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. Which of the following terms are associated with the purchase/redemption of open-end ...

    A) Forward pricing B) Current business day close C) At the money D) 90-day backdating The correct answer is A.Forward pricing ... Read Answer >>
  3. 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 >>
  4. 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 >>
  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 >>
  6. I've noticed executives buy a lot of stock below market value, and then they sell ...

    On October 30, 2006, a Google executive officer purchased 2,541 shares of Google at $9 per share and sold these same shares ... 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. Managing Wealth

    Executive Compensation: How Much Is Too Much?

    The proxy statement can help determine whether a CEO is well compensated - or just overpaid.
  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. Trading

    The Controversy Over Option Expensing

    There has been much debate over whether companies should treat employee stocks options as an expense. This article examines both sides of the argument.
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. Options Backdating

    The process of granting an option that is dated prior to the ...
  4. Backdated Liability Insurance

    Liability insurance that provides coverage for a claim that occurred ...
  5. In The Money

    1. For a call option, when the option's strike price is below ...
  6. Stock Option

    A privilege, sold by one party to another, that gives the buyer ...
Hot Definitions
  1. North American Free Trade Agreement - NAFTA

    A regulation implemented on Jan. 1, 1994, that decreased and eventually eliminated tariffs to encourage economic activity ...
  2. Trickle-Down Theory

    An economic idea which states that decreasing marginal and capital gains tax rates - especially for corporations, investors ...
  3. Derivative

    A security with a price that is dependent upon or derived from one or more underlying assets.
  4. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  5. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such ...
  6. Death Taxes

    Taxes imposed by the federal and/or state government on someone's estate upon their death. These taxes are levied on the ...
Trading Center