments on Stock Option Exercise Date Manipulation,”
Tax Notes, January 15, 2007, p. 215–216) suggests
that executives may have forward-dated stock option exercise dates
to a date on which the stock’s price is lower, which also
has the effect of maximizing executives’ income while minimizing
taxes. All these manipulations have the same outcome: Insiders
benefit at the shareholders’ expense. It is likely that
the SEC and the IRS will expand their backdating investigations
into these other fraudulent executive compensation practices.
and other employees who already have exercised backdated options
should amend their personal income tax returns, and their employers
should remedy the backdating problem. For companies that show
good faith and correct errors before they are enforced by the
IRS, penalties and interest charges are typically reduced significantly.
Otherwise, taxpayers would likely be subject to civil penalties
related to accuracy (20% of tax underpayment) and fraud (75% of
tax underpayment) along with interest charges that run from the
original date of filing.
The IRS has
yet to rule on how it will apply penalties tied to backdated options
exercised in 2005 and earlier. Nevertheless, the IRS’s recent
aggressive position on the subject sends a clear message that
top executives and other employees must take quick, corrective
steps to avoid severe civil penalties and possible criminal prosecution.
The tax law
does not prohibit corporations from issuing stock options that
are in-the-money to reward valued employees. Backdating stock
options to avoid taxation, however, represents fraud. Executives
and board members should be aware that IRS penalties and criminal
indictments arise from fraudulent disclosures and reporting. Under
the new IRC section 409A provisions, backdated stock options became
even more expensive to employees. Executives and corporations
should carefully consider the tax implications of backdated stock
Meyer Alexander, PhD, is an assistant professor; Mark
Hirschey, PhD, is the Anderson W. Chandler Professor of
Business; and Susan Scholz, PhD, is an associate
professor and the Harper Faculty Fellow, all in the School of Business
of the University of Kansas, Lawrence, Kan.
Alexander’s article “Tax Shelters Under Attack”
(coauthored with Randall K. Hanson and James K. Smith, The
CPA Journal, August 2003) received an Honorable Mention in the
area of taxation in the Max Block Outstanding Article Award program