How can unethical executives use options backdating to evade taxes?

By Albert Phung AAA
A:

The practice of options backdating has landed many companies into the hotseat. The SEC constantly investigates possible instances where high level executives have been issued options at a past point in time (or backdating) where the underlying stock's price was at a low.

This way the executive would be granted options with a very low strike price, so that they are quite often already deep in the money. However, it appears that some executives also may have used a different method of backdating options to "cheat" the IRS. The most common example of this is when executives sell the stock right after excercising in-the-money options in order to receive cash. By doing so, the executive will be required to pay taxes on the value between the option's strike price and price of the stock when it was excercised. Currently, this capital gains tax rate can be as high as 35%. The tax code lowers the capital gains tax rate if the executive does not sell the granted shares for a year (to around 15%). Therefore, if executives backdate the excercise date of an option to a day (from at least a year ago) when the stock's price was at a low, they can potentially cut the amount of taxes that they pay by as much as 50%.

For example, suppose that yesterday an executive backdated some options to when the underlying stock was $5.00 (the low for the last 1.5 years ). Thus, the strike price for the stock would also be $5.00. If stock's current price is $10.00 and 10,000 options are immediately excercised into shares and then sold, the executive will receive $50,000 of pre-tax profit. After accounting for the 35% captial gains taxes, net proceeds will be around $32,500.

Now consider what happens if the executive backdates both the date in which he receives the option and also the day that he excercises the option to when the stock was $5.00. Assuming that he sells the stock today for $10.00, he will now pay significantly less taxes since he has, at least on paper, "held" the shares for over a year before selling them. This time, he will only be paying 15% in capital gains taxes, which means his net proceeds post taxes will be $42,500. By backdating the excercise date as well, the executive managed to receive another $10,000.

Backdating excercise dates is considered to be an illegal act, as it is technically fraud.

For more information on options backdating, see What is options backdating?

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