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Backdated stock options

California's self-compliance program for employers regarding IRC Section 162 (m)

We are conducting a self-compliance program for employers who may have issued discounted stock options and/or stock appreciation rights (stock rights) to their employees. If this describes any of your clients, they may be contacted with a self-compliance letter.

California Revenue and Taxation Code (CR&TC) Section 24343 conforms to Internal Revenue Code (IRC) Section 162(m) for taxable years starting on or after January 1, 2002. IRC Section 162(m) limits the deduction for compensation paid to CEOs, as well as the next four highest compensated officers. The deduction is limited to $1 million dollars per individual.

In general, stock options provide the right to purchase company stock on a future date at a set price (the exercise or strike price), and this right is normally exercised when the stock share value is above the exercise price. Typically, when options are granted, the exercise price is set at the market value of the stock on the grant date so that the option holder will profit from exercising the option only if the stock price increases after the grant date. Stock appreciation rights (SARs) are similar to stock options in that they are granted at a set price, and they generally have a vesting period and an expiration date. Once a SAR vests, an employee can exercise it at any time before it expires.

A discounted stock right provides the holder with a built-in gain on the option at the time of grant, which can have an adverse consequence for the corporation issuing the option. Treasury Regulation Section 1.162-27(e)(2)(vi) provides a "qualified performance-based compensation" exception to the $1 million deduction limit for compensation attributable to the exercise of an option if the exercise price of the option equals or exceeds the share value on the grant date, and certain other requirements are met. However, if the exception is not met, the compensation resulting from exercise of the stock right may be subject to the $1 million deduction limit.

We are including instructions in the October letter on how to resolve the non-compliance, for corporations for which the $1 million dollar limitation is applicable. Taxpayers who receive the letter will be given 30 days to complete and return the worksheet included with the letter.