Thursday, July 19, 2007

Tax Attorney: Backdated Stock Options

IRS Large and Mid-Size Business Division (LMSB) Industry Directive on Backdated Stock OptionsJuly 13, 2007Backdated stock options: Internal Revenue Service: Large and Mid-Size Business Division.Industry Director Directive


Director, Field SpecialistsSUBJECT: Tier I Issue -

Backdated Stock Options Directive # 1

The Backdated Stock Options Issue has been designated as an LMSB Tier I issue. Laura M. Prendergast, Deputy Director, Field Specialist has been named as Issue Owner Executive for this Tier I issue and will be responsible for ensuring that the issue is identified, developed and resolved in a consistent manner.Background/Strategic Importance: This issue was identified from media reports of a practice among some publicly traded companies to backdate stock option exercise prices to a date that provides a lower cost to acquire the underlying stock. This issue also exists for stock options described as discounted, mis-priced, mis-dated, or in-the-money, and may arise from clerical or other errors in addition to deliberate backdating. Over one hundred companies have confirmed backdating stock options in SEC filings and press releases. Many are the subject of investigations by the Securities and Exchange Commission (SEC) and/or the Department of Justice (DOJ).Stock options provide the right to purchase company stock on a future date at a set price (the exercise or strike price), and this right is normally exercised when the per share stock value is above the exercise price. Typically, when options are granted, the exercise price is set at the per share value on the grant date so that the option holder will profit from the option only if the stock price increases after the grant date. A backdated option provides the holder with a "built-in" profit on the option at the time of grant, which may result in the company having to accrue a charge against its earnings for financial accounting purposes.The practice of granting options with a discounted exercise price can have adverse tax consequences for the corporation issuing the option. Generally, Regulations section 1.162-27(e)(2)(vi) provides a "qualified performance based compensation" exception to the $1 million deduction limit for compensation attributable to option exercises if the option exercise price equals or exceeds the per share value on the grant date and certain other requirements are met. A failure to satisfy this requirement may cause compensation attributable to the option exercise to be subject to the $1 million deduction limit. Treasury IRC section 422. As a result, if a discounted option was intended to be an incentive stock option, the issuing corporation may have an obligation to withhold and pay income and employment taxes when the option is exercised and the individual taxpayer may owe additional taxes at the time of exercise. Second, options granted with a discounted exercise price may be subject to Section 409A generally does not apply to options granted before January 1, 2005, but it does apply to discounted options that were not earned and vested as of December 31, 2004, and to discounted options that were materially modified after October 3, 2004. Under the transition rules, taxpayers generally may amend options until December 31, 2007 to avoid problems under Notice 2005-1, 2005-2 I.R.B. 274, Q&A 4(d); Preamble to Proposed Regulations §1.409A, 70 Fed. Reg. 57956 (October 4, 2005); Notice 2006-100, 2006-51, IRB 1109; section 409A, the taxpayer would be required to include the deferred income under the option in taxable income, pay an additional 20% tax, and an additional tax calculated by reference to interest on the taxes the executive saved by not reporting the deferred income in earlier years.Issue Tracking: To better identify and analyze patterns, trends and the compliance impact of the Backdated Stock Options Issue, the following issue tracking procedures are now required on all open examinations in which this issue has been identified.

1. On ERCS, Tracking Code 0537 and/or Project Code 0537 is required to be manually input on all Backdated Stock Option issues at the examination level.

2. On IMS, examiners need to accurately identify the proper UIL code.
Ÿ UIL Codes used to track issue on IMS for cases input after April 1, 2007:
o 162.40-00 - Compensation Limitation due to the backdating or discounting of Stock options for covered employees (162(m))
o 422.06-00 - Conversion of incentive stock options to nonstatutory options due to backdating or discounting of the option
o 409A.01-00 - Conversion of incentive stock options to nonstatutory options due to backdating or discounting of exercised stock options.Planning and Examination Guidance: The determination as to the existence of any Backdated Stock Option Issues should be addressed at the beginning of each examination to ensure proper statute control procedures are in place to address this issue at the individual level.When addressing backdated stock options issues, examiners must follow the issued guidance including this Industry Directive. If assistance is needed, examiners should contact one of the Executive Compensation Technical Advisors. An information document request (IDR) should be issued early in the examination.Planning and Examination Risk Analysis: This is a Tier I Compliance Issue and therefore is a mandatory examination item for taxpayers with backdated stock option grant and/or exercise prices. The field should address issues including section 422, Section 162(m) Audit Technique GuideSection 409A -

Alvin S. Brown
Tax Attorney
703 425-1400

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