United States: Tax Issues Arising Out of Stock Options Back-Dating Investigations

As the news reports of back-dating of stock options continue unabated, companies who may be facing this problem should be aware of several potential Federal income tax issues. There are three main areas of concern: (i) violations of Section 409A of the Internal Revenue Code (the "Code"), (ii) failure for such options to qualify under the rules governing incentive stock options (ISOs), and (iii) exceeding the compensation deduction limits of Code Section 162(m).

Code Section 409A

Code Section 409A, which was adopted as part of the American Jobs Creation Act of 2004, enacted a major overhaul to the tax treatment of deferred compensation, including discount stock options (i.e. stock options with in-the-money exercise prices at their date of grant). Stock options that have been back-dated in order to set an exercise price for the option that is lower than the fair market value of the stock on the actual date of grant will generally run afoul of Code Section 409A to the extent they were (i) granted after October 3, 2004, (ii) granted before October 4, 2004, but not vested as of December 31, 2004, or (iii) materially modified after October 3, 2004.1

Tax Implications for the Option Recipient

As mentioned above, discount stock options are treated as a form of deferred compensation subject to Code Section 409A. Section 409A requires that discount stock options have a fixed exercise date. As a result, the holder of discount stock options that lack a fixed exercise date will be subject to a 20% penalty tax, in addition to regular income tax, plus possible interest and other penalties. Current IRS guidance is not clear with respect to the amount that will be subject to the additional 20% penalty tax. The amount subject to the additional 20% penalty tax could be any of the following:

  • the difference between the exercise price and the fair market value of the stock subject to the option measured on the date of grant of the option;
  • the difference between the exercise price and the fair market value of the stock subject to the option measured on the date the shares subject to the option vest;
  • the difference between the exercise price and the fair market value of the stock subject to the option measured on the date of exercise;
  • the Black-Scholes value of the option measured on the date of grant of the option; or
  • the Black-Scholes value of the option measured on the date the shares subject to the option vest.

It is also possible that the tax could be determined as of the date of grant and then additional tax imposed if the option value increased on the later vesting dates. It is expected that the further guidance from the IRS will clarify the application of the 20% penalty tax to discount options.

Alternatives to Avoid the Section 409A Penalty Tax

One of the following approaches may be taken to avoid the adverse tax consequences occurring under Code Section 409A with respect to discount stock options that have not yet been exercised:

(1) Increase the Exercise Price to FMV as of the Grant Date. The exercise price of a discounted option can be increased by December 31, 2006 to equal (or exceed) the fair market value of the stock on the original grant date of the option.
If such an increase to the exercise price of a discounted option is made during 2006, the vested portion of the option may be exercised in 2006 so long as the option holder is not compensated for the exercise price increase, except as described in paragraph (2) below.
Under most stock option agreements, the consent of the option holder will be required in order to increase the exercise price of the option.
(2) Compensate the Option Holder no later than December 31, 2006 for the Loss of the Discount. If the exercise price of a discounted option is increased to the fair market value of the stock on the original grant date of the option (see paragraph (1) above), and the company decides to compensate the option holder in 2006 for the lost economic benefit resulting from such increase in the option’s exercise price, the cash or stock bonus must be subjected to a vesting schedule. The cash or stock bonus could not become vested or payable during 2006.
Any cash payable pursuant to a vesting schedule would be subject to Section 409A unless the cash will be paid within two and one-half months after the calendar year in which the right to the cash payment vests.
(3) Elect a Fixed Exercise Date. The 20% penalty tax under Code Section 409A may also be avoided if the option holder makes an election with respect to a future date on which the discount option will be exercised. The fixed exercise date may be any date prior to expiration date of the applicable option. The Proposed Regulations under Code Section 409A provide further that the fixed exercise date can be an entire calendar year. If an individual elects a fixed calendar year in which to exercise a discount option, and then fails to exercise the option within such calendar year, the option holder will forfeit the option. The fixed exercise date must be elected by the option holder no later than December 31, 2006. Once a fixed exercise date is selected, the exercise date may not be changed. If the fixed exercise date is selected during the 2006 calendar year, then the date selected must be a date after December 31, 2006.
(4) Discount Options Previously Exercised. To any extent a discount option has been exercised, there may not be a way avoid the penalties of Code 409A. Future guidance may address this issue.

Incentive Stock Options

Incentive stock options ("ISOs") are required to be granted at an exercise price that is no less than the fair market value of the stock on the date of grant. Therefore, a back-dated option that has been granted at a discount would violate one of the requirements that apply to ISOs. If the requirements for an ISO have not been followed, the option will be treated under the tax rules as a non-qualified option.

Unlike ISOs which are not subject to income tax upon exercise , but only upon sale of the stock (except for the possible imposition of alternative minimum tax on the option spread at exercise), non-qualified options (including options that have failed to meet the requirements for ISOs) are subject to income tax and FICA withholding upon exercise. As a result, a company that granted options at a discount that it believed were ISOs would ordinarily not have withheld income tax or FICA upon exercise of the option. In that case, the company would be liable for the amount of the income tax and FICA that the company failed to withhold upon the exercise of the discount option that failed to meet the ISO requirements, in addition to interest and potential penalties. Furthermore, any individual at the company who knowingly failed to withhold or pay income tax or FICA could be subject to personal liability for any such failure. Depending on the number of affected options and the degree to which those options have been exercised, the liability for underpayment of employee withholding taxes could be substantial.

$1 Million Cap on Executive Compensation Under Code Section 162(m)

Under Code Section 162(m), a publicly-held corporation’s deduction for compensation paid to its chief executive officer or to one of its next four highest compensated officers is limited to $1 million per year, except for payments that qualify as commissions or as "performance-based" compensation.

Ordinarily, stock options with an exercise price that is no less than the fair market value of the stock on the date of grant qualify as "performance-based" compensation under Code Section 162(m) that does not have to be taken into account in calculating whether an executive’s compensation has exceeded the $1 million compensation cap (assuming that the other requirements of 162(m) have been satisfied).

If a stock option has been back-dated, however, and as a result was granted with an exercise price that was less than the fair market value of the stock on the date of the actual grant, all of the income resulting from the exercise of the option (including the income recognized by the executive upon the exercise of a non-compliant incentive stock option) must be included for purposes of calculating whether the executive’s compensation exceeded the $1 million cap under Code Section 162(m).

Consequently, a company that mistakenly believed that the stock option qualified for the performance-based exception under Code Section 162(m) may have deducted compensation paid to an executive in excess of $1 million in violation of Code Section 162(m). In this case, the company may have to amend its income tax returns and could be subject to interest and penalties for any additional income tax it owes.

Footnotes:

1. Aside from Code Section 409A, deeply discounted stock options, that is options that are granted with an exercise price that is less than 25% of fair market value of stock on the date of grant, may be treated by the IRS as restricted stock and taxable to the recipient to the extent vested.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions