Taxes and the backdating of stock option exercise dates

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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.

This is a way of repricing options to make them valuable or more valuable when the option "strike price" (the fixed price at which the owner of the option can purchase stock) is fixed to the stock price at the date the option was granted.

In 1972, a new revision (APB 25) in accounting rules resulted in the ability of any company to avoid having to report executive incomes as an expense to their shareholders if the income resulted from an issuance of “at the money” stock options.

In essence, the revision enabled companies to increase executive compensation without informing their shareholders if the compensation was in the form of stock options contracts that would only become valuable if the underlying stock price were to increase at a later time.

The SEC’s opinions regarding backdating and fraud were primarily due to the various tax rules that apply when issuing “in the money” stock options vs.

the much different – and more financially beneficial – tax rules that apply when issuing “at the money” or "out of the money" stock options.

In our sample, 80% of CEO stock option grants are timed to occur on or before the split announcement date.

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