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By Michael Gray

Table of Contents

• Relief proposed for ISO stockholders with losses
• Cancellation of debt to buy option stock is income
• Will the AMT become our tax system?
• Developments for accounting for options
• Tax season is here
• Questions and Answers
  • How can I stop my company's fishy 401(k) transactions?
  • Can I transfer an NQSO to my child's college fund?
  • Do I need to report a gain for exercising NQSOs?
  • Can I put stock from ISOs in a revocable trust?
  • Can ISOs be granted to non-employees?
  • How are reinvested dividends treated in an ESPP?
  • Do I need to fill out any extra forms for exercised NQSOs?
  • Where does the tax withheld by my employer go on my W-2?
• Michael Gray, CPA's Tax & Business Insight
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Relief proposed for ISO stockholders with losses

Congressmen Erlach, English, Gillmor and Ehlers have introduced H.R. 3806, which would allow taxpayers who sell ISO stock at a loss to use the minimum tax credit attributable to the stock on the tax return for the year of sale.

If enacted, the proposed legislation would be effective for taxable years beginning after December 31, 2003.

Relief provisions have been introduced before, but haven't been successful. Congress doesn't seem to have much sympathy for employees with losses on stock received using employee stock options. There is a chance of some tax legislation being passed during 2004, so you should write your representatives in Congress to support this proposal.

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Cancellation of debt to buy option stock is income

The IRS has ruled that when an employee pays for option stock using a note, and the employer agrees to reduce the principal of the note when the value of the stock declines, the employee must report taxable income for the amount of the reduction. (Rev Rul 2004-37.)

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Will the AMT become our tax system?

According to a report by the Congressional Research Service for Congress, the alternative minimum tax (AMT) is growing out of control and supplanting the regular tax system. In 1997, about 605,000 taxpayers (1% of the total) were subject to the alternative minimum tax. If Bush's tax cuts are made permanent, 41 million taxpayers (37% of the total) will be subject to the AMT in 2013.

The AMT is a different way of figuring federal income tax for which certain items of income are accelerated, such as from the exercise of incentive stock options. Certain deductions are scaled back, such as depreciation, and certain deductions are disallowed, including the standard deduction, personal exemptions, employee business expenses, investment management expenses, state income taxes, property taxes and itemized deductions for legal fees. You pay the AMT when it is higher than the regular tax.

Repealing the AMT may be impossible. Depending on whether or not Bush's tax cuts are made permanent, repealing the AMT would cost from $640 billion to over $1 trillion between 2004-2013. According to the Congressional Research Service report, "Indeed, some projections suggest that by 2008 it would be less costly to repeal the regular income tax than to repeal the AMT."

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Developments for accounting for options

The International Accounting Standards Board has adopted the rule that companies must start deducting the cost of employee stock options on their income statements, effective in 2005. The rule would affect about 7,000 publicly-traded companies in 90 countries, but not in the United States.

The Financial Accounting Standards Board (FASB), which issues the accounting rules in the United States, is also expected to require expensing of employee stock options in 2005, but hasn't issued it's statement yet.

Meanwhile, the technology industry is lobbying Congress to override the FASB and only require expensing for options granted to the top five executives of a company. This proposal is made in H.R. 3574, authored by Rep. Richard Baker, R-La.

You should contact your representatives in Congress to give your opinion on this issue.

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Tax season is here. Do we have your information yet?

We encourage clients who want to avoid having the due date extended for their individual income tax returns to have their information to us by March 1. If we don't have your information yet and you want an appointment to bring it to us, please call 408-918-3162 to make an appointment now. Don't wait for that last 1099 form or K-1, get your tax return in the preparation queue now.

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Questions and Answers

Question

I work for an "employee owned" company. Employees are given a percentage of stock from profits for each year they are employed. After being there 16 years, the company decided to buy back some of the shares (at a $3 increase) and add it to our 401(k) portfolio. They said to treat it as if the shares had never been issued. We have never had a legal "certificate" stating that we owned shares. The company combined our 401(k) plan with our Company Stock about 5 years ago and the owner of the company was the administrator of it all until he passed away a year ago. I have sensed something fishy going on for a long time and, when questioning VPs about the loss of a large sum from our 401(k), I was given the run around. Everyone is afraid of causing trouble because they might lose their jobs if they say anything.

Any recommendations?

Answer

You should see a lawyer about this situation immediately. Remember what happened to the employees at Enron? They lost their life savings. You have 15 years invested in this company, and should act assertively to protect your investment. If your company is actually "employee owned", the employees should be able to act together to protect themselves.

Question

I am about to exercise an NQSO and will be using the funds to put into a college fund for my child. Are there any tax advantages to transferring the option to him and letting him exercise?

Answer

You will still be subject to income tax on the excess of the fair market value of the stock received over the option price. There is an estate planning advantage of shifting the stock to him while paying the tax on the exercise, but it could create a financial hardship for you if you don't have much cash for paying the taxes.

Question

I exercised some non-qualified stock options. I believe my employer withheld federal and state income taxes. The 1099-B showed that taxes were withheld in box 5 (description). I did not receive any money for the transaction. Do I need to report a gain or loss?

Answer

If the transaction was handled properly, your employer should have included additional wages income and withholding relating to this transaction on your Form W-2. Since you received a Form 1099-B (presumably for shares sold to pay the withheld taxes), you should report the net sale proceeds on Schedule D. The cost for the shares is the fair market value on the date of exercise (equals the option price paid plus the income reported on Form W- 2). You should have received a Confirmation of Exercise statement from the company that gives this information.

Question

If someone exercised an ISO and is holding the stock to meet the holding period requirements to avoid ordinary income, can he or she put the shares in a revocable trust?

Answer

Yes. A revocable trust is a "disregarded entity" for income tax reporting purposes, so the grantor is considered to continue owning the stock.

Question

Can ISOs be granted to non-employees, such as directors or consultants, or must non-employees receive non-qualified stock options.

Answer

Only employees may receive incentive stock options. Non- qualified stock options may be granted to non-employees.

Question

How are reinvested dividends treated in a qualified disposition of ESPP shares? For example, if someone was to sell 1200 shares of an ESPP that met the holding period requirements, of which 200 shares were purchased using reinvested dividends, do the dividends adjust the cost basis? I can't recall seeing a 1099- DIV issued on reinvested dividends for an ESPP.

Answer

The dividends are taxable and the amount of the reinvestment is tax basis. Companies should be issuing form 1099-DIV for dividends paid with respect to ESPP shares.

Question

My sister cashed in some restricted/non-qualified stock, and the income was reported on her Form W-2. She received a paper from her employer showing the grant date and tax basis, value date and value basis, number of shares, total price and total value, and W-2 income. How is that taxed?

Answer

The taxable income relating to the exercise is already included in your sister's Form W-2. There is nothing more to be done relating to that transaction. When she sells the stock, her basis (cost) will be the amount paid for the stock plus the amount of W-2 income reported for the exercise.

Question

Does the tax withheld by my employer for the exercise of an NQSO show up on Form W-2? Where?

Answer

It is included in the total federal and state withholding amounts on the form.

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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.)

P.S.

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