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Use caution when preparing your income tax returns with "do it yourself" software

I can't understand why people who have tens of thousands of dollars of taxes or more don't invest in having their tax returns prepared by a professional tax return preparer.

I'm not knocking the software. You can prepare correct returns with these programs. But when you don't know what you're doing, you can really screw up.

I just prepared amended 1999 income tax returns for a client who reported a sale of ISO shares using Turbo Tax. He prepared the returns in the "interview" mode. There was about $25,000 additional tax due with the federal return, or about a one-third underpayment of tax. The client didn't know how to check the amounts on the forms Turbo Tax generated. Evidently there was an input error. Also, the federal amounts didn't carry over to the California alternative minimum tax form.

By the way, the only tax return preparers who can represent you before the Internal Revenue Service are certified public accountants, attorneys and enrolled agents.

Disqualified dispositions of devalued ISO stock after the year of exercise

If stock acquired from exercising an ISO has declined significantly in value, it's most advantageous to sell it by the end of the year of exercise, because you remove the transaction from the alternative minimum tax. (The regular tax and AMT income is the same.) Also, the ordinary income is limited to the excess of the amount realized on the sale over the option price. (IRC Section 422 (c)(2).)

What if you didn't sell the stock before the end of the year of exercise?

If you sell the stock in a disqualifying disposition, the ordinary income limit of Section 422(c)(2) still applies for regular tax purposes. A disqualifying disposition generally is when the stock is sold within (1) 2 years after the grant date of the option, or (2) 1 year after the option is exercised. (Avoid repurchasing the stock for the "wash sale" period!)

You will also receive an AMT adjustment for the additional preference amount reported in the year of exercise. However, you will have a capital loss for the AMT, which is limited to AMT capital gains plus $3,000. The reason is, according to Internal Revenue Code Section 56(b)(3), ISOs are treated the same as NQOs for AMT reporting. (See also Treasury Notice 97-59.)

For example, Jill Taxpayer exercised an ISO for Supergrow stock in year 1. Her tax preference for the exercise is $100,000. Using a 28% federal tax rate for the AMT, her AMT would be $28,000.

In year 2, the value of the stock has declined. Jill sells the stock in a disqualifying transaction when she held the stock for less than one year. Her regular tax compensation income is $20,000. Using a 40% federal tax rate, the regular tax would be $8,000, which would be eliminated using the minimum tax credit. For the alternative minimum tax computation, Jill has a net capital loss of $20,000 - $100,000 (tax preference in year 1) = $80,000. This loss may be used to reduce Jill's other AMT capital gains income plus $3,000 to result in recovering the minimum tax credit. Any unused capital loss is carried forward to the next taxable year.

Jill has to deal with the problem of where to get the cash to pay the AMT for year 1. If there is enough value left in her stock, she may be able to sell it, effectively have no tax for the sale in year 2, and use the net proceeds for paying her tax. In our example, Jill would be $8,000 short.

Also note that if the stock is held to meet the holding period requirements, the long-term capital gain rates would apply for regular tax purposes. This would result in a bigger minimum tax credit carryover to year 3, but the net tax picture for years 1 and 2 would be the same. In our example, if Jill sold the stock after meeting the holding period requirements, she would have a federal regular tax of $20,000 X 20% = $4,000. Her minimum tax credit carryover with the long-term capital gain would be $8,000 - $4,000 = $4,000 greater than with the disqualifying disposition at the same sale price.

IRS Circular 230 Disclosure:

As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

Consult with a tax advisor

For our readers who aren't tax advisors, this newsletter is intended to alert you about tax issues that could affect you. It is not a substitute for advice from a professional tax advisor. You will find that getting advice from a qualified advisor is a worthwhile investment. We intend to eventually publish a directory of ESOAA members who are committed to helping clients with employee stock option issues.

Tax advisors should view the newsletter as an alert to become of issues relating to employee stock options for further research and study.

(Michael Gray is the co-author of Employee Stock Options – A Strategic Planning Guide for the 21st Century Optionaire. You can order the book at http://www.amazon.com or http://www.barnesandnoble.com/ or buy it at Stacey’s Books.)

P.S.

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