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?

RELATED FAQS

  1. Are stock dividends and stock splits taxed?

    Understand different tax implications for dividend payments and stock splits; main factors include the type of account and ...
  2. Can I still set up an SEP if one of my employees refuses to participate?

    You can establish the SEP IRA, even if the employee refuses to participant. However, you would need to establish an IRA for ...
  3. What was the Mahonia company and why did it become the subject of a lawsuit?

    In 1992, J.P.Morgan went into the energy trading business by creating a venture company called Mahonia Limited. At least, ...
  4. I have a small business, and I'm considering setting up an SEP IRA. What are leased ...

    Generally, a leased employee is the employee of an outside organization from which you lease the employee's services. For ...
RELATED TERMS
  1. Adverse Domination

    A legal doctrine that allows regulators to bring litigation against ...
  2. Entitlement Offer

    An offer to purchase a security or other asset that cannot be ...
  3. Financial Action Task Force (FATF)

    An intergovernmental organization that designs and promotes policies ...
  4. Variable Annuitization

    An annuity option in which the amount of income payments received ...
  5. Kickback

    The payment of something of value to an individual with the goal ...
  6. Strategic Management

    The management of an organization’s resources in order to achieve ...
comments powered by Disqus
Related Articles
  1. Educating Your Clients About Cybersecurity
    Investing News

    Educating Your Clients About Cybersecurity

  2. Pick the Right Brokerage Account for ...
    Options & Futures

    Pick the Right Brokerage Account for ...

  3. How The Patriot Act Works & Why Is It ...
    Investing News

    How The Patriot Act Works & Why Is It ...

  4. Examples Of Using SWOT Analysis To Get ...
    Investing Basics

    Examples Of Using SWOT Analysis To Get ...

  5. Benefits Of Doing A SWOT Analysis
    Investing Basics

    Benefits Of Doing A SWOT Analysis

Trading Center