The Internal Revenue Service has published new regulations to shield workers who unwittingly received backdated stock options from getting hit by a huge tax liability—but companies must act fast if they want to protect their employees via the new program.
Known as the Compliance Resolution Program and unveiled by the IRS on Feb. 8, the rules allow companies to pay the hefty tax penalties levied on certain discounted stock rights exercised in 2006 by non-executive employees; otherwise, under Section 409A of the federal tax code, those employees would have to pay that tax themselves, even if they had nothing to do with the backdating of the grants.
Bohmann
“The program offers employers a way to resolve 409A tax issues with the IRS for many affected employees with a single filing,” says Angela Bohmann, shareholder at the law firm Leonard, Street and Deinard.
Two catches: only employees who are not Section 16 officers—that is, only rank-and-file employees—are eligible, and companies must notify the IRS by Feb. 28 that they want to participate.
“The timing will catch lot of employers by surprise,” says Stephen Fackler, a partner at the law firm Gibson Dunn & Crutcher. “There’s a good chance a lot of employers won’t learn about this program until after the deadline has passed.”
In addition to notifying the IRS of their intent to participate, companies must identify all employees who exercised options in 2006 that were later determined to be discounted, Fackler says. Companies also must notify affected employees by March 15 of their intent to participate. (For full details on the program and how to participate, see sidebars below.)
Discounted stock rights, such as backdated options, are generally subject to penalties under Section 409A, the rules that govern deferred compensation. The IRS provided transition rules that generally give employers until Dec.31, 2007, to bring discount stock rights into compliance with Section 409A, either by raising the exercise price to the fair-market value as of the grant date or by imposing a fixed exercise date. Those rules don’t apply to certain discount stock rights granted to Section 16 officers, which had to be fixed by Dec. 31, 2006.
SUMMARY
As described in more detail below, the Program:
Applies only to discounted stock rights exercised during 2006.
Applies only to employees and former employees who are not subject to the disclosure requirements under section 16(a) of the Securities Exchange Act of 1934 (a non-insider), and were not subject to such requirements at the date of grant of the stock right.
Requires full payment by the employer of the applicable § 409A taxes arising from the exercise of the stock right.
Provides relief for the employees from the requirement to pay the § 409A taxes.
Does not affect an employer’s obligation to report the compensation income and wages arising from the exercise of the stock right on the Form W-2, in Box 1, 3 and 5, and to apply the appropriate employment taxes, and does not affect an employee’s obligation to report such compensation income on the Form 1040 and pay the applicable income tax (other than the additional § 409A taxes).
Requires treatment of the employer’s payment of the employee’s § 409A taxes as an additional payment of compensation to the employee in the employee’s taxable year in which the payment is made.
Requires notice to employees and to the IRS of the employer’s participation in the Program.
Source
IRS Announcement 2007-18 (Internal Revenue Service)
But if a discount stock right that wasn’t vested as of Dec. 31, 2004, was exercised in 2006 before it was modified to comply with Section 409A, an additional 20 percent tax and an interest charge apply. Employees who exercised such discounted options last year will have to pay those fees when they file their 2006 tax returns—unless their employers opt to pay them. However, the taxes companies pay to relieve employee tax bills will be treated as additional 2007 compensation income for those employees.
Olson
Pamela Olson, former assistant secretary for tax policy at the Treasury Department, and now a partner at the law firm Skadden Arps, says the IRS “went a long way toward taking care of the issues … Companies can take care of their rank and file employees.”
Olson and professionals from the Big 4 audit firms and the law firm Baker and McKenzie proposed in a letter that the IRS institute a program for employers to resolve the 409A tax issues related to mispriced options. “We got most of what we were hoping for 2006 exercised options,” she says. “We were looking for a program for employers to take care of the 409A tax liabilities, rather than sticking employees with the 20 percent liability for the companies’ mistakes. The program does that.”
The IRS notice clarifies “that there was more at stake than people realized,” Olson says. “There had been an understanding that the interest charge under 409A wasn’t going to apply, but that understanding was incorrect.”
Olson says the group still hopes the IRS will also do something for unexercised options that have been mispriced. “Otherwise, companies will have to do tender offers and replace the options with new options with appropriate prices,” she says.
Mixed Verdict On Guidance
The new program provides companies specific guidance on how to calculate the 20 percent additional tax and the interest charge. Fackler calls that language “particularly helpful,” since the IRS has issued no guidance on how to tax options subject to 409A generally.
DEADLINES
Timeline For Taking Advantage Of The Program
Date
Actions Required
By Feb. 28, 2007
The employer must provide the IRS with notice of the employer's intent to participate in the Program.
Within 15 Days After the IRS Notice is Submitted
All employees that the employer reasonably anticipates may be affected by the Program must be provided notice.
The employer must provide an additional notice to the IRS stating the number of employees to whom the notices referred to immediately above were provided.
By June 30, 2007
Extensive information regarding the applicable facts must be submitted to the IRS along with payment of the additional taxes and interest charges.
By July 15, 2007
Affected employees must be provided notice of the additional IRS submission and a certification that the additional tax and interest charge have been paid.
Gibson Dunn & Crutcher Client Update (Feb. 9, 2007)
Beyond that, Fackler says, the program is “disappointing.”
“Companies were hoping for greater relief, for some wider range of remedies than paying a tax [that] the IRS otherwise would go after the employee to pay,” he says. “The IRS isn’t really doing any one any favors ... from a tax payment perspective.”
Bohmann says the program is “helpful, but not as helpful as firms had hoped,” and offers little tax savings; it merely shifts responsibility for the bill from one party to another.
“It is largely a convenience to employers and a cost-effective way of handling the claims of multiple employees, who may otherwise expect their employers to reimburse them for the adverse tax consequences that the employees suffer as a result of the employer’s backdated stock option problems,” Bohmann says.
Fackler
Fackler says the benefits are largely related to tax-reporting issues. Employers will not need to issue amended W-2 forms to employees for 2006, which eases workers’ tax filings this spring for 2006. The solution also helps defuse what Fackler describes as “an employee relations nightmare” of workers annoyed at a tax-time surprise. But for the most part, “the same results could be achieved by employers without necessarily participating in the program,” he says.
Bohmann agrees. “Companies that have a lot of employees affected and that are fairly far along in the process of figuring out what options problems they have might want to participate,” she says. “Otherwise they might decide they can do most everything the IRS is offering on their own.”
Even if they miss the deadline or choose not to participate in the program, Fackler notes that companies can still opt to pay the tax liability for their affected employees through some form of additional payment or special bonus.
However, he says, “It will be a somewhat more onerous process for both the employer and employee to deal with the tax return preparation and reporting processes.”
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