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Backdating Headache Looms: The IRS
By Tammy
Whitehouse — July 11, 2006
Companies mired in
investigations over backdated stock options
already worry about visits from the
Securities and Exchange Commission, the
Justice Department and plaintiff lawyers
representing angry shareholders.
Next up might be the most unwanted guest of
them all: the Internal Revenue Service.
Tax experts say the potential backlash for
companies caught up in questions about
backdating of stock options is sure to
include an examination of tax
records—whether companies have paid enough
and withheld enough tax, and whether
compensation classified as “deferred” or
“performance-based” for tax purposes does in
fact qualify for such treatment. All of that
is certain to cascade into earnings figures,
too.
Brown
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Alvin Brown, an independent tax attorney who
spent more than two decades inside the IRS,
said it is bound to be following the SEC’s
mushrooming investigation closely. “If they
see noncompliance, there’s a lot of risk
there, risk of fraud,” Brown says. “If it’s
come to the attention of the SEC, you can
bet the IRS will investigate too.”
 Representatives
of the IRS could not be reached to discuss
how much auditors may already be targeting
returns for a second look, as tax experts
warn is likely. (The IRS recently relocated
to temporary headquarters following
extensive flood damage only a few weeks ago,
disrupting normal communications, a
spokesman says.)
More than 50 companies have already
disclosed they are under investigation,
either by the SEC, the Justice Department or
internally, to determine if stock options
were illegally backdated to create an
immediate compensation windfall for holders.
Such a windfall, if not properly reported to
the IRS, could create numerous tax and
financial reporting problems for companies,
as well as for the executives who have
received backdated options—possibly even if
they haven’t yet exercised them.
The first and potentially most important
problem, says Edward Bright, a partner with
Thacher Proffitt & Wood, is that companies
that have used backdated stock options to
compensate any of the five highest-paid
executives may have unwittingly exceeded the
boundaries of an important tax deduction.
The tax code caps an employer’s deduction
for the five highest-paid officers at $1
million per person per year for public
companies. An exception exists, however, for
certain performance-based compensation,
including stock options when they are
granted with an exercise price that equals
or exceeds the fair market value of the
stock under a shareholder-approved option
plan.
Bright
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“If it’s determined that the grant date and
the option pricing date are different, and
the option price is lower than the grant
date price, you’ve lost your qualified
performance-based compensation exception,”
Bright says. “The employer would lose the
tax deduction on all of the option gain at
exercise, to the extent it exceeds $1
million for the top five officers.”
Companies may also trip over new rules
governing deferred compensation plans,
Bright says. According to a new section of
the Internal Revenue Code adopted in 2004,
Section 409A, deferred compensation plans
must meet a litany of requirements for the
related tax to be deferred.
“Backdated options designed to be incentive
stock options will lose that treatment,”
Bright says, in some cases creating an
immediate tax liability. The rules differ
depending on when the options vest and when
they are exercised.
For companies, the loss of “deferred”
treatment creates a responsibility to report
a tax due to the IRS, withhold the amount
from the holder of the option, and fork it
over to the IRS. For executives, it can mean
a tax bill is due even if the option hasn’t
been exercised, Bright says.
Potentially Substantial Sums
All that could add up to “potentially
substantial” sums of taxes that should be
withheld and sent to the IRS, Bright says,
“at times when the employer may or may not
have funds from which to withhold and the
option may not have been exercised. It kind
of paints an employer into a corner in terms
of how to handle the withholding and the
funding and remittance.”
Ouellette
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Robert Ouellette, a partner with
Schottenstein Zox & Dunn, says that
projecting the magnitude of tax-related
adjustments due to backdating is impossible
right now. “The adjustments may or may not
result in material tax implications,” he
says. “To the extent the company should have
paid more tax, they’ll need to amend
returns, pay the additional tax, interest
and potentially penalties.”
The bigger issue, Ouellette warns, is
whether backdating and tax corrections will
force companies to revise their financial
statements. “The restatement possibility is
what is really causing people to lose
sleep,” he says.
If companies lose their deduction because
compensation is no longer classified as
performance-based, Bright says, they might
also face a related adjustment to earnings
in prior periods.
“If their after-tax profits in prior years
have been computed taking into account
actual tax deductions on exercised options
or an estimate of the future value of the
tax deduction for unexercised options, their
earnings may have been overstated,” he
explains. “If the amount is significant
enough, they may be required to restate
earnings and may face investor claims.”
Tom Ochsenschlager, vice president with the
American Institute of Certified Public
Accountants, says tax issues will be a
concern primarily for companies whose stock
prices have appreciated. “Some companies
don’t care if they get a deduction,” he
says. “The tax issues are not necessarily a
factor if the stock is in a loss position.
They’ll still have payroll taxes, but that’s
small potatoes if the dollars aren’t
significant.”
Ouellette says companies that have been
caught up in backdating quagmires might
consider policies going forward that either
set option dates into the future (after the
board of directors approves an option
grant), or establishes an annual award date.
In either case, the grant date is not
influenced by the stock price on any given
date.
The lesson in all of this, Brown says, is
that backdating stock options is a dangerous
practice because of the regulatory scrutiny
it invites. “For companies that have already
done it,” he says, “they’re stuck in the
mud.”
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