Option probes lead IRS to look into 40 firms

July 28, 2006|By NEW YORK TIMES NEWS SERVICE

The Internal Revenue Service is examining as many as 40 companies ensnared in stock options investigations to determine whether they owe millions of dollars in unpaid taxes.

In the past few weeks, the agency has directed its corporate auditors to start reviewing the tax returns of dozens of executives and companies, which may have improperly reported stock option grants. These preliminary investigations are expected to take months, but if there is early evidence of widespread tax trouble, IRS officials said they were prepared to step up their effort.

"Where there are indications of mischief, we want to now look at those cases and see if they complied with tax laws," said Bruce Ungar, the agency's deputy commissioner for large and midsize businesses. "It is possible that they are compliant, but the early indication is that there is a good likelihood there is some noncompliance."

"If this is a big problem, we will apply more resources," he added.

The IRS auditors are focusing on the potential tax obligations from backdated stock options that have been cashed out since 2002. Tax lawyers estimate the agency could reap hundreds of millions of dollars from civil penalties, unpaid taxes and interest payments if widespread wrongdoing is found.

The agency appears to be taking aim at companies that took improper tax deductions and at executives who received favorable tax treatment and might have misreported income. Rank-and-file employees who simply received potentially backdated stock options are not in the agency's crosshairs. "If you were involved in the mischief, you would want to be worried," Ungar said. "If you weren't involved in it, then you are not in the same situation."

The IRS follows several other federal agencies that have begun investigations into the myriad problems that arise from improperly reported or backdated stock option grants. The Securities and Exchange Commission is examining 80 companies for potential accounting and disclosure problems, and underlined that focus Wednesday with new rules on reporting executive compensation. The Justice Department has issued subpoenas to at least 35 companies and last week filed its first criminal charges, against two former executives of Brocade Communications.

The IRS is broadly focused on two areas that might have been abused: performance-based stock options for top executives and incentive-stock options frequently awarded to rank-and-file employees.

Performance-based stock options are generally granted to the five highest-paid executives and can often be worth millions of dollars when they are cashed out. As long as they are granted at the market price, companies can take a tax deduction on that full amount.

But backdating - effectively granting stock options with a discount - automatically disqualifies those options from receiving the tax break. Instead, a company's tax deduction would be capped at $1 million for the top five executives.

Improperly awarded incentive stock options could lead to more tax trouble. Backdating, which grants a discounted option, effectively voids the favorable tax treatment that incentive stock options provide employees, rendering those individual tax returns inaccurate.

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