Stock Option Backdating and Practices Conference Presented by

Stock Option Backdating and Practices Conference Presented by: Joseph T. Gulant, Esquire September 21, 2006

Option Backdating/Tax Considerations Employer Issues Ø Potential Loss of Tax Deductions Ø Failure to Withhold Ø Income AND excise taxes Ø Company/Responsible Officer Liability Ø Incorrect W-2 s Employee Issues Ø Potential Underreporting of Income Ø Section 409 A excise taxes, interest and penalties

Tax Consequences of Option Backdating Ø Three primary issues for Employers: Ø Section 162(m) Ø Incentive Stock Option (“ISO”) disqualification Ø Section 409 A

Section 162(m) Implications Ø Rule prohibits corporate tax deductions for certain compensation in excess of $1 million paid to certain “highly compensated” individuals Ø Employees subject to rules include CEO and next 4 highest compensated officers whose compensation is required to be reported to S. E. C. (as determined at the close of a calendar year)

Types of Compensation Ø Ø Cash Stock options Corporation’s stock Other property paid in exchange for services

When is Compensation Recognized? Ø Non-Qualified Stock Option: Spread taken into account at exercise Ø Incentive Stock Option: Spread taken into account if “disqualified disposition” Ø Deferred Compensation: Generally when paid

Compensation Not Subject to Section 162(m) Ø Commissions Ø “Performance based compensation” Ø Contributions to qualified retirement plans

What is Performance Based Compensation? Ø Compensation payable solely on account of attaining one or more pre-established, non-discretionary, objective, performance goals Ø Performance goals determined by a compensation committee if the board of directors comprised solely of two or more “outside directors” Ø Material terms under which compensation is to be paid are disclosed to shareholders and approved by separate majority vote Ø Before compensation is paid, compensation committee certifies that performance goals were satisfied

Stock Options and SARs Ø Grant or award must be made by the compensation committee Ø Plan must state the maximum number of shares with respect to which options or rights may be granted during a specified period to any employee Ø Amount of compensation based solely on an increase in the value of the stock after the date of grant

Section 162(m) Implications Ø “Performance based compensation” includes stock options issued at an exercise price equal to or greater than FMV of stock on date of grant Ø Option backdating at price below FMV on “real” grant date makes stock ineligible for performance based compensation exception to Section 162(m) Ø Loss of tax benefits from compensation deductions could lead to significant tax adjustments for affected corporations

Incentive Stock Options Ø If qualified, Incentive Stock Options (ISO) (unlike Nonqualified Stock Options) are not taxable upon exercise Ø Holder of ISO can obtain long-term capital gains treatment provided special ISO plan qualification rules are met, and stock not disposed of by holder until at least one year after exercise, and two years after grant

Incentive Stock Options Ø A stock option CANNOT qualify as an ISO unless (among other items) the options are issued at an exercise price not less than the FMV of the underlying stock on the “real” date of grant Ø Backdated option would likely have an exercise price below the FMV of the stock on the date of “real grant”, and therefore option would be converted into a nonqualified stock option

Incentive Stock Options Ø If the stock is a nonqualified stock option, the spread on the date of exercise (i. e. , the excess of the FMV on the date of the exercise over the exercise price of the option) is compensation to employee and deductible (subject to Section 162(m) among other items) to corporation Ø If company and employee treated the option as an ISO, employee will have underreported income at exercise of option, company would have failed to satisfy its Income Tax (and FICA, FUTA) withholding obligations, and company will have not taken eligible income tax deductions, subject to Section 162(m) considerations

Section 409 A Implications Ø Which discounted options are subject to Section 409 A? Ø Options granted after 10/3/04 Ø Options granted before 10/3/04 and vesting after 10/3/04 Ø Options materially modified after 10/3/04

Section 409 A Considerations Ø If Section 409 A is applicable, then: Ø Discounted options will be subject to a special 20% Excise Tax, and possibly interest and penalties Ø Calculation of 20% Excise Tax on discounted options is unclear, may be: Ø Excess of FMV over exercise price determined at date of grant Ø Excess of FMV over exercise price on date of exercise Ø Excess of FMV over exercise price on date options vest Ø Some other valuation approach (Blank-Scholes, etc. )

Section 409 A Considerations Ø Timing of income inclusions is unclear Ø May be taxed at issuance on spread, plus additional tax as options vest/or are exercised

Section 409 A Mitigation Ø If discounted options subject to Section 409 A have been issued, then: Ø Prior to 12/31/06, unexercised option price can be raised to FMV of stock (with agreement of holder) on original grant date to avoid Section 409 A Ø Company can pay employee bonus to compensate employee for loss of benefit (if vests in whole or part in subsequent year and is paid w/in 2 ½ months after calendar year of vesting)

Section 409 A Mitigation Ø If discounted options subject to Section 409 A have been issued, then: Ø Prior to 12/31/06, holder can elect fixed date of exercise prior to end of term of option. Ø Fixed date of exercise can be an entire calendar year Ø If option has already been exercised, it may be too late to mitigate