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By Michael Gray

Table of Contents

• "Lock out" does not defer tax on income
• Questions and Answers

  What are the company's reporting requirements for NQSOs?

  Is income reported for a NQSO exercise in the year of exercise or sale?

• Consult with a tax advisor

"Lock out" does not defer tax on income

Paul A. Tanner exercised a non-qualified stock option. He was a corporate insider under Section 16(b) of the Securities Exchange Act of 1934. He exercised the option more than six months after it was granted, so the stock received was not considered restricted under Internal Revenue Code §83(c)(3). Further, the stock received was subject to a two-year lock-up agreement, so it couldn't be sold when the option was exercised. In an unpublished opinion, the Fifth Circuit Court of Appeals affirmed the Tax Court in ruling the stock was not subject to a substantial risk of forfeiture, and Tanner was taxable as of the date of exercise based on the excess of the fair market value of the stock received over the option price. (Tanner v Commissioner, 5th Circuit Court of Appeals, 2003-1 USTC 50,385, March 26, 2003.)

Remember that the exercise of a non-qualified option is taxable unless two requirements are met: (1) the stock received must be not be transferable; and (2) the stock must be subject to a substantial risk of forfeiture. (Internal Revenue Code §83(a).)

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Questions and Answers

Question

We granted nonqualified stock options to some consultants. Their options vested and they exercised them. What are the company's reporting requirements? Our stock is not publicly traded.

Answer

Since the options were granted to consultants, I take it these people were not employees. (I'm not sure how "vesting" would apply to a non-employee.) Assuming this is correct, the company is required to determine a fair market value for the stock on the date of exercise and issue a Form 1099 MISC to the consultants reporting the excess of the fair market value of the stock over the option price as non-employee compensation. The information returns should be issued to the consultants by January 31 of the year following the year of exercise, and to the IRS by February 28.

The company will also need to give information about the details of the exercises to its accountants in order to claim a tax deduction for this item on its income tax returns.

You should check with your corporate counsel about any other reporting requirements under the securities laws and with your accountants about disclosure requirements for your financial statements. (This probably will have an impact on your earnings per share disclosures.)

Question

I exercised a non-qualified stock option on December 6, 2002. The stock was not transferable, because the company's stock wasn't publicly traded. At the time I exercised the option, the fair market value of the stock was $14. The option price was $2.30.

The company went public on December 11, 2002. I was "locked out" from trading my shares until after March 10, 2003. The market value of the stock on March 10 was $10.30.

The company issued Form 1099 MISC reporting income of $14.00 - $2.30 = $11.70 per share.

Should I report income for the exercise of the option in 2002 or 2003?

Answer

See the article at the beginning of this newsletter. It appears you should report the income reported on Form 1099 MISC on your 2002 income tax return. The only reason for deferring reporting the income on the stock is if it was not vested on the date of exercise and you didn't make a Section 83(b) election at that time.

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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.

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