Back dating of stock

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While the focus of the Securities and Exchange Commission ("SEC") centers on improper accounting practices and disclosures, thereby violating securities laws, a major yet little explored consequence to the scandal involves potentially onerous taxes on those who received these options.Basically, a stock option is a contract right to purchase an amount of stock at a set price for a period of time.If the stock dropped below /share, the stock would be "under water"; therefore, the option would not be exercised, since the stock price is lower than the cost of exercising the option.Unlike the abusive corporate tax shelter ploys which often involve complex manipulation of a transaction to achieve tax results that are inconsistent with the economic reality of the deal, stock option backdating is a relatively crude device: A corporation merely changes the date that a stock option was actually granted to an earlier time when the stock price was lower.Because the on-going possibility of securities litigation, it is important to carefully manage all responses to the IRS audit so as to avoid any waiver of the attorney-client privilege or the attorney work product privilege. Fuller, Partner, Tax Group [email protected], 650.335.7205 Scott P.Spector, Partner, Corporate Group [email protected], 650.335.7251 Barton W. Bassett, Partner, Tax Group [email protected], 650.335.7908 ©2007 Fenwick & West LLP. This alert is intended by Fenwick & West LLP to summarize recent developments in the law.The consequence of a discounted stock option being subject to § 409A is that the option holder recognizes taxable income as the option vests (and thereafter), whether or not the option has been exercised (in other words, whether or not the option holder has actually obtained any value from the option).This additional taxable income will be subject to a 20% federal tax in addition to the regular tax rate, plus regular state income taxes (and possibly additional state penalty taxes). It is important to note that taxpayers generally have until December 31, 2007, to amend their discounted stock options to comply with § 409A (generally by increasing the exercise price to what was fair market value on the date the option was granted), but any pre-amendment exercise made in 2007, however, are subject to § 409A taxes.

As noted below, the directive also signals the IRS's intention to pursue the issue against individuals who received such options.

There are three principal tax issues associated with the backdating issue.

Each of these three issues is identified and discussed briefly in the Directive.

In particular, California takes the position that its tax code imposes a parallel tax to that imposed by § 409A, with the result that the income deemed recognized may be taxed at an aggregate rate (U. With respect to options granted to certain executives subject to the disclosure requirements of Section 16(a) of the Securities Exchange Act of 1934, the transition relief to cure disqualified options was only available through December 31, 2006.

The Directive includes a form IDR for use in any audit of backdated options.

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