Shafting the shareholder, helping out the taxman

By Geoff Colvin, Fortune senior editor at large

The really wacky aspect of exercise backdating lies in the realm of taxes. Remember, executives who do this want to minimize their gain on exercise. But for the company that granted the options, that dreaded gain is a good thing because it's a tax deduction.

Thus, when an executive works a scam to reduce his reported gain on exercise, he's also shrinking his own company's tax deduction - causing it to pay more tax.

Note a couple of important points here. First, the shareholders are unambiguously getting shafted. Exercise backdating changes only one thing from their perspective, reducing the tax deduction their company gets. The company needlessly pays more tax, robbing shareholders of wealth, because some top executive got greedy.

Second, Uncle Sam probably comes out ahead on the deal. The executive, most likely a high-income person, is presumably paying the 35 percent top rate on his gain on exercise. The company he works for probably pays income tax at about a 40 percent rate - that's the average for U.S. corporations.

Now remember, for every dollar he reduces his gain, he also reduces his company's tax deduction by a dollar. Thus from the IRS's perspective, one less dollar taxed at 35 percent becomes one more dollar taxed at 40 percent.

So believe it or not, this new type of backdating is actually a tax dodge that leaves the taxman better off. Of course, it leaves the executive better off also, until he gets caught. Who loses? Just the shareholder.

Which is why you shouldn't merely shake your head at what looks like another tale of scoundrels trying to cheat the U.S. Treasury. In this case they weren't. They were stealing only from their own shareholders, and they knew it.


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