As the news reports of back-dating of stock options continue unabated, companies who may be facing this problem should be aware of several potential Federal income tax issues.  There are three main areas of concern:  (i) violations of Section 409A of the Internal Revenue Code (the "Code"), (ii) failure for such options to qualify under the rules governing incentive stock options (ISOs), and (iii) exceeding the compensation deduction limits of Code Section 162(m).

Code Section 409A

Code Section 409A, which was adopted as part of the American Jobs Creation Act of 2004, enacted a major overhaul to the tax treatment of deferred compensation, including discount stock options (i.e. stock options with in-the-money exercise prices at their date of grant).  Stock options that have been back-dated in order to set an exercise price for the option that is lower than the fair market value of the stock on the actual date of grant will generally run afoul of Code Section 409A to the extent they were (i) granted after October 3, 2004, (ii) granted before October 4, 2004, but not vested as of December 31, 2004, or (iii) materially modified after October 3, 2004.[1] 

Tax Implications for the Option Recipient

As mentioned above, discount stock options are treated as a form of deferred compensation subject to Code Section 409A.  Section 409A requires that discount stock options have a fixed exercise date.  As a result, the holder of discount stock options that lack a fixed exercise date will be subject to a 20% penalty tax, in addition to regular income tax, plus possible interest and other penalties.  Current IRS guidance is not clear with respect to the amount that will be subject to the additional 20% penalty tax.  The amount subject to the additional 20% penalty tax could be any of the following:

• the difference between the exercise price and the fair market value of the stock subject to the option measured on the date of grant of the option;
• the difference between the exercise price and the fair market value of the stock subject to the option measured on the date the shares subject to the option vest; 
• the difference between the exercise price and the fair market value of the stock subject to the option measured on the date of exercise;
• the Black-Scholes value of the option measured on the date of grant of the option; or
• the Black-Scholes value of the option measured on the date the shares subject to the option vest.

It is also possible that the tax could be determined as of the date of grant and then additional tax imposed if the option value increased on the later vesting dates.  It is expected that the further guidance from the IRS will clarify the application of the 20% penalty tax to discount options.

Alternatives to Avoid the Section 409A Penalty Tax

One of the following approaches may be taken to avoid the adverse tax consequences occurring under Code Section 409A with respect to discount stock options that have not yet been exercised:  

(1) Increase the Exercise Price to FMV as of the Grant Date.  The exercise price of a discounted option can be increased by December 31, 2006 to equal (or exceed) the fair market value of the stock on the original grant date of the option.

If such an increase to the exercise price of a discounted option is made during 2006, the vested portion of the option may be exercised in 2006 so long as the option holder is not compensated for the exercise price increase, except as described in paragraph (2) below. 

Under most stock option agreements, the consent of the option holder will be required in order to increase the exercise price of the option.

(2) Compensate the Option Holder no later than December 31, 2006 for the Loss of the Discount.  If the exercise price of a discounted option is increased to the fair market value of the stock on the original grant date of the option (see paragraph (1) above), and the company decides to compensate the option holder in 2006 for the lost economic benefit resulting from such increase in the option’s exercise price, the cash or stock bonus must be subjected to a vesting schedule.  The cash or stock bonus could not become vested or payable during 2006.

Any cash payable pursuant to a vesting schedule would be subject to Section 409A unless the cash will be paid within two and one-half months after the calendar year in which the right to the cash payment vests.

(3) Elect a Fixed Exercise Date.  The 20% penalty tax under Code Section 409A may also be avoided if the option holder makes an election with respect to a future date on which the discount option will be exercised.  The fixed exercise date may be any date prior to expiration date of the applicable option.  The Proposed Regulations under Code Section 409A provide further that the fixed exercise date can be an entire calendar year.  If an individual elects a fixed calendar year in which to exercise a discount option, and then fails to exercise the option within such calendar year, the option holder will forfeit the option.  The fixed exercise date must be elected by the option holder no later than December 31, 2006.  Once a fixed exercise date is selected, the exercise date may not be changed.  If the fixed exercise date is selected during the 2006 calendar year, then the date selected must be a date after December 31, 2006.

(4) Discount Options Previously Exercised. To any extent a discount option has been exercised, there may not be a way avoid the penalties of Code 409A.  Future guidance may address this issue.

Incentive Stock Options

Incentive stock options ("ISOs") are required to be granted at an exercise price that is no less than the fair market value of the stock on the date of grant.  Therefore, a back-dated option that has been granted at a discount would violate one of the requirements that apply to ISOs.  If the requirements for an ISO have not been followed, the option will be treated under the tax rules as a non-qualified option.

Unlike ISOs which are not subject to income tax upon exercise , but only upon sale of the stock (except for the possible imposition of alternative minimum tax on the option spread at exercise), non-qualified options (including options that have failed to meet the requirements for ISOs) are subject to income tax and FICA withholding upon exercise.  As a result, a company that granted options at a discount that it believed were ISOs would ordinarily not have withheld income tax or FICA upon exercise of the option.  In that case, the company would be liable for the amount of the income tax and FICA that the company failed to withhold upon the exercise of the discount option that failed to meet the ISO requirements, in addition to interest and potential penalties.  Furthermore, any individual at the company who knowingly failed to withhold or pay income tax or FICA could be subject to personal liability for any such failure.  Depending on the number of affected options and the degree to which those options have been exercised, the liability for underpayment of employee withholding taxes could be substantial.

$1 Million Cap on Executive Compensation Under Code Section 162(m)

Under Code Section 162(m), a publicly-held corporation’s deduction for compensation paid to its chief executive officer or to one of its next four highest compensated officers is limited to $1 million per year, except for payments that qualify as commissions or as "performance-based" compensation. 

Ordinarily, stock options with an exercise price that is no less than the fair market value of the stock on the date of grant qualify as "performance-based" compensation under Code Section 162(m) that does not have to be taken into account in calculating whether an executive’s compensation has exceeded the $1 million compensation cap (assuming that the other requirements of 162(m) have been satisfied).

If a stock option has been back-dated, however, and as a result was granted with an exercise price that was less than the fair market value of the stock on the date of the actual grant, all of the income resulting from the exercise of the option (including the income recognized by the executive upon the exercise of a non-compliant incentive stock option) must be included for purposes of calculating whether the executive’s compensation exceeded the $1 million cap under Code Section 162(m). 

Consequently, a company that mistakenly believed that the stock option qualified for the performance-based exception under Code Section 162(m) may have deducted compensation paid to an executive in excess of $1 million in violation of Code Section 162(m).  In this case, the company may have to amend its income tax returns and could be subject to interest and penalties for any additional income tax it owes.  

1:  Aside from Code Section 409A, deeply discounted stock options, that is options that are granted with an exercise price that is less than 25% of fair market value of stock on the date of grant, may be treated by the IRS as restricted stock and taxable to the recipient to the extent vested.