Despite all the bootlegging and murder Al Capone directed, his wrangling with the Internal Revenue Service ultimately did him in. The "Teflon Don" of his day, Capone was ultimately convicted of tax evasion and sentenced to 11 years in jail.
Many corporate executives may soon find themselves in a similar situation. Regardless of their actual hand in the stock-option backdating scandals that have jolted more than 140 companies, the IRS may ultimately cost them the most.
Opting for more profits
Stock options give a person the right to buy a company's stock at a fixed price in the future. The strike, or exercise, price of the option is set at the market price the day the option is granted. Backdating, on the other hand, means pretending that the strike price was actually set earlier than it was, or at some time when the share price was lower than on the day it was actually granted. It gives the recipient instant extra profits on the options.
The tech sector is heavily represented in the backdating scandal, with companies like Apple (NASDAQ:AAPL), Broadcom (NASDAQ:BRCM), and Comverse Technology (NASDAQ:CMVT) implicated. But its tentacles have also reached more staid enterprises like UnitedHealth (NYSE:UNH) and Cablevision (NYSE:CVC).
In addition to providing extra profits, backdating can also lower a recipient's tax bill. Most options are sold immediately when they're exercised. According to the IRS, the executive has to pay ordinary income tax on the difference between the value of the option at the time of the grant and its value at the time it was exercised. But those who hold the options for at least a year will only have to pay a much lower capital gains tax rate. The highest ordinary income tax rate is 35%, compared to the 15% capital gains rate.
By backdating the option, the executive lowers the amount subject to the ordinary rate and, potentially, can pay the lower capital gains tax rate on the difference. He or she keeps the same amount of money in profit when the option is sold, but significantly lowers the tax bill. While it would be difficult to determine exactly who knew what and backdated their options accordingly, an SEC economist says the probability that it was purposely done in many cases remains high.
"I find the favorable return patterns around exercises in each subsample are strong before the Sarbanes-Oxley rule change, and are greatly diminished in the post-rule change period, consistent with backdating of exercise dates," says David Cicero, who used statistical methodology to examine past behavior.
A pound of flesh
And the taxman is coming. He wants you to pay up on all the profits you evaded. Plus interest.
Where an option has been backdated, the recipient remains obligated to pay the full amount of income tax due upon exercise, including any additional gain realized from backdating, whether the recipient was aware of the backdating or not. Yet this must be part of the new touchy-feely IRS, because the agency has just instituted a program that will allow companies that backdated their options to pay the tax bill for their employees.
The IRS initiative allows companies to step up and pay the additional 20% tax and any interest tax that employees owe. What it doesn't do is permit a company to pay the additional tax for its top executives or other insiders. This is only for the rank-and file employees; the executives are on the hook for their own taxes.
Under a 2004 law, if stock options were issued at a discount, an additional 20% tax and interest tax is due on the options exercised in 2006. The law doesn't affect options exercised before 2005. Companies aren't required to suck it up for their lower-level employees, though. Though they routinely provide "gross ups" to their executives -- giving them additional money to pay their tax bills -- such beneficence rarely trickles down to the rank and file.
The Foolish fallout
The companies themselves will also face higher tax bills. According to a study released by Gradient Analytics, Maxim Integrated Products (NASDAQ:MXIM) may have reduced profits subject to taxation by nearly $9 million. McAfee (NYSE:MFE) may have reduced its profits by $343,000.
Moreover, companies can be penalized for failing to withhold an executive's unpaid taxes, resulting in penalties of as much as 15% of the total, interest payments of 8%, and the additional 20% tax for negligent failure to withhold.
In addition to misrepresenting to the IRS the real profits earned, backdating also misrepresents the true cost of stock options to shareholders. In addition, it gives the recipient unearned profits, causes the company to have to pay higher taxes (while at the same time withholding less payroll taxes), and subjects the company to costly internal investigations and possible restatements of finances.
While the companies and their employees may end up bearing the brunt of the fallout, shareholders too are harmed by the greed exhibited by these executives. Al Capone, it seems, has nothing on these modern-day corporate gangsters.
UnitedHealth is a recommendation of Motley Fool Inside Value. A 30-day guest pass lets you see why this company can opt to be a winner despite the backdating fallout. UnitedHealth is also a Stock Advisor selection. McAfee is a former Stock Advisor pick.
Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool's disclosure policy rules the Chicago underworld.
