IRS Gives Employees Relief for Backdated Options

The Internal Revenue Service announced a program aimed at providing relief for rank-and-file employees affected by their companies’ issuance of backdated and other mispriced stock options.  While the program will be available to help these employees who may be unaware that they held backdated options, it is not available for backdated options exercised by most executives or other insiders.

Many companies have backdated or mispriced options, either issued intentionally or through sloppy option issue practices.   Some companies failed to disclose the practice to shareholders, as required by securities laws, or forged documents to hide the practice. 

Under a 2004 law, the tax consequences associated with backdated and other mispriced stock options issued at a discount affect most recipients who exercised their options in 2006 or later.  The law does not affect options that were earned and vested before 2005, however.  If an employee exercised a backdated stock option after 2004, the employee may owe an additional 20-percent tax, plus an interest tax, on all the employee's vested options, even if the other options were not backdated. 

If the option had been properly priced, the employee normally would only have owed income tax on the difference between the value at the date of grant and exercise for a nonqualified option.  A qualified or incentive option issued with the proper exercise price is not taxed at either grant or exercise.  Where an option has been backdated, the employee remains obligated to pay the full amount of income tax due upon exercise, including any additional gain realized from backdating, whether or not the employee was aware of the backdating.

The new program, described in Announcement 2007-18, allows companies to pay the additional 20-percent tax and any interest tax that employees owe.  The program does not permit the company to pay the additional tax for stock options exercised by its top executives or other insiders.  The IRS pointed out that for these individuals, the IRS was continuing its enforcement investigations and coordinating activities with the SEC and Dept. of Justice, and the program had no effect on any SEC or DOJ investigations.

Employers must notify the IRS of their intent to participate by Feb. 28, 2007.  The employers, in turn, are required to contact affected employees by Mar. 15, 2007 to inform them that the employer has applied to participate in the Compliance Resolution Program.

Affected employees who have not previously taken corrective action on their own will remain liable for the additional 20 percent tax and the interest tax if their employers do not participate in the program or fail to abide fully by its terms.  Importantly, the IRS allows companies until December 31, 2007 to correct unexercised backdated options for non-executive employees.  Companies should take corrective steps now to avoid having the employee or employer face the additional tax that occurs upon exercising a backdated option.

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.   

The taxes the companies will pay to relieve employee tax bills will be treated as additional 2007 compensation income for those employees in the 2007 tax year.