IRS Stock Option Settlement Initiative

By: Cydney Posner

Yesterday, the IRS announced a settlement initiative affecting executives (and their companies) that participated in certain tax avoidance transactions involving stock options or restricted stock. Under this scheme, executives, often facilitated by their corporate employers, transferred stock options to family-controlled partnerships and other related entities typically created for the sole purpose of holding and exercising the options and avoiding taxes on compensation income normally taxed to the executive. These transactions were declared by the IRS to be abusive in July 2003. The tax objective was to defer taxes on the compensation for up to 30 years. In many cases, the companies involved also deferred a deduction they would otherwise have been entitled to take, but also did not pay appropriate withholding tax. These stock option transactions were aggressively promoted by auditing firms, including the final four, and others in the late 1990s and early 2000s as a legitimate mechanism to defer taxes. Both SEC Chair William Donaldson and PCAOB Chair William McDonough issued press releases commending the IRS for its settlement initiative.

The IRS describes a typical transaction as follows: "The transaction first involves the transfer of stock options by the executive to a related entity, such as a family limited partnership, under terms of an agreement to defer payment to the executive. Next, the partnership exercises the options and sells the stock in the marketplace. The executive then takes the position that tax is not owed until the date of the deferred payment, typically 15 to 30 years later, although the executive has access to the partnership assets undiminished by taxes. Tax laws require executives to include in income and pay tax on the difference between the amount they pay for the stock and its value when the option is exercised. Corporations are entitled to a deduction for the compensation when the options are exercised."

Under the initiative, corporate executives who engaged in these transactions will have until May 23, 2005, to accept the IRS settlement offer to resolve their tax issues. The offer also extends to corporations that issued the options to executives and directors as part of their compensation. Under the terms of the settlement, participating executives must report 100 percent of the compensation and must pay interest and a 10 percent penalty (one-half of the maximum 20 percent applicable penalty). Corporations and executives must also pay appropriate employment taxes. The parties will be allowed to deduct their out-of-pocket transaction costs, typically promoter and professional fees. Corporations will be allowed a deduction for the compensation expense reported by the executive.

The IRS has indicated that, to date, it has identified 42 corporations, many executives and unreported income of more than $700 million involved in this scheme. If the IRS has already identified a corporation whose executives are involved in one of these transactions, the IRS will contact senior management and ask that the matter be referred to the audit committee for appropriate review. The IRS is continuing to learn of other participants through investor lists obtained in investigations, corporate audits and successful DOJ enforcement actions and has advised that it intends to continue to pursue executives and companies who participated in these transactions and do not take advantage of the settlement opportunity.

In addition to tax compliance issues, these transactions raise questions about corporate governance and auditor independence, including the following identified by the IRS in its investigations:

• Corporate employees were told to manually override the company payroll system to avoid issuing the executive a Form W-2 that would otherwise include the stock option income.
• The company's Board authorizes an amendment to the company's Stock Option Plan permitting these stock option transfers to family-controlled entities.
• The corporation deferred for many years a tax deduction for its executive stock option compensation to match the executive’s attempt to defer inclusion of that same income. The tax deduction would have benefited all shareholders.
• The corporation often paid the executive’s promoter fee, claiming a tax deduction but not including the purely personal payment on the Form W-2.
• Conflicts of interest may exist where independent auditors certify to the public the accuracy and integrity of the company’s financial statements while these same auditors advise senior executives on their personal tax issues, including advice about these abusive tax shelters that they promoted. Moreover, the same executives oversee the relationship with the auditing firm.

Click here for the IRS announcement and here for the  fact sheet.