A hidden bull-market scandal comes to light
By Geoffrey Colvin

(FORTUNE Magazine) – YOU'LL HARDLY EVER HEAR ME USE THE WORD "GREED," because it's such a loaded, imprecise term. What's greed, and what's just profit maximization? But sometimes "greed" is the unavoidable word, as it is now in explaining one of the great bull-market scandals that has so far flown under the media radar. The IRS has for the first time suggested the dimensions of the scandal, and it's big.

The tale involves executives, their stock options, tax evasion, and auditing firms, and while the details may occasionally seem complex, the basic outline is quite simple. It's also a multidimensional story that becomes almost breathtaking in its seaminess. Cast your mind back to the late '90s, when the markets were still rocketing and stock options were making executives stunningly rich. The world had never seen so much wealth given to corporate executives, nor anything even close. Yet some of these executives--we don't know the exact number, though the IRS suspects it was a great many--wanted more. So they took a few far too clever steps to postpone paying the income taxes on their options gains, trying to postpone the tax not just for a year or two, but for up to 30 years.

An executive would set up a family limited partnership (FLP, pronounced "flip" by tax experts) owned and controlled by members of his family. The executive would transfer his options to the FLP, which would pay the executive with a promissory note due in 30 years. The FLP would then exercise the options and in most cases immediately sell the underlying shares. When the smoke cleared, the FLP was holding a whole bunch of cash that the executive used as if it were his own, since the family members who controlled the FLP knew what was good for them. But as if by magic, no taxes had been paid.

At this point what's most remarkable about the arrangement is that supposedly intelligent executives ever thought they could get away with it. The scheme seems obviously ridiculous. The IRS last year declared such deals illegal, plain and simple, which hardly seems surprising. But the story gets worse.

When employee stock options are exercised, the company gets a tax deduction equal to the gain--the difference between the market price of the shares and the strike price of the options. But now there's a problem. If the company takes its deduction when John Q. Executive's options are exercised (by his FLP), but John Q.'s own tax return shows no options exercised, then the IRS scratches its chin and starts asking uncomfortable questions. Solution: The company doesn't take its tax deduction, even though it's perfectly entitled to.

Think about that. To protect an illegal tax-avoidance scheme, the executive fleeces his own shareholders, whom he's legally required to serve. But the story gets still worse. It turns out that corporate executives didn't cook up this loony stratagem on their own. As the IRS explained in a recent statement, "Professional service firms and financial institutions aggressively promoted these transactions in the late 1990s and early 2000s, often leveraging their relationship as the company's independent auditor, tax advisor, or banker." So here's how it really worked: A major accounting firm is doing a lot of business with a company and suggests this method for top executives to postpone taxes on their massive option gains. Such creativity endears the accountants to the executives. Inconveniently, the scheme requires some bizarre corporate financial practices, like manually overriding the payroll system and refusing to take legitimate tax deductions. But--no problem, because that very same accounting firm is auditing the company's public financial statements. The full sliminess of the arrangement is deeply impressive.

The IRS has confirmed that executives and companies avoided taxes on $700 million in options gains from 1999 to 2002, but it believes the true total is much higher. It has now offered executives a chance to confess their sins by May 23 in return for reduced penalties. The IRS cannot disclose the names of the executives or companies it has identified so far, but experience suggests its offer will flush out many culprits. Resulting financial restatements may have to be reported in some companies' SEC filings--so in a few months we may actually learn the identities of the perps.

You thought that by now we'd heard all the tales of bull-market greed? Me too. Let's not overlook this one just because it was concealed for so long.

GEOFFREY COLVIN, senior editor at large of FORTUNE, can be reached at gcolvin@fortunemail.com. Watch him on Wall $treet Week With FORTUNE, weekends on PBS.