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?

RELATED FAQS
  1. What is options backdating?

    Options backdating occurs when companies grant options to their executives that correspond to a day where there was a significantly ... Read Answer >>
  2. What is the difference between in the money and out of the money?

    Learn about how the difference between in the money and out of the money options is determined by the relationship between ... Read Answer >>
  3. How does the term 'in the money' describe the moneyness of an option?

    Find out what in the money means about the moneyness of call or put options and what it indicates about the relationship ... Read Answer >>
  4. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  5. Why are options very active when they are at the money?

    Stock options, whether they are put or call options, can become very active when they are at the money. In the money options ... Read Answer >>
Related Articles
  1. Trading

    The Dangers Of Options Backdating

    This form of executive compensation can pose serious risks for investors.
  2. Investing

    Backdating: Insight Into A Scandal

    Any time money is involved, a scandal is sure to follow. Find out how a university study blew the cover off this one.
  3. Small Business

    A Close-Up On Gross Ups

    Learn about this hidden perk and why it's often bad news for investors.
  4. Trading

    Should Employees Be Compensated With Stock Options?

    Learn the good, the bad and the ugly sides of this type of payout.
  5. Trading

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  6. Trading

    A Newbie's Guide To Reading An Options Chain

    Learning to understand the language of options chains will help you become a more informed trader.
  7. Trading

    The Benefits And Value Of Stock Options

    The pros and cons of corporate stock options have been debated since the incentive was created. Learn more about stock option basics and the cost of stock options.
  8. Investing

    Why Options Trading Is Not for the Faint of Heart

    Trading options is not easy and should only be done under the guidance of a professional.
  9. Trading

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
RELATED TERMS
  1. Backdating

    Dating any document by a date earlier than the one on which the ...
  2. Exercise Backdating

    A practice where option holders fraudulently claim to have exercised ...
  3. Backdated Liability Insurance

    Liability insurance that provides coverage for a claim that occurred ...
  4. Options Backdating

    The process of granting an option that is dated prior to the ...
  5. Option Schedule

    A list of options grants to an employee or employees of a company ...
  6. In The Money

    1. For a call option, when the option's strike price is below ...
Hot Definitions
  1. Contango

    A situation where the futures price of a commodity is above the expected future spot price. Contango refers to a situation ...
  2. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  3. Acid-Test Ratio

    A stringent indicator that indicates whether a firm has sufficient short-term assets to cover its immediate liabilities. ...
  4. Floating Exchange Rate

    A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that ...
  5. Taxes

    An involuntary fee levied on corporations or individuals that is enforced by a level of government in order to finance government ...
  6. Impaired Asset

    A company's asset that is worth less on the market than the value listed on the company's balance sheet. This will result ...
Trading Center