The NASPP Blog

IRS Legal Memorandum on §162(m) Treatment of Backdated Stock Options

Just when you thought you’d heard the last on option backdating, last month the IRS issued a legal memorandum on the treatment of backdated stock options for Section 162(m) purposes.

A Little Background–Skip Ahead if You Already Understand §162(m)

Under Section 162(m), companies cannot claim a tax deduction for any compensation paid to “covered employees” in excess of $1 million per year. “Covered employees” are generally the same as the “named executive officers” included in the company’s proxy disclosures, except for terminated officers and the chief financial officer (see the NASPP alert “IRS Issues Guidance on ‘Covered Employees’ Under Section 162(m)“).

Performance-based compensation, however, is exempt from this limit. But, of course, that means there’s a whole bunch of rules you have to follow for compensation to be considered performance-based, and, there’s even a special set of rules that apply to stock options. One of the rules for stock options is that they can’t be discounted.

No Do-Overs

You don’t get to rewrite history with the IRS. According to the memo, the determination of whether an option is considered performance-based is made at the time of grant, based on the terms and conditions in effect at that time. If the option doesn’t qualify for the performance-based compensation exemption then, nothing you do to the option later can make it qualify.

Thus, if an option is discounted when it is granted, it doesn’t qualify as performance-based compensation under §162(m). Even if the option is later repriced upwards, so that it isn’t discounted anymore, this doesn’t change the fact that it was discounted when it was granted. It might help for other purposes (accounting, securities law, even other tax purposes), but it won’t make the option performance-based for §162(m) purposes.

More Financial Statement Restatements?

Many companies that have found option pricing errors related to backdating have already had to restate their financials for the additional expense attributable to the discounted options under APB 25, FAS 123, and FAS 123(R). The lost tax deductions under §162(m) will impact cash flow and tax expense, possibly resulting in more restatements.

No Do-Over for ISOs Either

The memo also points out that this same standard has been applied to ISOs that were subject to backdating. As I’m sure all my readers know, ISOs cannot be discounted. According to the memo, just as under §162(m), the determination of whether an option meets all the requirements of Section 422 (including the exercise price requirements), is made at the time of grant. Where an option doesn’t meet the ISO requirements when it is granted, there’s nothing that can be done later to bring it into compliance. Thus, if an option is discounted at grant, it can’t receive ISO treatment, even if the exercise price is later increased.

For more on the IRS legal memorandum, see the NASPP alert “Back-Dated Options Not Performance-Based Compensation Under Section 162(m).”

Keynotes and New Sessions Announced for the NASPP Conference
I’m thrilled to announce that the keynote sessions at the NASPP Conference will include an address from J. Mark Iwry, Senior Advisor to U.S. Treasury Secretary and Deputy Assistant Secretary. In this newly created role, Mr. Iwry is responsible for executive compensation, pensions, retirement savings and health care. His remarks are sure to be illuminating and of critical importance to companies as they begin to plan next year’s compensation packages.

The NASPP Conference will also feature a keynote presentation from John Olson of Gibson, Dunn & Crutcher and Jesse Brill of the NASPP and CompensationStandards.com on “Overcoming the Compensation Crisis: Sage Guidance,” and another keynote from Joe Nocera of the NY Times, Fred Cook of Frederic W. Cook & Co., and Ira Kay of Watson Wyatt on “The Basics Have Changed: How to Proceed in this New Environment.”

In light of recent regulatory developments, including Say-On-Pay, proposed restrictions on executive compensation and requirements for comp committee independence, and the SEC’s proposed new disclosures for executive compensation, we’ve announced several new sessions for the NASPP Conference:

• Meeting the New Standards: What Compensation Committees (and Consultants and Counsel) Should Now Be Doing
• The Consultants and Counsel Speak on Say-On-Pay and Plan Design; Risk Assessment & Pay; and Hold-Through-Retirement, Clawbacks, and Litigation Issues
• The Consultants and Counsel Speak on Severance and Change-in-Control Payments; Independence and Accountability; and Fixing Benchmarks and Internal Pay Equity
• Hot Button Issues: How to Implement Say-on-Pay Successfully–The Proxy Advisors and Investors Speak
• Getting Shareholders to Say “Yes” to Your Pay

Quick Survey on Equity Award Modifications
Take the NASPP’s Quick Survey on Equity Award Modifications to find out what types of modifications are most common and practices related to modifications. The survey is just seven short questions–you can complete it in just a few minutes. And don’t forget to email your questions on award modifications for our August 27 webcast, “Ask the Experts: Modifications of Equity Awards.”

NASPP “To Do” List
We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog. 

• Register for the 17th Annual NASPP Conference.
• Make your hotel reservations for the NASPP Conference (don’t delay–the hotel is filling up fast).
• Renew your NASPP membership for 2009 (if you aren’t an NASPP member, join today).
• Complete this month’s Compliance-O-Meter quiz on Incentive Stock Options.
• Email your questions on award modifications to experts@naspp.com for inclusion in our August 27 webcast, “Ask the Experts: Modifications of Equity Awards.” Don’t wait–all questions must be received by August 20 to be included in the program. 

– Barbara