Backdating Options Scandal Part II: Taxing Problems of Option-Exercise Timing

December 12, a WSJ article focused on another manipulation technique relating to the stock option backdating scandal:  avoiding paying income taxes.  See How Backdating Helped Executives Cut Their Taxes, Evidence Suggests Recipients Of Some Stock-Option Grants Manipulated Exercise Dates, By Mark Maremont and Charles Forelle.  The article suggests that an SEC economist, David Cicero, believes that there is “strong statistical evidence” that companies not only backdated stock options, but also manipulated the options’ exercise dates to avoid paying certain income taxes.  Generally under IRS rules, executives pay ordinary income tax [up to 35%], as well as payroll taxes, on any profit made when they exercise options and sell the resulting shares, i.e., the difference between the stock’s value as exercised and its strike price, the fixed purchase price set when the option was issued.  However, if the executives holds the shares, meaning they exercised their options but do not sell the shares for at least a year, they will pay only capital-gains tax [15%] on any profit. 

The WSJ article gives the following example:  Consider an executive who holds options on 100,000 shares with a strike price of $10. If he exercises and sells when the price is $20, he realizes $1 million in income and must pay $350,000 in income taxes.  If he instead can claim an exercise price of $16, he lowers his income tax to $210,000. If he then sells a year later and the stock is at the same price of $20, he pays $60,000 in capital-gains levies, for a total tax bite of $270,000. In other words, he has the same $1 million gain but saves $80,000 in taxes. The problem arises if the executive misrepresents when the exercise occurred to claim a lower exercise price. 

The article does acknowledge that without access to individual income tax returns it is difficult to assess which executives may have engaged in this conduct.  Also, the article does not assume that the practice was as wide-spread as option backdating.  Regardless of these limitations, however, the possibility that such conduct occurred should give executives and companies pause and provide yet another avenue to review when considering past practices.

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