In its announcement Tuesday, the IRS said the
settlement offer also extends to corporations that issued
the options to executives and directors as part of their
compensation. To date, the tax officials have identified
42 corporations, many more executives and unreported
income of more than $700 million involved in the
transactions, according to the IRS news release.
According to the IRS, executives carrying out these transactions transferred stock options to family controlled partnerships and other related entities typically created for the sole purpose of receiving the options and avoiding taxes on compensation income normally taxed to the executive. The objective was to defer for up to 30 years taxes on the compensation and, in many cases, resulted in the corporation deferring a legitimate deduction for the same compensation, according to the government.
“These transactions raise questions not only about compliance with the tax laws, but also, in some instances, about corporate governance and auditor independence,” said IRS Commissioner Mark Everson, in the news release. “These deals were done for the personal benefit of executives, often at the expense of shareholders.”
Under the terms of the settlement, participating executives must report 100% of the compensation and must pay interest and a 10% penalty – one-half of the maximum 20% applicable penalty. Corporations and executives must also pay appropriate employment taxes. The parties will be allowed to deduct their out of pocket transaction costs, typically promoter and professional fees. Corporations will be allowed a deduction for the compensation expense reported by the executive. Where corporations have been identified, the IRS will contact senior management and ask that the matter be referred to the board of directors’ audit committee for appropriate review.
The IRS said that professional service firms and
financial institutions aggressively promoted these stock
option transactions in the late 1990s and early 2000s.
The IRS announcement said that the transaction first involves the transfer of stock options by the executive to a related entity, such as a family limited partnership, under terms of an agreement to defer payment to the executive. Next, the partnership exercises the options and sells the stock in the marketplace. The executive then takes the position that tax is not owed until the date of the deferred payment, typically 15 to 30 years later, although the executive has access to the partnership assets undiminished by taxes.
Tax laws require executives to include in income and pay tax on the difference between the amount they pay for the stock and its value when the option is exercised, the IRS warned. Corporations are entitled to a deduction for the compensation when the options are exercised.
In many cases examined by the IRS, the executive’s inappropriate attempt to defer tax on the compensation was paired by the corporation with also deferring an otherwise legitimate tax deduction for that compensation.
The IRS also issued a Fact Sheet describing the transaction fundamentals, the corporate governance issues and the tax and penalty costs to executives and companies who participate and those that don’t.
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