Tax Alert: IRS Confirms Taxes Owed For Backdated Stock Options (February 12, 2007)
In addition to paying standard taxes for the spread at exercise, if you exercised backdated stock options in 2006 you owe an additional 20% tax plus an interest tax (the IRS confirmed this in Announcement 2007-18, February 8, 2007). This is because backdated stock options are considered discounted options subject to extra tax as nonqualified deferred compensation under Section 409A of the tax code. Fortunately, in this announcement the IRS is now letting companies step forward in 2007 to pay this additional tax for rank-and-file employees (not for executives and other Section 16 insiders).
What Your Company Can Do To Help
The IRS requires your company to do the following for what it calls the Compliance Resolution Program:
- Companies must notify the IRS by February 28 of their intent to participate in the program.
- Affected employees must be told within 15 days of notifying the IRS (i.e., no later than March 15). By the same deadline, companies must notify the IRS again about the number of affected employees who have been contacted.
- The owed tax must be paid to the IRS by June 30. Additional interest will be owed if payments are received after April 17.
- Companies must confirm this payment to affected employees by July 15.
If your company fully complies with the IRS requirements, you will not be responsible for reporting or paying this additional tax. However, you will have additional compensation for 2007 because your company paid the tax for you. If your company does not participate in this IRS program, you will remain responsible for the 20% tax, plus an interest tax, on your 2006 tax return. These same rules apply to any backdated stock appreciation rights that were exercised in 2006.
Ask Your Company
Whether you knew about the backdating or not doesn't matter to the IRS, so ask your company about your grant. "Backdating" has become an umbrella term to encompass a wide range of stock grant practices, ranging from intentional manipulation of grant dates to technical violations and sloppy record-keeping. For example, to smooth out volatility in your company's stock price, your company may have set the exercise price of its stock grants at the lowest or average stock price during the month of the grant. If it is not permitted by your plan, this grant practice is considered backdating, making those grants discounted options and triggering extra tax.
Although your company's executives may not have engaged in nefarious backdating practices, you may not know whether your grant violated provisions of your stock plan, and whether its exercise price was lower than the market price on the true grant date. If your company did backdate or "misdate" the stock options you exercised in 2006, you need to know whether it intends to pay the tax for you, and whether in that case your company will gross up your 2007 income to cover the taxes for the additional compensation you will receive because it paid the 2006 tax.
For more details on how backdating impacts rank-and-file employees, see a related FAQ on myStockOptions.com.
Editorial Staff, myStockOptions.com
PS: With tax season in full swing, visit the special section Reporting Company Stock Sales in our Tax Center. This section includes illustrated examples of Schedule D for stock sales from NQSOs, ISOs, restricted stock/RSUs, ESPPs, and SARs.