The executives responsible for backdating employee stock options are in big trouble, facing everything from shareholder lawsuits and tax audits to possible jail time. But now innocent employees who received certain kinds of options may get caught in the snare, too. They could owe unanticipated tax as well as interest and penalties.
It's not clear how many grants were backdated, or how many people have been swept into the mess. Still, some companies that have admitted to backdating, such as Brocade Communications (BRCD), Comverse Technology (CMVT), Mercury Interactive Corp., and Broadcom (BRCM), say they distributed tainted options to many levels of employees. Research firm Glass, Lewis & Co. says 138 businesses -- and counting -- are under internal or government investigation. "Quite a large number of people could be affected," says Michael Sirkin, head of the executive compensation practice at the Proskauer Rose law firm in New York.
Backdating creates potential tax problems for two groups: those with incentive stock options (ISOs) and those with any option -- ISO or nonqualified -- that vests after Dec. 31, 2004. ISOs are the more desirable perk. If holders exercise them and keep their shares at least a year, the profits are generally taxed at the 15% capital-gains rate. Better still, the tax is not due until the stock is sold. With nonqualified options, regular income tax of up to 35% is due when the option is exercised.
When backdated, ISOs generally are treated as nonqualified options. That's because the tax laws say ISOs must be issued at or above the stock's price on the grant date. Backdating happens when a company assigns a grant a bogus issue date, on which the stock sold at a lower price. That enhances option holders' opportunity for profit.
Those who have already exercised backdated ISOs may have to amend their tax returns. Aside from owing income tax -- rather than capital-gains tax -- on their profits, they may also be hit with interest for failing to pay tax when they exercised their shares, says S. James DiBernardo, a partner at Morgan, Lewis & Bockius in Palo Alto, Calif. Those ISO owners who sold their shares before qualifying for the capital-gains tax rate have already paid regular income tax but may still owe money: Backdating cancels an exemption ISOs enjoy from Social Security and Medicare taxes.
Backdated options that vest after Dec. 31, 2004, are another source of tax trouble. Options issued below the stock price on the grant date are subject to a new section of the tax code, known as 409 A. Tax kicks in when the options vest, rather than when they're exercised. Holders of vested, backdated options owe not just regular income tax but also a 20% penalty and possibly interest as well.
The Internal Revenue Service has yet to issue final regulations specifying how it will apply the penalty. Lawyers say the agency is unlikely to impose penalties on backdated options that were exercised in 2005. And it will allow employees to avoid problems if they take certain steps before the end of 2006 -- a deadline lawyers believe will be extended. One solution is for employees to identify, in writing, a specific year in which they will exercise their affected options, says DiBernardo. But if you promise to exercise in, say, 2007 and fail to do so, the options are forfeited.
Companies can also help employees avoid 409 A consequences. Brocade, a data storage networking concern, offered to exchange backdated options for cash or amended options plus cash. DiBernardo says he is working on similar arrangements that would reprice options for other outfits. Such plans may be the best that holders of tainted options can hope for.
By Anne Tergesen