IRS Offers a Partial Backdating Solution

Generally speaking employees that exercise stock options owe income tax on the difference between the value of the option at the date of grant and exercise.   However, if an employee exercised a ‘backdated’ stock option in 2006 – and a number of such instances have come to light in recent months (see  Gradient Finds 532 Companies at Risk of Exercise Backdating ) – the IRS says that the employee may owe an additional 20% tax, plus an interest tax, under the Federal tax laws governing deferred compensation.

Backdating occurs when a company executive (generally speaking, with a complicit corporate executive or stock plan administrator) waits until it is time to report their trades for a month to identify the lowest price of the month to exercise their stock options; lowering their own taxes and potentially lowering the company’s tax deduction at the same time.   The practice is not inherently illegal, but must be disclosed to investors (see  SEC Approves Updated Executive Comp Disclosure Rules ).

The New Initiative

The new initiative, described in  Announcement 2007-18 , allows companies to step forward and pay the additional 20% tax and any interest tax that employees owe. However, the IRS notes that while the program will be available to help these employees who may be unaware that they held backdated options, “the opportunity will not be available for backdated options exercised by most corporate executives or other insiders.”

Bear in mind, however, that the taxes employers pay to relieve employee tax bills will be treated as additional 2007 compensation income for those employees in the 2007 tax year.  

Notification Deadlines

Employers that plan to participate in the program must notify the IRS of their intent by February 28, 2007 .   The employers, in turn, will be required to contact affected employees by March 15, 2007 to inform them that the employer has applied to participate in the Compliance Resolution Program.  Corporations that elect to participate and relieve their affected employees will be required to provide the specific details about the options, including specifics on the tax calculation that will enable the IRS to ensure the U.S. Treasury has received the full amount of taxes owed.   

“This shameful practice was widespread,” said IRS Commissioner Mark W. Everson. “We are allowing employers to satisfy the tax obligations of employees who did not knowingly participate in these schemes. This initiative does not extend to the executives and insiders who were the principal beneficiaries of the backdating schemes. We continue to pursue these cases and work closely with the Securities and Exchange Commission and the Justice Department as appropriate.”

This initiative does not involve or affect any other federal agency’s investigations or regulatory action, according to the IRS.