Tax consequences of backdating options
SEC, Department of Justice, and IRS Investigations/Proceedings.One of the most immediate issues facing many companies is the possibility of civil and criminal investigations initiated by the SEC, the Department of Justice, and/or the Internal Revenue Service.In connection with announcing the charges, SEC chairman Christopher Cox stated that “options backdating strikes at the heart of investor confidence in our capital markets [and] . An immediate risk facing some companies under investigation is the potential restatement of historical financial statements resulting from the failure to record compensation expense with any backdated options.Under the long-standing APB 25 accounting standards (which have been superseded by FAS 123R), compensation expense for option grants needed to be recorded only if the exercise price was less than the fair market value of the underlying stock at the date of the option grant – so-called discount options.The option-granting practices called into question by the regulators can be grouped into three general categories In view of the recent indictments, the intense media scrutiny of this issue, the inquiries now being routinely made by third parties, and the likelihood of auditor inquiries as part of 10-Q reviews and annual audits, we recommend that our clients educate themselves about the issues arising from the option grant investigations and review their past and current option grant practices.If a review reveals questionable options practices, the company board should consider what action to take, which in some instances may include director-supervised investigations.Therefore, all or part of the spread when the option is exercised may not be deductible, depending on the circumstances.
With these baseline considerations in mind, a list of possible implications of option-granting errors or irregularities follows.
As noted below, the failure to record income tax expense properly can also trigger a restatement. Stock options granted at a discount, whether due to backdating or otherwise, may result in tax issues.