What Backdating Means For You

Backdating and other option pricing practices can wreak havoc with your company's financials, but they can also mess up your personal tax return.
Helen ShawJuly 27, 2006

With dozens of firms now under investigation for backdating stock options, and one already facing civil and criminal charges, it’s clear that practices such as backdating carry a heavy corporate cost. Lost amid the swirl of media attention, however, is what backdating, or other practices, such as re-pricing, might mean if you happen to be one of the people who holds those options.

In much the same way that backdating is now prompting some companies to restate, corporate tinkering with options can damage the personal equivalent of a financial statement: your tax return.

Backdating — setting the grant date of an option earlier than the actual date it is granted, typically in order to take advantage of a lower stock prices — can create tax implications for the recipient, as well as the company. In some instances, it can result in underpayment of income at the ordinary income tax rate and overpayment of capital gains taxes, which carry different rates.

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For example, say a company board meets on January 30, 2003, when the company’s share price is $25, and decides to grant an employee a $20 stock option with a date of January 1, 2003, when the stock was $20. The board’s action makes the option a non-qualified stock option because the exercise price does not equal the fair market value of the stock at the date of the grant.

Non-qualified stock options require tax payment at the ordinary income rate for the difference between the grant price and the price at which the option is exercised (the gain). Non-qualified stock options do not meet the criteria to be treated as an incentive stock option, which has a tax benefit of having the options taxed at the lower capital gains tax rate.

That’s a problem if the employee who received the stock options is unaware that the board backdated the options and therefore, believes it is an incentive stock option.

Say, for example, the employee exercises the options on January 1, 2004 at the current share price of $30 and does not report the $10 gain as income. The $10 of ordinary income should have been reported and taxed at the ordinary income tax rate, notes Andrea Rattner, a tax partner at Proskauer Rose. The ordinary income tax rate at the federal level is about 30 percent (excluding situations involving the alternative minimum tax). As a result of the board’s backdating and the employee’s exercise of the options one year later, the employee underpaid ordinary income tax for 2004.

Say, further, that the employee sells the shares in January 2006, when the stock has reached $40. Believing the stock option to be a qualified incentive stock option, the employee would report capital gains and incorrectly pay the lower, 15 percent capital gains tax.

What would that mean if the IRS then audited the employee? If the employee does not amend his or her tax returns before an audit occurs, the employee would need to assert reasonable cause for the tax position. “They could show a W-2 form from the employer that does not show a gain from options,” says Rattner. “The person may have to pay back taxes and interest, but not necessarily penalties.”

Re-pricing of Options

Similarly, there are some personal tax implications for a stock option recipient when a company restates the value of the stock options, according to Mark Steber, vice president of tax resources at Jackson Hewitt Tax Services. Companies re-price stock options when they are “under water,” meaning that the current share price is worth less than the option execution price. While re-pricing doesn’t carry the same stigma that backdating can, it still has tax ramifications that may catch employees by surprise.

For example, an employee who receives a stock option at $10 per share hopes the stock price will increase, because the employee holds the option to buy the stock at the lower, $10 price. However, if the stock declines significantly from $10 to $2, for instance, the company could cancel the $10 stock options and issue new options at the lower fair market value.

The re-pricing of stock options does not have a tax implication for the recipient. However, “when the stock option is re-priced, the clock starts over,” said Steber, referring to the stock holding requirements. For statutory, qualified stock options, a stock must be held for at least two years from the date the option was granted and one year from the date the option was exercised to enjoy tax benefits from a long-term capital gain on the sale of the stock, notes Steber.

The regulators’ investigation of stock option backdating underscores the need to understand how stock options are granted, even if the paperwork looks clean. “Stock options are no longer compensation for the rich and famous,” said Steber. “They apply to a lot of people today and you have to understand the rules. The difference between the long-term capital gain tax rates and income tax rates is significant and needs to be understood.”