Stock Option Backdating and Practices Conference

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Stock Option BackdatingandPractices Conference
Presented by Joseph T. Gulant, Esquire
September 21, 2006
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Option Backdating/Tax Considerations

• Employer Issues
• Potential Loss of Tax Deductions
• Failure to Withhold
• Income AND excise taxes
• Company/Responsible Officer Liability
• Incorrect W-2s
• Employee Issues
• Potential Underreporting of Income
• Section 409A excise taxes, interest and penalties

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Tax Consequences of Option Backdating

• Three primary issues for Employers
• Section 162(m)
• Incentive Stock Option (ISO) disqualification
• Section 409A

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Section 162(m) Implications

• 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)

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Types of Compensation

• Cash
• Stock options
• Corporations stock
• Other property paid in exchange for services

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When is Compensation 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

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Compensation Not Subject to Section 162(m)

• Commissions
• Performance based compensation
• Contributions to qualified retirement plans

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What is Performance Based 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

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Stock 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

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Section 162(m) Implications

• 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

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Incentive 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

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Incentive 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

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Incentive 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

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Section 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

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Section 409A Considerations

• 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.)

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Section 409A Considerations

• Timing of income inclusions is unclear
• May be taxed at issuance on spread, plus
  additional tax as options vest/or are exercised

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Section 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)

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Section 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