Backdated stock options are not qualified performance-based compensation under IRC §162(m), according to a memo from the IRS Chief Counsel, even if, before or after exercise, the executive reimburses the company for the discount or the option is “repriced” based on the fair market value on the actual date of grant. Further, for purposes of §162(m), the date of grant of a stock option is the date the granting corporation completes the action constituting an offer of sale to an individual of a certain number of shares of stock at a fixed price per share.
Under 162(m), the deductibility of compensation paid to senior corporate officers is limited to $1 million. However, 162(m) excludes performance-based compensation from the deduction limitation; and thus it is not taken into account in determining whether executive compensation exceeds $1 million.
The Chief Counsel cited the legislative history of 162(m), particularly the conference report, which stated that stock options granted with an exercise price that is less than the fair market value of the stock at the time of grant do not meet the requirements for performance-based compensation.
Section 162(m) and its regulations contain very specific requirements that must be met for compensation to qualify as performance-based compensation. One of the requirements is that the amount of compensation the employee could receive under an option must be based solely on an increase in the value of the stock after the date of grant or award. Whether a stock option is qualified performance-based compensation is determined at the time of grant. Subsequent actions such as a repayment by an employee cannot change the fact that the option was issued at a discount. Moreover, the grant and exercise of an option, and a later voluntary repayment of a compensatory amount, are separate transactions for federal tax purposes. Therefore, none of the compensation attributable to the discounted grants qualified as performance-based compensation under § 162(m)
Since the § 162(m) regulations do not provide a standard for determining the grant date, the Chief Counsel looked to the standards in similar tax code regs, as well as an SEC staff accounting letter. The standard for determining the grant date in the IRC regulations, based on the date the corporation completes the corporate action constituting an offer of sale of a certain number of shares of stock to a designated individual at a set price, is an appropriate standard for purposes of § 162(m). Regulations under § 409A were deemed particularly appropriate because of the similarity to 162(m).
The IRS Chief Counsel also relied on a letter of the SEC Chief Accountant, dated September 19, 2006, discussing backdating practices, and advising companies on determining the grant date for financial accounting purposes. Although SEC accounting standards are not controlling for federal tax purposes, noted the Chief Counsel, the letter provides useful background on the practices that led to backdated options and the standards companies used to determine grant dates for financial accounting purposes. The SEC official observed that the grant date for accounting purposes, termed the measurement date, is the date when the individual recipient, the number of shares, and the option price are first known.
The standards under the tax code regulations are more stringent than the accounting standards described in the SEC staff letter, noted the Chief Counsel, because the tax regulations require the completion of all required corporate granting actions. Nonetheless, although SEC accounting standards are not controlling for tax purposes, and are less stringent than existing tax standards, it is reasonable in the circumstances of these cases to use the measurement dates determined by the taxpayers for purposes of their accounting restatements as the grant dates for purposes of § 162(m).
The Chief Counsel described the SEC accounting standard as a reasonable one that is not open to the type of abuse and manipulation to which an ad hoc standard, developed after the fact to rationalize what had been done, is vulnerable. Accordingly, given the lack of specific guidance under § 162(m) for determining the date of grant and administrative concerns, the use of the accounting standard is reasonable. However, the IRS reserved the right, in future cases, to insist on determining grant dates strictly in accordance with the standards under the current § 421 and § 409A regulations.
The Chief Counsel rejected an argument for additional flexibility based upon the lack of an explicit standard for determining a grant date under § 162(m), adding that such
flexibility is ``singularly inappropriate here.’’ The taxpayers not only failed to abide by the longstanding standards for grant dates for statutory options, a closely analogous provision, said the IRS official, but their “flexible” interpretations of the grant date resulted in substantial additional compensation to the executives that was not likely to have been contemplated by the shareholders approving the plan. This casts doubt on the validity of the shareholder approval of the plan, which is also a requirement for treatment as qualified performance-based compensation.
Moreover, noted the Chief Counsel, these taxpayers failed to comply with applicable accounting standards and may have violated state law duties as well. Many state law corporate governance issues arise from option backdating, including the propriety of the executive compensation, whether the requisite disclosures relating to stock compensation was made, and whether shareholder approved plans have been complied with.