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By Michael Gray

Table of Contents

• IRS says NQO plan chance doesn't result in current tax
• Updated report on employee stock options issued to Congress
• Questions and Answers
  • Do I categorize my NQSO sale as an exercise and sale?
  • Do I need to pay ordinary income AND capital gains taxes?
  • Should I take NQSOs now or wait for ISOs?
  • Should I exercise and hold my ISOs or sell them all?
  • Can I put private stock in my IRA?
  • How do I get a refund for a bad fair market value?
• Michael Gray, CPA's Tax & Business Insight
• Consult with a tax advisor

IRS says NQO plan change doesn't result in current tax

A company proposed to amend its non-qualified option plan to permit employees who were already granted NQOs to make a one-time election to sell their options to a designated third party, for a price to be established by the third party under a formula.

The company asked if the plan change would result in the options having an ascertainable value and therefore be taxable to the employees who received the options.

Under the terms of the third party offer, option holders electing to transfer options with a value of $A or less will receive the full purchase price in a single lump sum at the time of transfer. Option holders who transfer options with a total value greater than $A will receive the greater of $A or 33% of the total payment at the time of transfer. The remainder of the purchase price will be deferred to later taxable years and paid according to a payment schedule.

The IRS ruled that, even if the change did result in the options having an ascertainable value, income isn't recognized until the option is exercised or otherwise is disposed of, because the value wasn't ascertainable when the options were granted and the change happened after the grant date. (Temporary Treasury Regulations Section 1.83-7T(a).)

Those employees who elect to sell their options will recognize income based on the cash received, and the company will receive a tax deduction based on the income reported by the employees. (Letter Ruling 200414007.)

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Updated report on employee stock options issued to Congress

The Congressional Research Service has issued an updated report, "Employee Stock Options: Tax Treatment and Tax Issues" to Congress. James M. Bickley updated the previous report written by Jack L. Taylor.

The principal changes in the report are to add information about the Financial Accounting Standards Board Proposal issued on March 31, 2004 that would require expensing the value of options granted to employees on corporate financial statements and to update the list of proposed legislation that has been introduced in the 108th Congress concerning employee stock options

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Questions and Answers

Question

I had to exercise three different non-qualified stock options in June, 2003. I received the options in 1998, 1999 and 2000. I also cashed them in since it was the last day in my 90-day grace period after the break up. Do I categorize this as an exercise and sale or just a sale?

Answer

If you didn't receive any stock (including any document showing a sale of stock), you just have a sale. Otherwise, you have an exercise and sale.

Question

I exercised employee stock options for approximately 73,000 shares in two different transactions over two days during December, 2003.

The person who is preparing my income tax returns for 2003 says that I will need to pay ordinary income tax on the gross proceeds from these transactions and capital gains taxes on top of that. This would amount to 75% of what I made from the transactions. She says that I actually did own the stock while the options were executed.

What is your take on this?

Answer

Your tax return preparer should be aware that you receive a basis (cost for reporting tax gain or loss) adjustment addition for the ordinary income reported relating to exercising your options. (It sounds like you made same day sales.) When you add the ordinary income to the option price paid for the stock, it should result in eliminating virtually all of the capital gains for the sales.

Maybe its time to upgrade your choice for tax return preparation.

Question

I am currently consulting for a company. They would like to offer me NQSOs now, or I could receive ISOs when I become a regular employee in about 6 months.

But, I might never become an employee.

Should I take the NQSOs now or wait for ISOs?

Answer

If there is a chance you might never become an employee, take the NQSO "bird in the hand."

Question

I left a company and exercised some ISOs. I sold some shares and planned to hold some others. The company reported income on my W-2 for the shares sold, and my accountant is telling me that I owe AMT for the shares that I'm holding.

If my accountant is right, I might have been better off selling all of the shares.

Answer

Your accountant is probably right and you might have been better off selling all of the shares. Under the recent tax law changes, more people are becoming subject to AMT. The tax advantages of ISOs compared to NQOs are now minor. You should be very optimistic about the future appreciation potential of shares received from exercising an ISO or NQO to justify holding the shares after exercising the option.

Question

1. Can I offset AMT gains incurred upon exercise of NQOs (but not sale of the stock) with a capital loss carryforward?
   
   
2. I would like to put this private stock in my IRA as an "after tax" contribution that doesn't take any cash out of my pocket. Can I do this?

Answer

1. There are no "AMT" gains when an NQO is exercised. For an employee, the income is taxed as additional wages and is not eligible for reduction by capital losses in excess of the $3,000 annual limit. For non-employees, the income is taxed as ordinary income, also not eligible for reduction by capital losses.
   
   
2. The non-qualified stock options can't be transferred to the IRA. You won't be able to make the transfer without an "out of pocket" cost. The IRA might be able to purchase closely held stock, but most IRA administrators limit the types of investments they are willing to hold.

Question

In 2001, I paid $140,000 to the IRS for income relating to a Section 83(b) election. I later learned the fair market value was in error. The company was fraudulent and had a fair market value of zero on the date of the election.

Might I be able to get a refund of the $140,000 tax paid in error? How do I get it?

Answer

You need to file an amended return. The federal form is Form 1040X. You will need to be able to prove that the value that you originally reported was in error, and what the value should have been. The amended return is due within three years after the due date for the year at issue. If you filed your income tax return for 2001 by April 15, 2002, the due date would be April 15, 2005.

Good luck!

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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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