Hopefully we can look forward to a fuller elucidation by Prof. Fleischer of what he means by "the tax problems companies now face."

Maybe (but I doubt it) this is a reference to the fact that appellate courts are awakening to abusive corporate tax shelters (see Coltec).

Otherwise, I'm not certain what these tax problems are. A corporation that keeps 65% of what it earns, after tax, has a "problem" that many who earn nothing in the first place would love to have.

Jake -- Companies have been deducting the cost of the backdated options, but section 162(m) limits deductibility to $1MM unless the comp is performance-based. Under the regs, in the money options aren't performance-based; similarly, it would appear that backdated options aren't either, at least in the usual case. So when I refer to "tax problems", I mean that corporations have been taking deductions that they are not entitled to.

I appreciate the clarification, Vic. If Congress wanted to regulate executive compensation policy, it's hard to imagine a blunter tool than the Internal Revenue Code.

Allegedly "backdated" options are often, in fact, "performance-based," so long as we are not talking about options that are "backdated" more than a few weeks or a month. The strike price, as H. Jenkins argues persuasively in the WSJ, is not the only aspect of an option contract that influences executive behavior.

Why the tax law should take account of such matters, and draw arbitrary lines between the taxed and the untaxed, is a mystery.

Jake,
In a couple of cases that are public now, companies are suing their legal firm and other cases (Micrel) their auditor for "advising" them on how to backdate.

As Vic points out there is limits in deduction of taxes. My question for you both - Is there a gueestimate one can make based on either # of backdated options, size of option grant and other factors, or will it be a case by case basis?

Mukund http://blog.vangal.com

Vic, I can't imagine what would cause a company to deduct any non-qualifying compensation paid to a proxy-level officer other than ignorance or incompetence.

The default rule of Section 162(m) makes any compensation over $1,000,000 for a proxy-level officer non-deductible. The exception has very specific criteria (approval of performance goals by comp committee, disclosure to and approval by shareholders, etc.) for what makes compensation performance-based and therefore not "applicable employee remuneration" as defined by the statute.

So if you pay the CEO a base salary of $1,500,000, automatically $500,000 is non-deductible. Indeed, you have to assume, as the default rule, that anything on the executive's W-2 in excess of $1,000,000 is non-deductible unless the compensation fits into the exception.

For this reason, companies regularly include the following disclaimer in the Compensation Committee report of the proxy statement (this is from the one I know best):

Position on Deductibility of Compensation

The Omnibus Budget Reconciliation Act of 1993 limits the deductibility of compensation in excess of $1 million paid to the Company's chief executive officer and the other Named Executives during any fiscal year, unless such compensation meets certain criteria.

The Committee seeks to qualify officer compensation for deductibility where feasible, but retains the discretion to pay nondeductible amounts. The Committee believes that such flexibility is an important feature of the Company's compensation programs and one that best serves the interests of the Company and its shareholders by allowing the Committee to recognize and motivate individual executive officers as circumstances warrant.

I have a hard time seeing nefarious plots behind anything as dumb as deducting what you clearly cannot deduct. Moreover, at least as I read 162(m), there's no distinction between backdated options, un-backdated options, or salary for services. If it exceeds $1,000,000 to a proxy level officer, and it wasn't paid pursuant to a performance plan adopted by the comp committee, and approved by the shareholders, it's not deductible.

In the case of 162(m), I agree that "nefarious plots behind anything as dumb as deducting what you clearly cannot deduct" should be rare. What is dumb is how companies refuse to run options grants by the in-house tax lawyer or VP before granting them, so as to address 162(m).

This is due to the unfortunate natural position of the tax executive. A former CEO that I worked for, in a moment of candor, once explained to me that a corporate tax manager is the fellow who gets to follow the parade with a shovel.

Tax issues aside (and I think there will plenty of them -- I doubt that back-dating was an appropriately monitored activity in most companies), Vic pins the tail on the donkey: “But what's clear to me is that compensation committees have been too anxious to maximize the present value of executive compensation while minimizing the public appearance of that value.” Backdating provides a nice example of the agency costs that arise when you let the inmates run the asylum.

One thing that interests me about the backdating discussion is that the question of what backdating IS is rarely discussed. If e.g. there is a handshake deal with respect to a new executive that he will get x options at the price on the day of the handshake, but the deal isn't papered until say one month later (a not unusual delay I believe due to normal paperwork issues) is that backdating? Because the options don't actually issue until later, and that's when vesting must start, and there are probably some minor negotiating points along the way, I think there is a strong position that the later date is the right date. But that view would quickly frustrate an honest businessman who thought he had the deal done (and DID have the deal done from a pragmatic business perspective) at the earlier time.

Susan, what is the empirical basis for saying that is how pricing for a new executive works? (apart from whether what you described is backdating).

Here is a link to an actual stock plan with which I'm pretty familiar:

http://www.sec.gov/Archives/edgar/data/43362/000091205702012288/a2073489zdef14a.htm

As you can see, the Plan is designed first off, if desired, to comply with 162(m). Second, and I think this is the more normal practice among public companies (at least non-pathological ones), the Comp Committee retains the right to grant all stock compensation. It's not uncommon for the Committee to grant the CEO the discretion to commit to grants below a certain number for mid-level executives. But the appointment of a proxy-level officer, or a Section 16 level officer, as well as the stock award, is within the purview of the board (even if per Disney, the executive may be fired by the CEO).

So the general practice, I think, but my non-anedotal empirics (based on my own experience) are no better than yours, is that the executive will get a letter confirming appointment as the Executive VP of ABC Corp. and President of its Household Fungicide Division, at a salary of $X, target bonus of Y% of base, and target long-term comp of Z shares, with a sign-on bonus of A shares, all of which are conditioned on approval by the board at the next board meeting. And then the pricing of the options (if options are used) is done as of the formal time of grant - the next board meeting.

Sorry for the response delay. I didn't mean to make an empirical assertion. The question that interests me is partly empirical and partly legal. The empirical part is (in any particular situation) were the options backdated in the sense that people on day 30 looked back and picked out day 1 as the lowest pricing date, or were they backdated in the sense that people understood that a commitment was made to grant them options on day 1 and expected (regardless of the plan) to receive a day 1 price, and the company used the day 1 price even though the paperwork wasn't completed until day 30. A variation on this might be a fully disclosed ex ante agreement to use the lowest price in a given quarter. I don't think the existence of a legally conforming plan answers that question.

The legal part is, does it matter? (I'm thinking not of tax here but of pending investigations.) Surely every practicing lawyer has had the occasion to repeat the mantra, "an oral contract is binding." Is it, here, if there is a basis for claiming an earlier commitment? (My most frequent experience with that mantra involved intercompany cost sharing or transfer pricing agreements which were often treated as agreed to as oral contracts although they were not papered until later.) Even if an earlier oral contract is not binding, it seems to me that the day-1 commitment / day-30 papering story (again, if true -- I don't know if it is) would play pretty well for a defendant in court.