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By Michael Gray

Table of Contents

• AMT a growing problem
• Options, S corporations and ESOPs a bad combination?
• Questions and Answers
  • Do NQSOs need to be exercised in date order?
  • What are the tax considerations for giving options to a family member?
  • What happens to non-vested shares when a company is acquired?
  • What taxes will apply when I exercise NQSOs?
  • What is the tax treatment of a stock grant?
  • Is there a tax benefit from investing options in an LLP/LLC?
  • Does AMT apply to ISOs exercised for private company stock?
• Michael Gray, CPA's Tax & Business Insight
• Consult with a tax advisor

AMT a growing problem

On January 13, National Taxpayer Advocate Nina E. Olson released a report to Congress that identifies the alternative minimum tax (AMT) and sole proprietor tax noncompliance as the top two problems faced by taxpayers. Ms. Olson met with tax advisors at a Washington, D.C. law firm to discuss her report.

Ms. Olson said, "Although the AMT was originally enacted to prevent wealthy taxpayers from avoiding tax liability through the use of tax avoidance techniques, it now affects substantial numbers of middle-income taxpayers and will, absent a change of law, affect more than 30 million taxpayers by 2010."

The report says that in 2005, a projected 65% of married couples with an adjusted gross income between $75,000 and $100,000 and with two or more children will be affected by the AMT, compared to one percent for 2003. The AMT is projected to affect about 12.7 million taxpayers in 2005, compared to 2.4 million for 2003.

The National Taxpayer Advocate recommends that Congress either repeal the AMT or modify it to reduce its impact on middle-income taxpayers.

When asked about the dilemma taxpayers face when the value of stock received from the exercise of an incentive stock option falls, leaving a big tax liability with no cash to pay it, Ms. Olson said the only solution to the situation is for Congress to change the law.

Congress is facing its own challenges. Substantial tax cut legislation combined with military actions in Iraq and Afghanistan have combined to result in massive federal spending deficits. The AMT reduces some of the cuts, thus reducing the deficits. It will be hard for Congress to repeal the AMT with our current situation.

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Options, S corporations and ESOPs a bad combination?

In Revenue Ruling 2004-4, the IRS has said that using employee stock options to shift the economic benefits of S corporations to key employees when the stock is owned by an ESOP is a "listed transaction" requiring special tax shelter disclosure. If you have this combination arrangement, you should consult with your tax advisor.

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Questions and Answers

Question

I can't find anything that says NQSOs need to be exercised in date order. Has that rule changed?

Answer

No. To my knowledge, NQSOs were never required to be exercised in date order. Some plans could have provisions to that effect, which could supercede the general rule.

Question

I have been terminated. I have substantial vested options. The vested options will soon be exercised. If I transfer the options to a family member, what will the tax considerations be for the family member and myself?

Answer

If the options are non-qualified stock options, the ordinary income from the exercise of the options will still be taxable to you as additional wages. (You can't assign earned income to another taxpayer.) The transfer of options may also be subject to gift tax. There is an exclusion from federal gift tax of up to $11,000 of direct (present interest) gifts. The IRS has issued complex rules for valuing gifts of employee stock options.

If you are very wealthy, there are estate planning reasons for doing this, otherwise I don't recommend it.

Only employees are permitted to hold incentive stock options. If you are allowed to transfer ISOs to another family member, they will be converted to NQOs.

Question

My wife owns an NQSO for 7,000 shares of a public company that is not yet vested. If that company is acquired by a private company, what happens to the non-vested shares in that NQSO?

Answer

In most cases they will be replaced with equivalent options for shares of the acquiring company. Of course, she won't be able to sell those shares on the stock market. I suggest that your wife direct the question to the management of her company.

Question

I received a grant of NQSOs in 1999. They are going to expire October, 2004. I am planning to exercise the options. What taxes will apply at exercise? Will the exercise be taxed as ordinary income? I am a resident of Tennessee.

Answer

The excess of the fair market value of the stock over the option price on the date of exercise is taxed as ordinary wages income. The federal withholding rate at the time of exercise is 25%, but the income could ultimately be taxed at up to a 35% income tax rate, depending on your other income and deductions. Other employment taxes like social security and Medicare withholding will also apply. For this reason, I usually recommend that the stock should be sold when the option is exercised.

Tennessee doesn't have an income tax on wages.

Question

Our company gives employees stock grants as incentive compensation. Employees pay no cash for the stock. The stock vests at a rate of 5% per year. When the employee leaves the company, the company buys back the stock.

What is the tax treatment for the stock grant? Is this a non- qualified plan? Will employees be subject to FICA, FIT, FUTA, SUTA and SIT?

Answer

The stock grant results in ordinary (wages) income to the employees. The income is computed as the stock grant vests based on the fair market value on the vesting dates, unless the employee elects under Internal Revenue Code Section 83(b) within 30 days of receiving the grant to have the transaction considered completed on the date of grant, in which case all of the income will be taxable on that date. The income is subject to income and payroll taxes. Your employer should have given you information about these consequences.

Question

Assuming a person's option agreement allows transfer, is there any tax benefit derived from investing in an LLP/LLC with vested NQSOs?

Answer

The IRS has issued temporary and proposed regulations (T.D. 9067) to the effect that a transfer of compensatory stock options to related persons (including a partnership in which the employee is a member) is not considered to be an arm's length transaction. The ordinary income at exercise will not be shifted to the partnership or LLC, and a sale of the option to the entity does not avoid having future appreciation before exercise taxed to the employee. The IRS also requires that such transactions be disclosed as listed "tax shelter" transactions. If you are considering such a transaction I recommend that you consult with a tax attorney. You might have trouble finding a tax return preparer who is willing to be associated with a return including such a transaction.

Question

Does the AMT apply to ISOs exercised for private company stock, even though there is no market or liquidity for the stock? Is there any AMT difference between exercising ISOs with an option price of 25¢ per share now when the current value is also 25¢ per share, or in six months if the value is then 45¢ per share?

Answer

Yes, ISOs for shares of private companies are also subject to AMT, even though the shares aren't marketable.

Whether you exercise your options now or in six months could make a difference, depending on your facts (number of shares, other income, itemized deductions you are claiming.)

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

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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.

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.)

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website 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.

P.S.

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