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Stock Option Stock Option BackdatingBackdating
andandPractices ConferencePractices Conference
Presented by:Presented by:
Joseph T. Gulant, Esquire Joseph T. Gulant, Esquire September 21, 2006September 21, 2006
Option Backdating/Tax Option Backdating/Tax ConsiderationsConsiderations
Employer Issues Potential Loss of Tax Deductions Failure to Withhold
Income AND excise taxes Company/Responsible Officer Liability
Incorrect W-2sEmployee Issues Potential Underreporting of Income Section 409A excise taxes, interest and
penalties
Tax Consequences of Tax Consequences of Option BackdatingOption Backdating
Three primary issues for Employers: Section 162(m) Incentive Stock Option (“ISO”)
disqualification Section 409A
Section 162(m) Section 162(m) ImplicationsImplications
Rule prohibits corporate tax deductions for certain compensation in excess of $1 million paid to certain “highly compensated” individuals
Employees subject to rules include CEO and next 4 highest compensated officers whose compensation is required to be reported to S.E.C. (as determined at the close of a calendar year)
Types of CompensationTypes of Compensation
Cash Stock options Corporation’s stock Other property paid in exchange for
services
When is Compensation When is Compensation Recognized?Recognized?
Non-Qualified Stock Option: Spread taken into account at exercise
Incentive Stock Option: Spread taken into account if “disqualified disposition”
Deferred Compensation: Generally when paid
Compensation Compensation NotNot Subject to Subject to Section 162(m)Section 162(m)
Commissions “Performance based compensation” Contributions to qualified retirement
plans
What is Performance Based What is Performance Based Compensation?Compensation?
Compensation payable solely on account of attaining one or more pre-established, non-discretionary, objective, performance goals
Performance goals determined by a compensation committee if the board of directors comprised solely of two or more “outside directors”
Material terms under which compensation is to be paid are disclosed to shareholders and approved by separate majority vote
Before compensation is paid, compensation committee certifies that performance goals were satisfied
Stock Options and SARsStock Options and SARs
Grant or award must be made by the compensation committee
Plan must state the maximum number of shares with respect to which options or rights may be granted during a specified period to any employee
Amount of compensation based solely on an increase in the value of the stock after the date of grant
Section 162(m) Section 162(m) ImplicationsImplications
“Performance based compensation” includes stock options issued at an exercise price equal to or greater than FMV of stock on date of grant
Option backdating at price below FMV on “real” grant date makes stock ineligible for performance based compensation exception to Section 162(m)
Loss of tax benefits from compensation deductions could lead to significant tax adjustments for affected corporations
Incentive Stock OptionsIncentive Stock Options
If qualified, Incentive Stock Options (ISO) (unlike Nonqualified Stock Options) are not taxable upon exercise
Holder of ISO can obtain long-term capital gains treatment provided special ISO plan qualification rules are met, and stock not disposed of by holder until at least one year after exercise, and two years after grant
Incentive Stock OptionsIncentive Stock Options
A stock option CANNOT qualify as an ISO unless (among other items) the options are issued at an exercise price not less than the FMV of the underlying stock on the “real” date of grant
Backdated option would likely have an exercise price below the FMV of the stock on the date of “real grant”, and therefore option would be converted into a nonqualified stock option
Incentive Stock OptionsIncentive Stock Options
If the stock is a nonqualified stock option, the spread on the date of exercise (i.e., the excess of the FMV on the date of the exercise over the exercise price of the option) is compensation to employee and deductible (subject to Section 162(m) among other items) to corporation
If company and employee treated the option as an ISO, employee will have underreported income at exercise of option, company would have failed to satisfy its Income Tax (and FICA, FUTA) withholding obligations, and company will have not taken eligible income tax deductions, subject to Section 162(m) considerations
Section 409A ImplicationsSection 409A Implications
Which discounted options are subject to Section 409A? Options granted after 10/3/04 Options granted before 10/3/04 and
vesting after 10/3/04 Options materially modified after
10/3/04
Section 409A Section 409A ConsiderationsConsiderations
If Section 409A is applicable, then: Discounted options will be subject to a special
20% Excise Tax, and possibly interest and penalties
Calculation of 20% Excise Tax on discounted options is unclear, may be: Excess of FMV over exercise price determined at date
of grant Excess of FMV over exercise price on date of exercise Excess of FMV over exercise price on date options
vest Some other valuation approach (Blank-Scholes, etc.)
Section 409A Section 409A ConsiderationsConsiderations
Timing of income inclusions is unclear May be taxed at issuance on spread,
plus additional tax as options vest/or are exercised
Section 409A MitigationSection 409A Mitigation
If discounted options subject to Section 409A have been issued, then: Prior to 12/31/06, unexercised option
price can be raised to FMV of stock (with agreement of holder) on original grant date to avoid Section 409A Company can pay employee bonus to
compensate employee for loss of benefit (if vests in whole or part in subsequent year and is paid w/in 2 ½ months after calendar year of vesting)
Section 409A MitigationSection 409A Mitigation
If discounted options subject to Section 409A have been issued, then: Prior to 12/31/06, holder can elect fixed
date of exercise prior to end of term of option. Fixed date of exercise can be an entire
calendar year
If option has already been exercised, it may be too late to mitigate