Here's a nice, though not simple, explanation from CFO.com
:Backdating — setting the grant date of an option earlier than the actual date it is granted, typically in order to take advantage of a lower stock prices — can create tax implications for the recipient, as well as the company. In some instances, it can result in underpayment of income at the ordinary income tax rate and overpayment of capital gains taxes, which carry different rates.
For example, say a company board meets on January 30, 2003, when the company's share price is $25, and decides to grant an employee a $20 stock option with a date of January 1, 2003, when the stock was $20. The board's action makes the option a non-qualified stock option because the exercise price does not equal the fair market value of the stock at the date of the grant.
Non-qualified stock options require tax payment at the ordinary income rate for the difference between the grant price and the price at which the option is exercised (the gain). Non-qualified stock options do not meet the criteria to be treated as an incentive stock option, which has a tax benefit of having the options taxed at the lower capital gains tax rate.
That's a problem if the employee who received the stock options is unaware that the board backdated the options and therefore, believes it is an incentive stock option.
Say, for example, the employee exercises the options on January 1, 2004 at the current share price of $30 and does not report the $10 gain as income. The $10 of ordinary income should have been reported and taxed at the ordinary income tax rate, notes Andrea Rattner, a tax partner at Proskauer Rose. The ordinary income tax rate at the federal level is about 30 percent (excluding situations involving the alternative minimum tax). As a result of the board's backdating and the employee's exercise of the options one year later, the employee underpaid ordinary income tax for 2004.
Say, further, that the employee sells the shares in January 2006, when the stock has reached $40. Believing the stock option to be a qualified incentive stock option, the employee would report capital gains and incorrectly pay the lower, 15 percent capital gains tax.
What would that mean if the IRS then audited the employee? If the employee does not amend his or her tax returns before an audit occurs, the employee would need to assert reasonable cause for the tax position. "They could show a W-2 form from the employer that does not show a gain from options," says Rattner. "The person may have to pay back taxes and interest, but not necessarily penalties."
Believe it or not, this is not against the law. Crime pays... if you're a corporation!