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By Michael Gray

Table of Contents

• First extended due date for individual income tax returns
• Should employers report an expense?
• Old ruling suggests guidance for early-exercised ISOs
• Non-discrimination requirement proposed
• New employee stock purchase plan incentive proposed
• Brokers need not report same day sales on form 1099B
• Our web site operation will be changing
• Information available for self-study course
• Questions and Answers

  Do non-qualified stock options count for social security

  What are the holding requirements for ESPPs?

• Consult with a tax advisor

First extended due date for individual income tax returns is August 15

Four months is up. The initial extended due date for 2001 calendar individual income tax returns is August 15. You can request an additional extension to October 15 using Form 2688. Be sure to include a reason for the extension, because it isn't automatic.

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Should employers report an expense for granting employee stock options?

I am not a financial reporting expert. My focus is more in the area of giving tax advice. Since this newsletter focuses on issues relating to employee stock options, I am going to throw in my two cents' worth.

The Financial Accounting Standards Board issued a proposed opinion that employer corporations should report an expense on their financial statements for granting employee stock options. It backed down under severe political pressure, permitting employers to report the information in footnotes instead of on the income statement.

The International Financial Accounting Standards Board has said that corporations who list their stock on exchanges in Europe or Australia must start reporting the expense for employee stock options in 2005.

So those who are supposed to be the experts in financial reporting have said an expense should be reported for granting employee stock options.

The business community, especially high-technology companies, continue to fight reporting this expense, arguing (1) the value of the options at grant is difficult to measure and (2) there is no cash expenditure by the company. Also, these companies intimidate investors and politicians by saying stock options will not be available to rank-and-file employees if an expense must be reported for them.

Meanwhile, these same companies fight for the right to claim an income tax deduction for the amount reported as ordinary income by employees relating to their stock options, including claiming those expenses as a basis for the research credit.

Rationalizing this tax benefit while avoiding a financial reporting expense is clearly a contradiction.

When you look at the issue this way, you can understand why there are proposals in Congress to only allow an income tax deduction when the amount is reported as an expense on the company's financial statements, even though the amount and timing of the expense under the financial reporting rules is different from the rules to determine an income tax deduction.

As much as I appreciate the contribution of employee stock options to the economic growth of our country, I think employers, together, should make a choice. The price of the employer's tax benefits from options is to admit they are a valuable employee benefit for which an expense should be reported on the income statement.

So far, the high technology industry has been successful in protecting the status quo in the United States.

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Old ruling suggests guidance for early-exercised ISOs

When researching another issue, I stumbled on an old letter ruling (LTR 8307138) about the interplay of a risk of forfeiture and ISOs. I previously thought the "exercise date" for an ISO exercise might be postponed by a risk of forfeiture, such as for unvested stock received from an early ISO exercise.

According to the ruling, Internal Revenue Code Section 422, which governs ISOs, supercedes Section 83, under which the risk of forfeiture rules apply, unless there is a disqualifying transfer. The ruling specifically applies to the six months "insider" holding period under Securities and Exchange Act Section 16.

First, it appears the one-year after exercise period for qualification of the disposition of the ISO stock for long-term capital gains starts on the actual date of exercise. (You must also hold the stock more than one year after the grant date to qualify.)

Second, if there is a disqualifying disposition, Section 83 will apply. Unless an election under Section 83(b) was made to disregard the risk of forfeiture, the holding period for the stock will start when the risk of forfeiture lapses (the stock becomes vested) and the ordinary income amount will also be measured based on the fair market value of the stock on that date. (The ordinary income for disqualifying dispositions of ISO stock is reported in the year of disposition.)

Remember that the Incentive Stock Option rules under Section 422 do not apply for the alternative minimum tax, so you will determine the amounts to report on Form 6251 based on Section 83, as described for a disqualifying disposition above.

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Non-discrimination requirement proposed for employee options

Senators Lieberman and Boxer have co-sponsored Sen 2877, Rank and File Stock Option Act of 2002, introduced in the Senate on August 1, 2002.

Under the proposed legislation, an employer would not be permitted to claim a tax deduction for non-qualified stock options granted to employees unless they met certain non-discrimination tests.

No deduction would be allowed with respect to the employee stock options granted in a taxable year in two situations.

First, if the total number of shares which may be acquired under options granted to highly-compensated employees during a taxable year exceeds 50% of the total number of shares granted.

Second, if the options granted to a single highly-compensated employee during a taxable year exceeds 5% of the total number of shares granted.

If passed, the proposed legislation would be effective for taxable years beginning after December 31, 2002.

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New employee stock purchase plan incentive proposed

Representatives Houghton and Boehner have co-sponsored H.R. 5242, Workplace Employee Stock Option Act of 2002, introduced in the House of Representatives on July 26, 2002.

Under the proposed legislation, employee stock purchase plans could be modified to function for employees more like Section 401(k) plans. Amounts withheld from an employee's wages would not be subject to income tax or payroll taxes unless they were not invested in employer stock and were distributed by the trustee holding the funds. A trustee would hold the withheld funds and use them to pay for employer stock. The price of the stock would be not less than the fair market value on the date the option is granted. The payroll deductions to pay for the stock would be withheld over a period of not less than 12 months and not more than 60 months.

The employer would not get a tax deduction in the year the amount is withheld from the employees' wages, but would receive a tax deduction equal to the fair market value of the stock on the date of transfer to the employee for the taxable year of the transfer.

When the employee sells the stock, the employee will report ordinary income for the amount of gain up to the amount the employer reported as a tax deduction. Any additional gain will be a capital gain. Whether the capital gain qualifies for favored tax rates will be based on the holding period for the stock.

This is an interesting new deferral alternative proposal for employee stock purchase plans.

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Brokers need not report same day sales on Form 1099B

One of the hassles of reporting same-day sales is to report the ordinary income and also report the sale of stock on Schedule D.

The IRS has issued Revenue Procedure 2002-50, which will provide some relief from this requirement.

Under the Revenue Procedure, stock brokerage firms are no longer required to issue Form 1099B for certain sales of stock received by exercising a non-qualified stock option or an incentive stock option. Since no 1099B is issued, there will be no item for an employee to match by reporting the transaction on Schedule D.

Here are the conditions for the exception.

1. The sale is executed for the service provider (employee) on the same day that the stock being sold is acquired through the exercise of an option (same day sale.)
   
   
2. The option was granted in connection with the performance of services, reported under Internal Revenue Code Section 83 (sale of NQO stock or disqualifying sale of ISO stock.)
   
   
3. The service recipient (employer) certifies in writing to the broker that the service recipient will report any compensation income generated by the exercise of the option, or disposition of the stock acquired pursuant to the exercise of the option on Form 1099 or Form W-2.
   
   
4. The broker either (a) does not charge a commission or other fee on the transaction, or (b) does charge a commission or other fee on the transaction, but provides the information to the employer, which will reduce the income reported to the service provider (employee) for the expenses.

The procedure will not apply if the employer doesn't use the sales price of the stock to determine the compensation amount or if the option had an ascertainable value at exercise (very rare.)

The procedure is effective for sales of stock after December 31, 2001.

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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.

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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.

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Questions and Answers

Question

Our department recently received an inquiry regarding the ramifications of exercising non-qualified stock options and the social security earnings test.

During the course of our research, we came across a faq at your web site about this same matter. In your reply, you stated that the spread between the fair market value of the stock and the option price at exercise is compensation income that can reduce social security benefits.

We just want to let you know that the SSA/IRS Reporter, Fall, 1997 refers to the spread as a "special wage payment" which does not count toward the annual earnings test.

Since you are in a position to provide individuals with information regarding stock options we're sure this information will be of use to you.

Jackie Perlman, CPA
Sr. Tax Research Analyst
H & R Block

Answer

Thanks for the tip. We removed the faq from our web site.

The SSA/IRS Reporter refers to Publication 957, Reporting Back Pay and Special Wage Payments to the Social Security Administration. This publication tells employers how to report special payments, including compensation income received after retirement, to the tax authorities so the former employee's social security benefits will not be reduced.

My social security references are fairly limited. Since I wrote the faq you referred to, I learned that exercising a stock option after retirement is treated as a form of deferred compensation. Thanks again for writing so I can make this correction and for the information of our readers.

Question

What are the holding period requirements for stock purchased through an employee stock purchase plan?

Answer

In order to qualify for long-term treatment, the stock must be held more than two years after the grant (subscription) date and more than one year after the exercise date. Confirm these dates with your employer. Also, remember you will still report ordinary income when you sell the stock based on the discount available at the grant date. If the holding period requirements are met, the ordinary income is the lesser of the gain from the sale of the stock or the discount as of the grant date.

There is no "escape hatch" for ESPP shares like for ISOs, so avoid disqualifying dispositions. The ordinary income for a disqualifying disposition is the excess of the fair market value on the date of exercise over the option price, not limited to the gain at sale.

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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.

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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.

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(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.

To receive the next issue of Michael Gray, CPA's Option Alert with more employee stock option tax developments and answers to questions from our readers automatically via email, subscribe by filling out the form below.