IRS to audit recipients of options

Backdating to maximize gain on stock may bring tax penalty

Stock options may bring tax audit

September 06, 2006|By San Jose Mercury News

SAN JOSE, Calif. -- While much of the attention in the stock option scandal has focused on which top executives could face jail time, more bosses could face a more mundane fate: a tax audit.

It lacks the drama of the government "Untouchables" angling to toss Al Capone into the clink on tax charges, but Internal Revenue Service auditors have teamed with the Securities and Exchange Commission to determine whether companies and their highest-ranking executives dodged billions of dollars in taxes because of misdated options.

Tax headaches could even await some lower-ranking employees and executives running startups that are still privately held.

The IRS audit team, announced in late July, initially focused on 30 public companies that were not identified. With at least 119 U.S. companies entangled in federal or internal investigations - and more disclosing problems every week - it's easy for auditors to identify potential targets.

"I will say we read the papers," said Bruce Ungar, an IRS deputy commissioner whose division focuses on business.

Auditors will zero in on three questions, IRS and tax experts say:

Did corporations deduct too much compensation? Corporations generally are limited to deducting no more than $1 million of compensation paid to a top executive.

Options are exempt from the limit if they're priced according to the rules, but companies could lose millions of dollars of write-offs if they gave executives an immediate paper profit by backdating the options.

Did the options qualify for tax breaks? Properly priced incentive stock options feature tax benefits that can enable recipients to slash their tax bills. But those benefits would be canceled if the options were backdated. In those cases, corporations and individuals could owe Social Security, Medicare and other payroll taxes when the options were exercised.

Are the options subject to new tax rules and penalties? A new law aimed at curbing deferred compensation imposes taxes on the paper profit on options when they "vest" - even if recipients leave the options in a drawer rather than cash them in. Also, the options could trigger a 20 percent penalty and interest.

Ungar of the IRS said corporations and top executives will be the primary targets because "it does seem there was abuse and mischief in those areas."

Practical reasons also make corporations the obvious first target, experts say. For starters, the corporate tax deductions could be worth tens of millions of dollars.

If it turns out incentive stock options were tainted, then corporations were responsible for withholding the proper amount of taxes when employees cashed in options.

"The deep pockets are at the company level," said Cindy V. Schlaefer, a law partner with Pillsbury Winthrop Shaw Pittman in Palo Alto, Calif.

Executives make obvious targets if they engineered and benefited from the options abuses.

That doesn't mean rank-and-file workers can assume they're off the hook if they underpaid their taxes but played no role in rigging the pricings.

The IRS "cannot walk away from that," Ungar said. "But where there might have been unwitting victims - we'll call them victims by mischief - there may still be tax adjustments. ... We would take into account their role, but at the end of the day that would have to be dealt with."

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