Adverse Tax Consequences of Option Backdating Becoming More Evident

Implications: Restatement charges for option backdating were initially perceived to be a largely noncash adjustment to earnings.  However, it is becoming apparent that the backdating may result in very significant tax liabilities, with a material impact on a company's cash flows.


Analysis: When companies backdate option grants to a lower exercise price, the result is often a larger taxable gain to the employee upon the exercise of the option.  In the case of "nonqualified stock options", the company receives a corresponding tax deduction for compensation expense.  Therefore, as a result of the backdating, the company has overstated its tax deduction.

There are other examples where a company has likely overstated its tax deductions as a result of the backdating.  For example, the tax code limits the tax deduction for nonperformance based compensation paid to certain highly compensated officers to $1,000,000.  To the extent that, as a result of the backdating, the options were "in the money" on the grant date, the compensation would no longer be considered performance based compensation and would be subject to the $1,000,000 limit.  Thus, to the extent that the employee already had nonperformance based compensation in excess of $1,000,000 (which is very likely), the company's tax deduction for the stock option compensation expense would be overstated.

There are other examples which represent situations where the company would have understated its payroll withholding tax obligations.  For example, "Incentive Stock Options" (i.e., qualified options), if backdated, would lose their preferential tax treatment and result in additional payroll tax liabilities to the company.

These are but three examples illustrating the potential for the imposition of large tax, interest and penalty assessments.  In addition to the adverse tax consequences faced by the company, the employees will also face additional tax liabilities.  To the extent that those employees were not responsible for the backdating, will the company have an obligation to make those employees whole (i.e., reimburse them for their incremental tax costs)?  This, of course, would further add to the company's outflow of cash.