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IRS SAYS BACKDATED OPTIONS ARE A 'TIER 1' EXAM ISSUE

July 12, 2007

The TaxProf reports:

The IRS yesterday made public a directive sent to agents in the field targeting transactions involving backdated stock options for the highest level of specialized enforcement within the Large and Mid-Size Business Division.

This can't be good news for the dozens of companies that appear to have backdated stock options to lower the exercise price and maximize income to executives.

DEDUCTION ISSUE

The directive focuses on three issues, but the issue likely to cause the most headaches is the likelihood of the loss of millions of dollars of executive comp deductions.

The tax law exempts stock options from the $1 million limit on executive compensation deductions. That allows the corporation can deduct the amount that the stock has appreciated from the time the stock option was awarded to the executive to the time the option is exercised and coverted into shares. For example, if an option is issued at $1 per share and the executive exercises it when the stock is trading at $10, he has $9 income and the corporation has a $9 deduction.

The exemption from the $1 million deduction lid only applies for option income resulting "solely" from appreciation from the grant date. If the options are backdated, it's hard to say that the option income is "solely" attributable to subsequent appreciation.

It seems unlikely that the government will consider all stock option backdating to be a securities law crime, and they may not succeed if they try.

The real breach of trust, it seems to me, is the willingness of executives to risk the loss of their companies' compensation deductions to squeeze a bit more out of their stock option programs. The $1 million compensation limit is bad tax policy, but that doesn't excuse executives who cause it to apply by backdating their own options

Now that the IRS is making backdating a priority, maybe they can engage Remy Welling as a consultant. Ms. Welling was fired for blowing the whistle when the IRS ignored option backdating on a corporate exam.

Link: Complete Tax Update coverage of backdating.

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