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Next Backdating Headache Looms

Compliance Week

Next 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.

Alvin Brown

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."

Graphic of the letter CRepresentatives 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.

Edward Bright

"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."

Robert Ouellette

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."