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State of California Franchise Tax Board

Franchise Tax Board Reports Results from Backdated Stock Option Program

Released: September 6, 2007

The Franchise Tax Board (FTB) today reported collecting nearly $31 million from 46 employers who agreed to pay taxes that their employees incurred last year through discounted stock options and stock appreciation rights. Certain practices used to grant options, including backdating, resulted in higher taxes for employees who exercised those options in 2006. A resolution program administered by the FTB this year allowed companies who employed these practices to voluntarily pay the taxes on their employee's behalf.

"Nearly 3,700 employees who may have been unaware of the tax consequences related to their options benefited from this program," said State Controller and FTB Chair John Chiang. "By agreeing to pay the taxes owed, these companies have relieved their employees of a significant burden."

New legislation in 2004 changed the tax consequences of certain discounted stock options and stock appreciation rights, including improperly backdated stock options. Under tax rules for nonqualified deferred compensation, improperly priced options may trigger a 20 percent surtax and additional interest on top of the ordinary income tax.

A backdated stock option refers to the practice of granting an option that is dated prior to the date that the company actually granted it. Options generally give an employee a future right to buy an employer's shares of stock at a specified price. If the stock price rises, the employee may exercise the stock option and purchase the stock at the lower specified price. If the company inappropriately backdated an option to a period when the stock price was lower than the day it was actually granted, the employee may have a greater financial gain.

Earlier this year, the IRS issued IRS Announcement 2007-18, creating a Compliance Resolution Program where employers could pay the taxes arising under Internal Revenue Code section 409A that were incurred by their employees because of this practice. The program applied to the exercise of certain discounted stock options and stock appreciation rights in 2006.

The FTB followed the IRS and issued FTB Notice 2007-1 in February. The California program corresponded with the federal program that allowed companies to step forward and pay the added 20 percent tax and any interest tax that employees owed due to the exercise of these options.

Some employees exercised options last year that were priced incorrectly and now owe added tax. The federal and state programs apply to rank-and-file employees who are not subject to specific federal Securities Exchange Act disclosure requirements. The programs were not available for most corporate executives or other insiders that exercised discounted stock options.

The California program was available to employers who notified the FTB by March 15, 2007, of their intention to participate. Final payments were due by June 30, 2007.

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