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By Michael Gray

Table of Contents

• First step for option stock sales - check W-2
• Our web site operation will be changing
• Financial reporting requirements proposed for stock options
• Proposed regulations on employment taxes
• Lesson from Enron
• For advisors, write about membership and study courses
• For option holders, write about our self-study course
• Questions from readers

  When should I receive a 1099 for my warrant?

  Can I use my AMT credit to reduce my regular tax?

  What goes on line 9 for form 6251?

  I gave stock to my relatives - do I need to pay taxes for it?

• Consult a tax advisor

First step for option stock sales - check W-2

When preparing an income tax return for a taxpayer who has sold option stock or exercised a non-qualified stock option, my first step is to check the taxpayer's Form W-2. Get started preparing your income tax returns early.

I find that, mostly because of communication SNAFUs, the Form W-2 is often in error. The employee may not have reported a disqualifying disposition of stock received from exercising an ISO or employee stock purchase plan. The employer has not considered the effect of the employee's making a Section 83(b) election, possibly because those who administer the option plan have not received a copy of the election.

Some employers fail to limit the ordinary income for an early disposition of ISO stock to the excess of the amount realized from the sale of the stock over the option price. Remember this limitation only applies when the disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized to the individual. Gifts of stock and wash sales don't qualify.

Former employees believe the employer is no longer required to issue a Form W-2 when there is a disqualifying disposition or the employer fails to remind former employees to provide this information.

Employers should issue a corrected Form W-2 when these errors are discovered.

The person preparing the income tax return needs to understand how the additional compensation reported on Form W-2 was computed. The additional compensation is added to the tax basis of the stock to determine the taxable gain or loss when the stock is sold.

Our web site operation will be changing

We have been offering all of the information on our web site for free. In order for ESOAA to be financially viable, we can't continue this practice. The current newsletter, our special reports and a few questions and answers will continue to be free. The rest of the site will be available on a subscription basis. The details will be posted at the site.

Financial reporting requirements proposed for employee stock options

In response to the collapse of Enron, co-sponsors Senators Levin, McCain, Fitzgerald, Durbin and Dayton have introduced S. 1940, the Double Standard for Stock Options Act.

Under this proposed legislation, a corporation could not claim a deduction relating to stock option compensation expenses unless those expenses are also reported as an expense on the corporation's financial statements.

In the past, Silicon Valley companies have bitterly fought a financial reporting requirement for stock options, which was previously proposed by Financial Accounting Standards Board (FASB.) The argument is that since the compensation is funded using capital instead of corporate assets, no expense should be required to be reported.

The current financial reporting requirements for stock options promulgated by the FASB do not coincide with the rule proposed by Congress. Some may question whether Congress should be dictating financial reporting requirements.

If this legislation passes, will Congress have killed the goose that laid the golden egg?

Hearing scheduled for proposed regulations on employment taxes for ISOs and ESPPs

The IRS has rescheduled a public hearing about proposed regulations for the application of employment taxes and employer reporting to the exercise of incentive stock options and employee stock purchase plans. The hearing will begin at 10:00 a.m. on May 14, 2002, in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Ave., NW, Washington, D.C.

Written documents for the hearing must be submitted by April 23, 2002. The documents should be sent to IRS, P.O. Box 7604, Ben Franklin Station, Room 5226, Attn: CC:ITA:RU (REG-142686-01), Washington, D.C. 2004. Alternatively, outlines of oral comments may be submitted electronically using the IRS's Web site at http://www.irs.gov by selecting the "Tax Regs in English" option, clicking on "Tax Regulations," scrolling down to the regulations' description, and clicking on "Submit Comments."

Lesson from Enron

Many Enron employees lost their life savings because their 401(k) accounts were totally invested in Enron stock. Corporate management encouraged employees to do this.

Very rarely does it make sense as investment strategy to have all of your investment assets in one stock.

Most employee option holders diversify too late and are taking unnecessary risks.

Further, when there is going to be a large tax due because of the exercise of a stock option, it makes sense to plan at the time of exercise how that tax will be paid. If you will be financially ruined if the company stock becomes worthless, consider selling stock at the time of exercise, paying more tax, and taking less risk.

Remember the income tax withholding at the exercise of a non-qualified option will probably not be enough to cover all of the income tax for the transaction. Project what your tax will be to provide for additional withholding, estimated tax payments or paying the balance on April 15 following the year of exercise.

Questions from readers

Question - During his employment, Individual A was awarded stock warrants to purchase 7,500 shares of company P, a publicly traded company, at $10.00 per share. In December, 1999, A's employment was terminated. His warrant allowed him a year from the date of termination to exercise them. In November, 2000, A sold/assigned his warrant to B, a third party (non-employee) for $50,000. The market value of the stock at that time was $175,000. A reported the cash received as income in 2000.

In February, 2001, B exercised the warrant when the stock was trading at $27.00 per share. In January, 2002, A received a 1099 from P for $127,500.

Was the 1099 correctly issued?

Answer - It sounds like there may have been a communication error between employee A and company P. Assuming B is unrelated to A and the transfer of the warrants from A to B was an arm's length transaction.

According to regulations section 1.83-1(b), the sale of the warrants in an arm's length transaction results in ordinary compensation income to A. A should have reported this transfer to P, and P should have then generated an information return. (Probably the transaction should have been reported on a W-2, and taxes should have been withheld.)

After A reports compensation income for an arm's length sale of the warrants, Section 83 no longer applies to them. (Internal Revenue Code Section 83(a), Treasury Regulations Section 1.83-1(b).)

Question - When ISO is stock is sold in a disqualifying disposition after the year of exercise and the stock has declined in value, will the employee be able to eliminate or reduce the regular tax in the year of sale using the minimum tax credit in the year of exercise?

Answer - For AMT reporting, the basis of the stock is increased by the AMT adjustment for the year of exercise. If the stock has declined in value, the sale of the stock in a subsequent year will result in an AMT capital loss, which is limited to the amount capital gains plus $3,000. Because of the limitation of the AMT capital loss, the employee may not be able to use some or all of the minimum tax credit to reduce his or her regular tax in the year of sale.

Question - I'm confused on what applies for line 9 of Form 6251. If I have a $200,000 capital loss (which is all from sales of stocks this year and carryover from prior year losses) on Schedule D, and I reported a $3,000 loss on Form 1040, does that mean I can enter $197,000 on line 9? If so, that would offset my ISOs.

Answer - You should prepare Schedule D on both an AMT basis and a regular tax basis. The difference in the gain or loss is entered at line 9. The $3,000 capital loss limitation applies for both regular tax and alternative minimum tax. See the instruction for Form 6251, where this is highlighted this year.

Question - Last year I gave some ISO stock to my relatives. When I gave the stock it was less than 1 year since the day I exercised and less than 2 years from the grant date. My company included ordinary income relating to the gift in my W-2. I had thought I could give a $10,000 gift to anyone and not be taxed. What can I do now?

Answer - You are one of those caught between the rules for income tax reporting and gift tax reporting. For 2001, you could make a gift of a present interest with a value up to $10,000 per donee and not be subject to gift tax. However, a transfer to anyone of ISO before the holding period requirements are met is a disqualifying disposition. Since this is not a transfer for which a loss (if realized) would be deductible, the ordinary income is the excess of the fair market value on the date of exercise over the option price.

You can't do any tax planning relating to this type of transaction after the year of sale. You might check whether you are subject to any penalties for underpayment of estimated tax. If you are, paying your tax early will stop the penalties from accruing.

* * *

Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter.

The answers to most questions can be found in our course, "Secrets of Tax Planning For Employee Stock Options". For details write Dawn Gray at info@stockoptionadvisors.com.

For advisors, write about becoming an ESOAA member and our study courses for advisors

For an information package, send your name, company, address, email address, telephone number and fax number to Dawn Gray at info@stockoptionadvisors.com.

For option holders, write for information about our self-study course about tax planning for employee stock options

For an information package, send your name, company, address, email address, telephone number and fax number to Dawn Gray at info@stockoptionadvisors.com.

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.

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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 aware 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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