Tax Haven Abuse: (Wyly Case) (Compensatory Stock Options)

The 8/1/06 Report: United States Senate (Permanent Subcommittee on Investigations/Committee on Homeland Security and Governmental Affairs), (Wyly Case) Compensatory Stock Options (excerpted pages 163-167, 174, 194-195):

(2) Transferring Assets Offshore

Assets can be transferred offshore in a number of ways. In this case history, the Wyly assets were transferred offshore in three groups of transactions, several years apart. The first group took place in 1992, when the initial offshore trusts were established. The second group took place in 1996, after the foreign grantor trusts were established. The third group took place in 1999 and 2002, surrounding the 2000 sales of Sterling Software and Sterling Commerce. On the first two occasions, the primary mechanism used to move assets offshore were stock option annuity-swaps, in which millions of stock options and warrants were transferred to 20 offshore corporations in exchange for 20 annuity agreements promising to make payments to the Wylys years later. In the third instance, Sam and Charles Wyly transferred millions of stock options directly to several offshore corporations in return for cash. Altogether, from 1992 to 2002, about 17 million stock options and warrants, representing at least $190 million in compensation, were transferred offshore.

All 17 million stock options and warrants transferred offshore had been provided to Sam and Charles Wyly by Michaels, Sterling Software, or Sterling Commerce as compensation for services performed. Wyly legal counsel took the position that the Wylys did not have to pay any income tax on most of this compensation at the time it was sent offshore, because the Wylys had exchanged most of the stock options and warrants for annuity agreements of equivalent value. Wyly legal counsel advised further that the securities had been transferred to independent third parties, even though the corporations who received the securities were owned by trusts established by or for the benefit of the Wylys and allowed the Wylys and their representatives to direct how the securities should be handled. Wyly legal counsel also advised that when the offshore corporations exercised the stock options, the stock option gains did not have to be reported as Wyly income, despite a long-standing IRS requirement that when stock options are transferred to a related party, any stock option gains must be attributed to the original stock option holders as compensation income. Instead, Wyly legal counsel advised that the Wylys were liable for taxes only if and when they actually received annuity payments from the offshore corporations years later. In the meantime, legal counsel advised that the Wylys could transfer their stock option compensation offshore tax-free. This untaxed compensation provided the seed money that enabled the Wyly-related offshore entities to initiate an extensive investment effort.

The stock option-annuity swaps used in this case history sought to manipulate the unusual tax status of stock options, which are virtually the only type of compensation that is not routinely taxed during the year when received, but is usually taxed during the year in which the stock options are exercised, often years after receipt. The swaps attempted to take advantage of this delay in taxation by transferring the stock options offshore to purportedly independent entities; the Wylys and their representatives then convinced the corporations that originally issued the options not to report any compensation when those offshore entities exercised the options. A number of U.S. executives attempted to defer taxation on their stock option compensation by transferring their options to other persons and entities in various types of transactions. In 2003, the IRS announced that it considered some of these stock option transactions to be potentially abusive tax shelters and offered to settle the tax liability of persons who participated in them with reduced penalties. The Wylys chose not to participate in this settlement initiative.

(a) Stock Options in General

In the United States, over the past ten years, stock options have commonly provided 50 percent or more of the compensation awarded to chief executive officers of publicly traded companies.626 They are also commonly used to compensate the directors of a public company.

Stock options give the stock option holder the contractual right to purchase company stock at a fixed price, called the “strike price,” for a designated period of time. Frequently, the strike price equals the price that the stock is trading on a public stock exchange on the day the stock option is granted. The stock option typically guarantees that the stock option holder can buy the company stock at the designated strike price for a period of years. The expectation is that the executive will then work to increase the company stock price, not only to build a
stronger company, but also to increase the value of the executive’s personal stock option holdings.

Some stock options do not permit the stock option holder to immediately purchase the company stock. Instead, they require the stock option holder to remain with the company for a designated period of time, such as two or three years, before the stock option “vests” and the executive can “exercise” it to buy the company stock. This vesting period is used to encourage the executive to remain with the company.

In some cases, stock options lose value, because the company stock price falls below the strike price. In such cases, some companies “reprice” the stock options, lowering the strike price so that the executive can profitably purchase the company stock, even though the public stock price has decreased. The SEC discourages such “repricing,” since it rewards corporate executives at the expense of investors left holding the higher priced shares.627

Historically, compensatory stock options were typically nontransferable, meaning the executive given the stock option was not permitted to transfer it to a third party.628 The purpose of this restriction is to preserve the incentives for the executive to remain with the company during the stock option’s vesting period and work to increase the company stock price; both employee incentives are reduced if the stock option were transferred to an outside party. Despite this general practice, some companies have allowed stock options to be transferred with the permission of the company’s board of directors; a few have allowed executives to transfer their stock options at will with notice to the company. In addition, in 1996, the SEC relaxed provisions that had made stock option transfers subject to Rule 16 insider trading restrictions; the new rules exempted from Rule 16 all securities provided by an issuer to an officer or director if certain conditions were met, including requiring any stock options to be held for at least six months from the time of award.629

Compensatory stock options are taxed under Section 83 of the Internal Revenue Code. This section, which codified a longstanding IRS position, provides that stock options are generally not taxed when granted, but are instead taxed when exercised.630 When exercised, the difference between the strike price paid by the option holder for the stock and the market price of the stock on the day of the exercise is taxable as ordinary income to the stock option holder. In addition, under Section 83(h), the corporation that granted the stock option is allowed to take a “mirror” deduction for the compensation included by the executive in his or her gross income at the time of exercise.

Treasury regulations in effect since 1978 provide that, if a compensatory stock option were sold to a third party in an arm’s-length transaction, the stock option holder must treat the amount received for the options at that time as taxable compensation income.631 If the sale were to a related party, however, the transfer would not be considered a taxable event; instead, when the stock options were later exercised by the related party, any profit between the option’s strike price and the stock’s market price at the time of exercise would be attributed as compensation to the person who was originally awarded the stock option and who would then be required to pay tax on that income.632 The purpose of this requirement is to prevent sham stock option sales to related parties for less than fair value.

Beginning in the 1990s, some accounting firms began selling a tax shelter to U.S. corporate executives to delay or eliminate the payment of tax on stock option compensation.633 In this tax shelter, an executive typically transferred compensatory stock options to a related person, such as a family member or an entity controlled by family members such as a family-related partnership or corporation. In exchange, the related person typically promised to pay the executive an amount equal to the stock option’s value, using a long-term, unsecured promissory note or some other unsecured, deferred payment plan promising future payments, often 20 or 30 years in the future. Often the related person had few, if any, assets other than the transferred stock options. The tax shelter promoters claimed that, because no payment was made on the transfer date to the executive, the stock option transfer was not a taxable event, and no tax was due until actual payment of the promised sums in the future. In the meantime, the related person could exercise the stock options, buy and sell the company stock, and, if the related person were located in an offshore tax haven, invest the cash tax-free.

For the tax shelter to work, however, the corporation that provided the stock option to the U.S. executive had to assist the transaction. For example, the corporation had to allow normally nontransferable stock options to be transferred by the executive to the related person. The corporation also had to allow the related person to exercise the options and take ownership of the company stock. In addition, the corporation had to agree not to issue a Form1099 or W-2 reporting compensation to the executive from the stock option exercise, and give up the corporate deduction available to it for the stock option compensation on the date of exercise. These actions typically represented an economic hardship to the corporation since it had to forego a valuable tax deduction for the stock option compensation. Nevertheless, many corporate executives were able to convince their corporations to go along.

In 2003, the IRS concluded that this executive stock option transaction had no economic substance apart from tax avoidance, and announced that it considered it a potentially abusive tax shelter.634 In 2005, over 100 executives and corporations accepted an offer by the IRS to settle possible tax liability and penalties related to the executive stock option tax shelter by agreeing to pay back taxes on the stock option compensation, interest, and a reduced amount of penalties.635 The IRS calculated that U.S. corporate executives had used the stock option tax shelter to avoid
reporting nearly $1 billion in taxable income.636

Sam and Charles Wyly used transactions similar to those described in the IRS notice to move their assets offshore. Each brother had millions of compensatory stock options that had been granted to him by the three publicly traded companies they founded or expanded, Michaels Stores, Sterling Software, and Sterling Commerce, for which, at various times, the brothers served as directors, officers, or large shareholders.637 In 1992 and 1996, with the assistance of legal counsel, the Wyly brothers arranged for the transfer of many of these stock options to the offshore entities examined in this Report. In return, they accepted, not promissory notes, but private annuities.

Each of the legal opinion letters addressed to the Wylys advised that they could defer the payment of any tax on the $41.8 million in stock option compensation sent offshore in exchange for the private annuities. The letters reasoned that a promise to make lifetime annuity payments had no immediately determinable value, an unfunded and unsecured promise to pay money in the future did not qualify as taxable property, and the stock options themselves had no readily ascertainable fair market value under Section 83 of the tax code, so none of the transactions resulted in an immediate tax liability to the Wylys. The letters also reasoned that, because the value of the private annuity being provided equaled the fair market value of the stock options being contributed in exchange for the annuity, no gift tax would apply. The letters asserted further that the exercise of the stock options would not result in taxable compensation to the original stock option holders, because the stock options had been disposed of in arm’s-length transactions.

The legal opinion letters failed to acknowledge or analyze the key issue of whether the stock option transfers were transfers between related parties and, thus, under Section 83 of the tax code, had to attribute any stock option exercise gains as taxable income to the original stock holders, Sam and Charles Wyly. Instead, each letter simply asserted without explanation that the stock options were transferred in arm’s-length transactions.

Counsel forwarded copies of the letters addressed to the Wylys to Michaels and Sterling Software, presumably to aid both corporations in reaching a decision not to report any stock option compensation for the Wylys either at the time the Wylys initially transferred the stock options to the Nevada corporations or later when the offshore corporations exercised those stock options.664 The evidence indicates that neither Michaels nor Sterling Software, in fact, issued a W-2 or 1099 form reporting the Wyly stock option compensation, either in 1992 or later.665 Apparently both corporations determined that the stock option-annuity swaps, as represented to them, meant that neither Sam nor Charles Wyly would receive any taxable income from their stock options until the annuity payments began years later.

(g) Analysis of Issues

The 17 million stock options and warrants moved offshore over a ten-year period, from 1992 until 2002, represented at least $190 million in compensation provided to Sam and Charles Wyly by Michaels, Sterling Software, and Sterling Commerce.746 Of this $190 million, Sam and Charles Wyly appear to have reported $31 million as taxable income in 2002. Since 2003, another $35 million was transferred to the Wylys in the form of annuity payments, for which taxes were presumably paid. It appears that the remaining $124 million in stock option compensation remains offshore and untaxed.

The U.S. publicly traded corporations that issued the stock options could have reported to the IRS the stock option gains realized when the options were exercised, but chose not to do so. The 20 offshore corporations that exercised the stock options and warrants then sold the shares or used them in securities transactions to produce additional income that was also untaxed.

The offshore transfers at the center of this case history involve sending valuable stock options and warrants to newly created shell entities with no employees, offices, or assets, in exchange for unsecured promises to make annuity payments years in the future. These transactions do not make economic sense, unless the recipients of the assets are understood to be related parties under the direction of the persons who sent the assets offshore.

Also key to understanding these transactions is the immense effort that was undertaken to keep them secret. Securities were directed to shell corporations in Nevada which sent them to IOM corporations bearing the same corporate names. Offshore grantor trusts were established to act as intermediaries for stock options intended to be transferred to still other offshore entities. Public corporations were persuaded not to file W-2 or 1099 forms reporting stock option gains to the IRS. A public corporation that made nearly $74 million in cash payments to offshore corporations was told it had no legal obligation to file forms reporting those payments to the IRS. When the IRS asked CA, in 2002, about Wyly stock option transfers to four offshore corporations, no one disclosed to the IRS that the offshore corporations were owned by trusts benefiting the Wyly family. In short, the extent of the stock option compensation sent offshore was kept hidden from the IRS.

Five publicly traded corporations, Michaels, Sterling Software, Sterling Commerce, SBC and CA, facilitated these offshore transfers and helped the Wylys avoid the immediate payment of taxes on their stock option compensation. Michaels and Sterling Software allowed the transfer of stock options that were supposed to be nontransferable. Four of the five amended their ownership records to accept stock option ownership by the offshore corporations. All five chose not to file 1099 or W-2 forms reporting Wyly stock option compensation to the IRS. All but one gave up taking multi-million-dollar tax deductions for the Wyly stock option compensation. As part of a repricing of all its employee stock options, Michaels even repriced the stock options held by the offshore entities, substantially increasing their value. None conducted a detailed investigation into the true relationship between the offshore entities and the Wylys to determine whether, in fact, they were independent or related parties.

View complete report: Tax Haven Abuses: The Enablers, The Tools, & Secrecy