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