Practice Limited to Taxation


Posted on 07/15/2008



The stock options backdating scandal largely involves stock options granted before August 29, 2002, the date on which Section 403 of the Sarbanes Oxley Act (SOX) became effective.  Before SOX Section 403 stock option grants had to be reported to the SEC within 45 days after the grant.  This delayed reporting calendar allowed officers and directors to look back over the 45 day period and select the lowest stock price day as the reported grant date. The earlier date was used even thought the grant process was incomplete until the grant date was selected.  The scandal was uncovered by the Wall Street Journal article, “The Perfect Payday” published March 18, 2006.  The article revealed that companies were uncanny in always selecting the lowest price day in the 45 day period.  The odds of that most advantageous selection being fortuitous are astronomical.  In fact, SEC investigations have revealed that the best scenario date selections were not by chance.  It is now estimated that as many as 2,000 companies may have a backdating problem.  While SOX Section 403 changes the reporting date to 2 days following the event and eliminates the ability to look back to a great extent, the implication for both companies and stock option grantees from prior backdated stock options is huge.


To date over 160 companies have been or are being investigated.  Several securities fraud indictments have been reported.  One tax indictment involves charges that the exercise dates of stock options were backdated as well as the grant dates.

 The implications of the stock option backdating scandal will flow over into the divorce court.  The parties or courts in settled or decided cases may have used false assumptions about company and stock option value and tax consequences of exercise events; and, most certainly will not have considered potential civil and criminal exposure to fines and disgorgement  and imprisonment, respectively.  In pending cases the parties will have to consider the possible impact of these matters with regard to stock options granted before the effective date of SOX Section 403.







There are both non-tax and tax consequences that flow from a finding that stock options have been backdated:


1.    The stock option will be in the money when it is issued.  For example, the grant date is stated to be June 1 when the traded price was $20 per share but the grant date was actually July 1 when the traded price was $30 per share.  The option price is actually $10 below the fair market value (FMV) of the stock on the true date of grant.

2.    The issuance of the stock option at a discount will likely violate the terms of the company stock option plan which typically require shareholder approval to amend.

3.    Disclosures to the shareholders and SEC that all stock options were issued at FMV will have been false.

4.    Certifications under SOX included in quarterly SEC filings by the company CFO and CEO will have been false.

5.    Company earnings will have been substantially overstated.

6.    Company share value based on earnings will have been inflated.

7.    SEC administrative action against the company and its officers and directions will be forthcoming if not already under way.

8.    Department of Justice criminal indictment may be forthcoming.

9.    Shareholder derivative or class actions may be expected.

10.                       Exchanges may delist the company.



1.    The IRS will be calling.  The agency has stated in hearings before Congress that it will examine companies and executives involved in stock options backdating and has reportedly already examined over 40 companies.

2.    Non-qualified stock option – Grant date backdated – tax consequences remain the same under pre-section 409A rules.  Beginning in 2005 in the money value of unexercised options may have to be included in W-2 under Section 409A subject to further guidance from IRS

a.    Potential 20% tax penalty on grantee.

b.    Potential loss of current compensation deduction to employer under Section 162(m).

c.     Potential under-withholding

3.    Non-qualified stock option – exercise date backdate – unreported income and conversion of capital gain into ordinary income.

4.    Incentive stock options – backdated grant date

a.    Price discount converts option into a non-qualified stock option with results as above.

5.    Criminal tax charges may follow for executives and directors involved in the scheme regarding alleged tax evasion, filing a false return, etc.


Steinberg Talks Tax™ Volume 2, No. 2, July, 2008. © 2008 by Robert S. Steinberg, All rights reserved.


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