IRS Takes a Hard Line on Fixing Backdated Discount Options-162(m)

Late this summer, the IRS released an internal counsel memorandum addressing the treatment of options issued at a discount due to backdating (click here for the memorandum).  The memorandum discusses a variety of situations in which a corporate employer "discovered" the backdating problem in a subsequent year (including some that discovered the problem after the option had been exercised) and then proposed a variety of techniques to eliminate the discount element. The memorandum is specifically addressed to whether any of these purported fixes actually solves the corporation's Section 162(m) problem.

Not surprisingly, the IRS answer to that question is a resounding "no."

The statute at issue is Section 162(m), which is the $1 million limit on executive compensation. Performance-based compensation is generally exempted from the Section 162(m) limitation. A stock option with an option price equal to fair market value on the date of grant has a built-in performance requirement; the option will have value only if the stock price increases. However, if the option was issued at a discount, there is a built-in compensation element. The Regulations provide that if any portion of an award is not performance-based, the entire award is defective and counts against the $1 million Section 162(m) limit.

The memorandum focuses on a number of potential "fixes," including retroactively increasing the option price to a higher price or requiring the executive to "voluntarily" pay back the discount. The IRS concludes that all of these fixes are ineffective to reinstate the corporation's compensation expense deduction under Section 162(m).

It is important to keep in mind that this is just an IRS internal memorandum; it reads like a brief setting forth the IRS position. It has no precedential value and does not necessarily reflect how a court might resolve the issue. It does, however, indicate the IRS will not be sympathetic with taxpayers in this setting. Moreover, while the memorandum is specifically focused on Section 162(m), similar problems with discount options arise under Section 422 (dealing with incentive stock options) and Section 409A (dealing with deferred compensation).

Companies should be mindful of the following:

• Don't issue discount options and be wary of proffered fixes. Consider canceling the old, defective options and replacing them with new options granted at current prices.
  
• Keep on top of your documentation and timing. The date of grant for tax purposes is the date when all of the corporate actions necessary to constitute the award have been completed. The memorandum mentions situations in which either the board resolutions or the option agreements are actually drafted and signed long after the purported date of grant. While such a delay is often benign, the memorandum suggests that any delay should be investigated to determine whether the corporation is attempting to use the benefit of hindsight to grant options at the lowest possible price. The IRS scrutiny of these grant practices suggests it is very important to 1) be precise about exactly when the option is granted and 2) complete all of the corporate documentation of option grants in a timely manner.