By Dennis G. Raible, CPA
Regulators at the Securities and Exchange Commission (SEC) have been keeping watch the last several years for the backdating of stock options. Nationwide, more than 140 companies are under investigation by the SEC and the Department of Justice (DOJ) for possible exploitation of employee stock option rules.1
The SEC first became aware of stock option machinations from an academic study by Erik Lie. Lie, finance professor at the University of Iowa, uncovered option schemes in 2004. Lie concluded that some executives were retroactively choosing grant dates that generated larger profits. Soon after publication of the study, the U.S. Congress convened hearings on the matter. Backdating schemes may be more pervasive and widespread than imagined, involving dollar amounts well in excess of prior corporate scandals.
The SEC and DOJ civil and criminal investigations are proceeding, and the hunt for violators is intensifying. The IRS has also heightened its efforts to ferret out companies that backdated stock options. In June 2007, the IRS issued a directive to its revenue agents that will influence many corporate income tax examinations.2 The directive applies to examinations of corporations with assets in excess of $10 million, and designates backdated stock options as a "Tier 1" issue. As such, backdated options joins other dubious tax issues among the highest in strategic importance to tax regulators. Revenue agents assigned to the Large and Midsize Business Division are now required to follow the mandate, and inquire about backdated stock options in all corporate examinations.
This article focuses on the general treatment of stock options under federal income tax rules, tax issues involving backdated stock options, and strategies for complying with IRS inquiries during tax examinations.
Stock Options Overview
Stock options are common incentives for executives and other employees to work efficiently and effectively toward increasing the value of company stock. In the case of executives, stock options are often a significant portion of their overall compensation package. Stock options provide the right to purchase company stock on a future date at a preset price. In many instances, the set price is the market value on the day the option is issued. If the value of a company’s stock increases, an option holder can exercise the option to acquire stock at the lower, set price. If the stock options are retroactively dated, or backdated, to a date when the company’s stock price was even lower than it was on the actual grant date, then even more profit will result when the option is exercised.
In general, the accounting rules for stock-based compensation, including stock options, require companies to measure compensation cost based on the fair market value at the grant date. The costs are recognized as expense over the period during which the employee is required to provide service.3
There are two general types of compensation-related stock options listed in the Internal Revenue Code (IRC): qualified options and nonqualified options. Qualified options include incentive stock options and options provided under employee stock purchase plans. Any other options granted in connection with performance of services are nonqualified options.
Tax Issues and Backdated Stock Options
The IRS’s directive on backdated stock options instructs revenue agents to make factual determinations as to whether corporations under examination exhibit any of the three principal tax issue criteria associated with the illegal scheme.
Deductibility of Compensation Expense - In general, IRC §162(m) places an annual limit of $1 million per employee on a publicly traded company’s allowable deduction for compensation paid to the CEO and the four most-highly compensated officers. The regulations also state that "qualified performance-based compensation" is exempt from the $1 million limitation.4 Stock options issued to executives would qualify as performance-based compensation. To qualify for the exception, however, an option must have an exercise price that equals or exceeds the fair market value of the stock on the grant date. If a company played with the SEC rules and backdated executive options, then the exception contained in the regulations would not be met. Therefore, any compensation expense exceeding $1 million that includes misclassified stock options would not be an entirely allowable deduction, and would result in an additional tax assessment.
Qualification as ISO - Because incentive stock option (ISO) rules require an option’s exercise price to not be less than the fair market value of the stock at the time of grant,5 companies that backdate stock options to a lower exercise price, and then treat such options as ISOs for tax return purposes, may find that the options do not qualify as ISOs. The misclassified options could result in unexpected employer withholding, income, or employment tax obligations due on gains realized at the time the options were exercised.
Classification as Discounted Options - If an option was backdated to a lower discounted exercise price, then the "discounted option" may be subject to IRC §409A, which covers nonqualified deferred compensation.6 Taxable income is recognized under IRC §409A as discounted stock options become vested, regardless of whether the options have been exercised. Interestingly, the new law provides that in addition to the regular federal tax on the reclassified transaction, the taxable income will be subject to an additional 20 percent tax. Generally, §409A does not apply to options granted before Jan. 1, 2005, but it does apply to discounted options that were not earned and vested as of Dec. 31, 2004, and to discounted options that were materially modified after Oct. 3, 2004. Under the original transition rules, taxpayers had until Dec. 31, 2007, to amend options to avoid problems under §409A. In September 2007, the IRS announced that taxpayers will have until Dec. 31, 2008, to bring documents into compliance with the final nonqualified deferred compensation regulations. For options granted to certain executives subject to certain disclosure rules of the Securities Exchange Act of 1934, the transition rule was available only through Dec. 31, 2006.
The IRS directive requires agents to make a determination early on in corporate examinations as to whether a backdating of option exercise dates occurred. This ensures that sufficient time remains on the statutory period for assessment on employees’ individual tax returns. Even if a corporation did not participate in a misdating ploy, revenue agents will likely request and inspect copies of the individual tax returns of corporate officers to determine if stock options were treated properly. If necessary, examining agents will place the individual income tax returns under examination if they find that the treatment afforded options on the corporate tax return is inconsistent with reporting on the individual tax returns.
IRS Examination Strategies
The IRS mandates an information document request in all corporate examinations to determine whether backdated stock options are an issue. During a tax examination, respond to all IRS inquiries and furnish all documents sought by the revenue agent. If circumstances make it difficult for a taxpayer to comply with an agent’s requests in a full and timely fashion, most IRS examiners will work with taxpayer representatives to find alternative means to satisfy inquiries.
Companies under IRS examination that did not take part in misdating options could still receive an information document request seeking information to determine whether the company complied with the provisions in IRC §162(m). Corporate tax managers may have to produce executive compensation records, summaries of deferred compensation arrangements, contracts, compensation committee minutes, a description of records, the names of authorizing individuals, and methods used by executives to exercise stock options to satisfy an agent’s inquiry.
If an IRS examiner establishes that a company did misclassify stock options, the IRS will ask the taxpayer to provide various documents, including any SEC filings, internal audit reports, and independent investigative reports. Additionally, the IRS will inquire about the names and positions of executives, exercise prices, the backdate, grant and exercise dates, and the fair market value of underlying stock at key dates.
If a company receives notification that the IRS will be initiating an examination, yet an audit has not commenced, company officials may consider filing a statement with the assigned agent to disclose the existence of backdated stock options. A disclosure made before the corporate examination commences will minimize the likelihood of an accuracy-related penalty being assessed.7 Any resulting stock option tax issues can be rolled up in the agent’s final report.
If a company had backdated stock options in the past, but has not received official notification of an IRS examination, the best course of action to consider is reassessing the company’s tax obligations pertaining to misclassified options and, if necessary, file an amended tax return. The company also may want to consider any withholding and employment tax issues and, if appropriate, amend previously filed returns. Finally, if an appraisal of the corporation’s treatment of misdated options has an effect other than what was originally reported to recipients or employees, the company should notify the individuals and take all necessary actions to treat stock options properly. In some instances, employees may be required to file amended individual income tax returns to reflect the revised corporate classification of stock options.
If a revenue agent proposes an increase in corporate taxable income because backdated options were found, a taxpayer can expect the accuracy-related penalty to be assessed for that portion of an underpayment of tax, attributable to negligence or disregard of rules or regulations, or to any portion attributable to any substantial understatement of tax.8
Several media releases reported that some accounting and law firms reviewed and approved the decisions by compensation committees to backdate stock options.9 If a legal or accounting firm was the preparer of a corporate tax return that incorrectly reported misdated options, and circumstances indicate the preparer’s direct involvement in the decision to backdate the options, then an examining agent may consider a referral to the IRS Director of Practice.10 In such an instance, the return preparer would likely be subject to penalties under IRC §6694.11
By one estimate, more than 2,000 companies may have illegally backdated stock options.12 Most believe that unlawful backdating is now harder for companies to hide from the SEC. Much of the stock option backdating reported in the media appears to have been done prior to the 2002 enactment of the Sarbanes-Oxley Act, which requires grants of stock options to be reported within two days of grant. The two-day reporting requirement may make stock option backdating more difficult, but until the IRS rescinds its directive to Large and Midsize Business Division revenue agents, all corporate returns in the examination pipeline, as well as those scheduled to be examined in the near future, will continue to undergo IRS scrutiny.
1 "Stock Options Backdating," The Wall Street Journal chart of companies under scrutiny, http://online.wsj.com/public/resources/ documents/info-optionsscore06-full.html
2 Industry Director Directive on Backdated Stock Options, Directive #1. Walter L. Harris, director, field specialists, June 15, 2007.
3 Statement of Financial Accounting Standards No. 123(R) is effective for all companies for reporting periods after Dec. 31, 2005, and is a revision of FAS No. 123, Accounting for Stock-Based Compensation.
4 Treas. Reg. §1.162-27(e)(2)(vi)
5 IRC §422(b)(4)
6 The American Jobs Creation Act of 2004 added §409A to the IRC, which provides specific rules governing the tax treatment of nonqualified deferred compensation.
7 IRC §6662(b)(1) & (2) provides for an accuracy-related penalty attributable to the portion of any underpayment of tax attributable to negligence or disregard of rules or regulations, or any substantial understatement of income tax.
8 IRC §6662(b)(1) & (2)
9 "A Founder of Brooks Faces Charges Over Option," Ross Kerber, Boston Globe, July 27, 2007. "Backdating Conviction, A Big First," Eric Dash and Matt Richtel, The New York Times, Aug. 8, 2007.
10 Treasury Department Circular No. 230. If a practitioner is found to have violated any provision of the laws or regulations, they may be censured, suspended, or barred from practice before the IRS, including disbarment and suspension from practice as an attorney, certified public accountant, public accountant, or actuary.
11 IRC §6694(a) provides that income tax preparers shall pay penalties due to an understatement of liability due to unrealistic positions. IRC §6694(b) states that an income tax return preparer shall pay a penalty due to any understatement of liability due to willful or reckless conduct.
12 "Backdating of Executive Stock Option (ESO) Grants," Erik Lie, University of Iowa, www.biz.uiowa.edu/faculty/elie/backdating.htm.
Sidebar 1: Tax Implications of Options
Qualified Options
Corporations. No compensation expense deduction is generally allowable to a corporation with respect to the grant or exercise of qualified options.
Individual Recipients. An employee who receives an incentive stock option (ISO) recognizes income at the time stock is sold, not upon the grant or exercise of the stock option. If certain holding period rules are satisfied, gains on the shares acquired by exercising ISO are taxed as capital gains.*
Nonqualified Options
Corporations. Corporations are entitled to a deduction for compensation expense equal to the amount of ordinary income included in the gross income of the option recipient. A deduction is allowable to a corporation in the same taxable year the employee reports gross income.
Individual Recipients. A nonqualified stock option is taxed to the recipient when it is granted if the option has a readily ascertainable fair market value at that time. If the nonqualified option does not have a readily ascertainable value, then the exercise of the option, and not the grant of the option, is when the individual recognizes ordinary income.
* For purposes of the individual Alternative Minimum Tax, the transfer of stock on the exercise of an incentive stock option is treated as the transfer of stock pursuant to a nonqualified plan.
Sidebar 2: Recent Legislative Attempt to Control Options
This past September, U.S. Senator Carl Levin introduced legislation (S. 2116) that would require a company’s tax deductions for stock option compensation to equal the expense shown on its corporate financial reports filed with the SEC. The legislation would allow corporations to deduct stock option compensation in the same year it is recorded on company books, without waiting for the options to be exercised. The bill would also eliminate favored treatment of corporate executive stock options under IRC §162(m) by making executive stock option compensation deductions part of the existing $1 million limit on deductions that apply to other types of compensation paid to the CEO and the four most highly compensated officers of a publicly held corporation.
Dennis G. Raible, CPA, is a full-time visiting instructor in the accounting department of Saint Joseph’s University, and a member of Raible, Cornaglia, Wenstrom & Raible LLC in Cherry Hill, N.J. He also is recently retired from the IRS’s Large and Midsized Business Division. He can be reached at draible@sju.edu.
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