In an internal memorandum released July 17, the Internal Revenue Service (IRS) addresses how the agency is handling the treatment of backdated stock options under Section 162(m) of the Internal Revenue Code (IRC). The IRS memorandum identifies two primary categories of cases that it was handling—(i) those that were the result of intentional manipulation of the grant date using the benefit of “hindsight” and (ii) those that were the result of poor recordkeeping and documentation. As a result of backdating or misdating practices, the options were determined to have been granted with an exercise price below the fair market value on the grant date and, therefore, became “discounted options.” IRC Section 162(m) generally permits stock options that satisfy specified requirements to be treated as “qualified performance-based compensation” and, therefore, exempt from the $1 million limit on deductibility applicable to the compensation paid to certain key individuals at public companies. However, discounted stock options are not considered to be performance-based compensation because a portion of the compensation to be received upon exercise is not attributable to an increase in the company’s stock price.  

The memorandum states that the IRS will not treat backdated stock options as satisfying the performance-based compensation exception under IRC Section 162(m). In reaching this conclusion, the IRS focuses upon two key issues: (i) determining the date of grant of an option and (ii) whether an attempt to correct the exercise price after the date of grant will allow a backdated stock option to be treated as performance-based compensation. The IRS acknowledges that there is no clear guidance in the IRC Section 162(m) regulations for determining a stock option’s grant date. In the cases thus far addressed by the IRS, the agency found it appropriate to use the “measurement date” that is commonly used for financial accounting purposes. However, the memorandum also indicates that more stringent standards applicable under other federal tax provisions (e.g., IRC Sections 421 and 409A) could be applied to future backdating cases.  

In determining the grant date, the IRS indicates that it is looking for detailed, contemporaneous documentation of compensation committee actions in the form of minutes or unanimous written consent. The IRS’s basis for this position is that taxpayers are required to maintain adequate records to establish an entitlement to a tax deduction. Interestingly, this appears to be a new standard for purposes of Section 162(m) that the IRS may be applying with the benefit of hindsight. Nevertheless, compensation committees may want to pay particular attention to the documentation and substantiation process they use for their stock option grants.  

In examining different methods that have been employed by companies attempting to correct the backdating issue, the IRS takes a strong position that if an option is discounted on the grant date, it cannot later be changed to qualify as performance-based compensation. The two key correction methods identified were (i) “repricing” options through voluntary reimbursements made by the executives to the company, particularly used when the options had already been exercised, and (ii) voluntary side agreements between the company and the executives whereby the executives agreed to an increase in the exercise price, particularly used when the options had not yet been exercised. Regardless of the method used or the reasons for the modification, such as accounting or state law requirements or securities law considerations requiring reformation of the grant to comply with the governing equity plan document, the option will be treated as a discounted option for purposes of the deductibility exception under IRC Section 162(m).  

Read more.