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By Michael Gray

Table of Contents

• Happy New Year!
• "Buy buttons" now operational
• Fourth quarter estimated tax payment is due
• 'Tis the season to exercise ISOs?
• On Bush's proposal to eliminate income taxes on dividends
• W-2 reporting required for 2003 for NQOs
• California explains non-resident & part-year resident rules
• New "insider" rules part of Sarbones-Oxley
• Questions and Answers

  Can I avoid reporting income by not exercising my ISOs?

  Can I "hedge" my NQOs by using traded options?

  What forms must be filed when issuing stock options?

  Can I protect employees from losses from NQOs?

• Consult a tax advisor

Happy New Year!

"Bad ol' 2002" is behind us and we have a fresh new year ahead. I hope it's a profitable one for you. Remember, though, that it usually takes a while to "dig our way out" of a correction after a major expansion. Patience is the order of the day.

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"Buy buttons" now operational

We had some challenges getting things set up, but you can now apply for access to the "members only" information, our reference manual, and ESOAA memberships for professional tax advisors. For details, visit www.stockoptionadvisors.com/seminar.shtml. If you have questions or problems with this, call Dawn Siemer at 408-918-3162.

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Fourth quarter estimated tax payment is due

Remember the final estimated tax payment for 2002 is due on January 15, 2003. There is still time to make adjustments to the final payment, if required (such as for a decline in income or for year-end sales of ISO stock). See your tax advisor if you need help with this.

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'Tis the season to exercise ISOs?

Remember when you plan to exercise an ISO and hold the stock for long-term capital gains, it's often best to exercise the option early in the year. You then have more control of the risk during the holding period. If the stock maintains its value or appreciates, you may be able to sell it for a long-term capital gain early next year. (Remember you must meet two holding period requirements. 1) More than two years after the option is granted. 2) More than one year after the exercise date.) If the stock declines in value, you may be able to use the "escape hatch" to limit the income from the option exercise and avoid alternative minimum tax by selling the stock before the end of the year of exercise.

Since the "best case" scenario is to save about a 9% tax difference of the gain, many employees are deciding to simply sell the stock when they exercise the option. They aren't willing to take the risk of value decline in our current stock market environment.

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On Bush's proposal to eliminate income taxes on dividends

As part of the budget and tax package that President Bush recently submitted to Congress, he has proposed eliminating income taxes on corporate dividends. If enacted, that "simple" proposal will have huge repercussions for the economy, including standing most "traditional" income tax planning for businesses on its head.

Obviously the proposal favors the wealthy. The federal tax advantage of "growth stocks" (those traditionally issuing employee stock options) would be lost. I'm sure the banking industry will fight the proposal, since interest income-generating investments will no longer have tax parity with dividends. Even retirement plans could be impacted. Why tie up investments in a retirement plan, taxed as ordinary income at distribution, when you can currently receive tax-free dividends and long-term capital gains rates for appreciation?

Personally, I think that when the debate heats up, the proposal will fail. But I've been wrong before.

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W-2 reporting required for 2003 for NQOs

The IRS has announced that employers should expect to report employees' income from the exercise of non-qualified options separately on Forms W-2 for 2003 (to be issued during January, 2004.) The new requirement was originally announced for 2001, but the IRS decided to postpone action and made reporting optional for 2002. The income will be reported in box 12 of Form W-2 and identified using Code V - Income from exercise of nonstatutory stock options.

(IRS Announcement 2002-108.)

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California explains rules for non-residents and part-year residents

The tax rules for reporting income and deductions of non-residents and part-year residents to California are very complex. When you study the rules, the transition of moving to or from California is especially intimidating. The Franchise Tax Board has issued Publication 1100, Taxation of Nonresidents and Individuals Who Change Residency, and Publication 1031, Guidelines for Determining Resident Status, with details about how these rules work.

Publication 1004 has also been issued, which is just about non-resident and part-year resident issues for employee stock options. You can request the Publications at 800-852-5711 or find them on the Web at www.ftb.ca.gov.

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New "insider" rules part of Sarbones-Oxley

Please be aware there are new "insider" rules that were enacted as part of the "Anti-Enron" Sarbones-Oxley Act. For example, if 50% of employees participating in a defined contribution retirement plan can't trade securities in their retirement accounts for a period exceeding three days, there is also a blackout period during which corporate officers can't trade their securities. Any profits for a disqualifying trade must be disgorged back to the company. Consult with a securities lawyer for details.

(Public Law No. 107-204, Signed 7/30/02)

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Questions and Answers

Question

I have a lot of ISOs which had a vesting schedule, but if my company merges with another company, all of the ISOs will become 100% vested.

For ISOs with an option price exceeding $100,000, the company has converted the excess shares into non-qualified options.

Can I avoid reporting all of the income during 2002 by doing nothing?

Answer

Unless there is some requirement by your company relating to the merger that the options must be exercised, it should be OK to exercise them after 2002 and delay reporting the related income for regular tax and alternative minimum tax.

Question

Can I "hedge" my non-qualified employee stock options using traded options?

Answer

It appears to me you can hedge unexercised NQOs. However, you need to be careful that the hedge is not deemed to be a sale. A wash sale may be deemed to be a sale, because the selling price and closing date are certain. Some straddles are deemed to be sales. (Internal Revenue Code Section 1259 and regulations thereunder.) According to regulations section 1.83-1-(b), a sale of the option results in recognition of ordinary income.

I have a problem with hedging unexercised ISOs because it seems to me the IRS can claim the holding period from the grant date is suspended or lost when there is an offsetting option position, especially a purchased put or short sale.

These are complex rules. Get some help.

Question

We have issued a stock option to an employee. What forms are needed for IRS purposes?

Answer

Usually no forms are required to be filed with the IRS when a stock option is granted. I suggest that you consult with your CPA firm about the requirements when an option is exercised or the stock is sold. There are some companies that specialize in administering employee stock option plans. Maybe your company should hire one of them.

Question

Our private LLC has a non-qualified option plan to attract, retain and give an incentive to our employees.

Many of the employees exercised options when the fair market value of membership units was higher than the current value.

Our company is now being restructured and employees have a capital loss for the redemption of their membership units. Most of them won't be able to deduct more than the $3,000 limit for capital losses.

What can we do?

Answer

I will warn you this is an expensive approach. The company could hire an appraiser to re-value the membership units at the dates of exercise, and file amended returns for the deductions claimed based on the new amounts. The company will also have to re-issue amended Forms W-2 to the employees. The employees could then amend their income tax returns based on the new information.

Filing all of these amended returns could result in IRS scrutiny of the situation. The appraisal, legal and accounting fees could be very substantial.

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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.