Backdating employee stock options tax implications

The stock plans of many public companies prohibit the granting of below-market options; other companies disclose in their SEC reports that stock options are granted at market and prepare their financial statements on that basis.

The term “backdating” refers to a number of option granting practices in which the reported grant date is different from the date on which the option is actually awarded, resulting in an option that is already “in-the-money” at the time of the grant.

This problem occurs most often when boards or committees act by unanimous written consent but there is a delay in the receipt of all of the signed consents.

Even though no documents are backdated and there may be no intent to select a lower exercise price, backdating issues may arise if the stock price increases before the corporate formalities have been completed.

Most employee stock options are, or purport to be, granted “at-the-money,” meaning that the exercise price of the option equals the market price of the underlying stock on the date of the grant.

But if these conditions are not met, a number of negative consequences can result, depending on the individual circumstances of the practice at issue.

Options that are granted at less than fair market value result in higher levels of compensation expense.

State law and bylaw provisions as to the time of effectiveness of unanimous consents may be helpful in evaluating these issues. It is important to note that most of these practices are not inherently illegal.

The practice of granting options in advance of the disclosure of positive news does not involve option backdating, but it is often discussed in the context of backdating and is also under scrutiny. If no documents are forged, and if practices are properly approved and disclosed, appropriately accounted for, properly treated for tax purposes and in accordance with the terms of the option plan, most option granting practices should fall safely within the law.

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An option granted at less than fair market value will not qualify as an incentive stock option and therefore generally will be subject to income tax and withholding requirements upon exercise of the option.

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