Backdating Employee Stock Options: Tax Implications

By Raquel Meyer Alexander, Mark Hirschey, and Susan Scholz

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OCTOBER 2007 - 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 SEC, 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.

Backdating 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.

Both employers 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, see “Backdating Employee Stock Options: Accounting and Legal Implications.”

Compensation Expenses and IRC Section 162(m) Limitations

Employee 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 as performance-based:

  • 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.
  • Shareholders 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.

Three additional conditions are required for stock options (and stock appreciation rights) to qualify as performance-based compensation:

  • Stock 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.

Violating 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.

Employers 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?” 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

Nonqualified 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 NSOs.

NSO grants 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.

Example. 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.

Perversely, 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 details).

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.

Example. 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.

If discounted 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 gain rates.

The rules 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.

Incentive 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.

ISOs are 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.

To receive 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.

Employees 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 ISOs.

Deferred Compensation and IRC Section 409A

IRC section 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.

Along with 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.

IRC section 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.

Backdating, Forward-dating, or Misdating

The backdating 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, 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.

A Clear Message

Top executives 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 options.

Raquel 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.
Note: 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 for 2003.




















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