The Internal Revenue Service is chasing down scores of companies and their executives who participated in a stock option tax shelter scheme to settle up their tax bills. In many cases the tax service was sold to corporate officers by audit firms attesting to the financial statements, representing just the kind of tax service that led the Public Company Accounting Oversight Board to introduce new rules creating greater separation of audit and tax services.
The IRS says it has identified 42 corporations who participated in the scheme, representing more than $700 million in unreported income. A separate report issued recently by the U.S. Government Accountability Office says its own study identified 61 companies among the Fortune 500 alone, representing as much as $3.4 billion in revenue lost to the federal government from 1998 to 2003.
Everson
“These transactions raise questions not only about compliance with the tax laws, but also in some instances about corporate governance and auditor independence,” said IRS Commissioner Mark Everson. “These deals were done for the personal benefit of executives, often at the expense of shareholders.”
How It Worked
Here’s how the scheme worked:
First, a public company would grant unqualified stock options to a senior executive.
The executive would sell the shares at market value to another entity, such as a family limited partnership that was owned and controlled by the executive’s family, in exchange for a long-term, unsecured note.
Typically, payment of the note was deferred for up to 30 years.
The stock-owning entity would then sell the shares in the open market. The transfer is structured in such a way that the gain on the sale wouldn’t be recognized until the note is due, deferring the tax consequences.
Executives could only pursue such a strategy when their corporate employers participated, by allowing the transfers to family-controlled entities and by deferring the tax deduction they would normally take when executives exercise their options and accept their compensation.
To settle up, the IRS is allowing any who voluntarily report their income and pay the related tax to pay only half the usual 20-percent penalty through May 23, 2005. After that date, the full penalty will apply.
Ochsenschlager
Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants, said the settlement offer could lead to a cascade of legal actions. Companies and their executives may protest the IRS position, dispute responsibility among themselves or point the finger at their audit firms or other financial advisers who recommended the strategy.
“It’s a very, very tangled web,” he said. “It could well throw executives into bankruptcy,” if the proceeds from the stock sale have already been spent. “Some executives will be in a fight for their life.”
Inherent Conflict
The PCAOB is deliberating new rules establishing greater separation of audit and tax services for accounting firms who audit the financial statements of public companies. The rules do not fully prohibit audit firms from providing tax services to companies and their executives, but they create much greater separation than currently exists.
Zaino
Thomas Zaino, a tax attorney with McDonald Hopkins, said the stock option scheme represents a clear compromise of independence. “The auditor has a responsibility to audit the company and take an independent look at the books,” he said. “If the auditor is also selling tax services to executives, now the executives become the client. There’s an inherent conflict.”
The AICPA does not favor a strict separation of audit and tax services, but Ochsenschlager concedes that the stock option treatment currently targeted by the IRS represents an inappropriate crossover for audit firms. In this particular scheme, companies essentially were forgoing a tax deduction at the advice of their auditors, he said. “What’s favorable for the executive is not always best for the company,” he said.
The IRS statement does not identify taxpayers to whom the settlement offer has been extended, nor does it characterize the taxpayers as being related in any way. Ochsenschlager said the scheme would probably appeal most in a setting where executives stand to gain a great deal on stock options, yet the company isn’t terribly profitable and therefore doesn’t mind forgoing the prospective tax deduction. High-tech companies come to mind, Ochsenschlager said.
The Securities and Exchange Commission and the PCAOB both issued statements supporting the IRS initiative. “The settlement initiative announced by the Internal Revenue Service reflects serious questions about abusive tax practices,” said PCAOB Chairman William McDonough. “The Board will continue to monitor the IRS’ efforts and consider their impact on the Board’s mandate to assure the ethics and independence of registered public accounting firms.”
SEC Chairman William Donaldson said, “I commend the IRS for resolving this matter. The IRS’s settlement initiative is a step forward in the effort to protect the integrity of our capital markets.”
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