The consequences of backdating executive stock options

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IRS intends the program to minimize compliance burdens on employees who are not corporate insiders while collecting the additional taxes due.Under the IRS initiative, employers will not report the additional taxes on the employee's W-2 and the employee will not be obligated to pay the additional taxes.Employers must submit a notice of intent to participate in the program by February 28, 2007.(Check to see whether the initiative has been extended).When an incentive stock option ("ISO") is issued under IRC Sec.Also, Mike has ordinary income on the date the options are exercised and could be subject to much harsher rules under IRC Sec.409A instead (discussed below). 409A, was enacted after the Enron scandal and targets deferred compensation schemes, including in-the-money options granted before October, 2004 and vesting after December 31, 2004. 409A applies, Mike is taxed on the spread (,000,000) at the time his stock options vest, not when he exercises them. 409A triggers a 20% excise tax penalty in addition to the immediate income tax, plus interest (currently about 9% per annum, plus a 1% per year interest penalty) and potentially an accuracy-related penalty of an additional 20%!In our example, Mike's options vested immediately, so he owed ,000,000 in ordinary income on the date he received the stock grant. Note: IRS has a new initiative (IR 2007-30) allowing employers to pay the additional taxes incurred by rank and file employees caused by the company's backdating of stock options during 2006.422, the employee does not pay taxes on the date of grant or exercise, although he is subject to the alternative minimum tax on the spread once the option is exercised.If the employee holds the stock for at least one year after the date of exercise and two years after the date of grant, he is entitled to the federal long-term capital gains tax rate of 15% on the spread.

Mike will have ,000,000 of ordinary income on the date of exercise (100,000 x the spread of /share).

Stock option backdating has erupted into a major corporate scandal, involving potentially hundreds of publicly-held companies, and may even ensnare Apple's icon, Steve Jobs.

While the focus of the Securities and Exchange Commission ("SEC") centers on improper accounting practices and disclosures, thereby violating securities laws, a major yet little explored consequence to the scandal involves potentially onerous taxes on those who received these options.

Some companies set the grant date at the lowest point within a 30-day window ending on the actual grant date, thereby virtually guaranteeing a below market price option.

In other situations, when a company believes its stock would dramatically increase in value based on a future event, options are granted just prior to the favorable event. Another type of backdating occurs when the company will announce bad news that could temporarily depress its stock price.

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