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IRS APPLIES DEFERRED COMP RULES FOR 2006 BACKDATED OPTIONS

February 09, 2007

The IRS yesterday set down a plan dealing with small fry in the options backdating scandal. The program "allows" companies to pay the 20% penalty tax for backdated options exercised in 2006 by employees who are not "insiders" for SEC disclosure purposes. The employees have to include the company payment in income.

The 20% penalty tax under the recently-enacted Section 409A applies to non-compliant deferred compensation plans. In this announcement the IRS lays down a marker: it says that 409A applies to backdated options.

There doesn't appear to be much of a concession here on the part of the IRS. It seems that the company always has the option to pay the employee's Section 409A penalty, as long as the payment is included in employee income. Tax Analysts reports ($link) that tax advisors for holders of backdated options aren't happy:

The IRS program departs significantly from the practitioners' recommendations and was quickly criticized. The group had suggested that employers be allowed to make a payment equal to 20 percent of the option discount at the time it was granted to remedy any backdated options, whether or not exercised. Instead, the IRS would force employers to make the 20 percent payment, plus interest, and then count the payments on behalf of their employees as compensation.

One practitioner, who asked to remain anonymous to protect IRS relationships, said the initiative offers no carrots for either companies or taxpayers. Companies are not currently liable for the tax and would be acting only to save thousands of potential taxpayers from having to fix the problem individually -- thus saving the IRS from the trouble of pursuing thousands of cases.

"I will not recommend that any of my clients take this offer," the practitioner said.

Unfortunately for this practitioner's clients, the IRS already has them over a barrel. The only thing that can keep the IRS from catching up with them not assigning enough agents assigned to the option backdating project. If I were an employee, I'd rather have my employer pay my 20% penalty, even if it increases my taxes, if I would otherwise have to pay the whole penalty myself. If I were the employer, though, I'd have another view entirely.

Link: Complete Tax Update backdated option coverage.

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