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By Michael Gray

Table of Contents

• Estimated tax reminder.
• Option exercise proceeds were not alimony.
• Caution about old faqs for early ISO exercises.
• CRS issues updated report on employee stock options.
• Questions and answers.
  • Does an exercised option become stock?
  • Is there a grace period for exercising options after termination?
  • Can I use IRA funds to exercise incentive stock options?
  • Does the holding period apply to non-qualified stock options?
• Do you know about our other newsletter?
• Consult with a tax advisor.
• Subscribe to Michael Gray, CPA's Option Alert.

Estimated Tax Reminder

Remember the third estimated tax deposit is due September 15. Although most employees pay their estimated tax through payroll withholding, there are many tax items for which supplemental payments may be required. Examples include the alternative minimum tax when an ISO is exercised, underwithholding when an NQO is exercised, and capital gains when stock is sold.

There may be underwithholding when an NQO is exercised because federal income tax is generally withheld for these transactions at a 25% rate, but the maximum federal income tax rate is 35%.

Recent changes in the IRS regulations for incentive stock options may result in an unexpected increase in tax liability for a disqualifying disposition of stock purchased with an early exercise of an ISO. See the last newsletter for details at http://stockoptionadvisors.com/optionalert/2004-08-18.shtml.

The penalty for underpayment of estimated tax can be avoided by paying estimated tax or withholding based on the tax on last year's income tax return. Individuals with adjusted gross income over $150,000 on last year's income tax return ($75,000 for married persons filing a separate return) can make "protected" estimated tax payments of 110% of the tax on last year's income tax returns.

When the tax liability for this year is expected to be substantially less than last year's, at least 90% of this year's tax liability should be paid as estimated tax payments.

Estimated tax payments and withholding should be subjects of ongoing consultation with your tax advisor during the year

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Option exercise proceeds were not alimony

The Tax Court ruled that proceeds paid by a former husband to his ex-spouse from the sale of stock received by exercising employee stock options was not a payment of alimony, but a distribution of her share of property. The divorce agreement specifically stated that each spouse waived the right to alimony.

(R.L. Tovar, TC Summary Opinion 2004-120.)

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Caution about old faqs for early ISO exercises

We are in the process of updating our web site material about early exercises of ISOs. The IRS recently issued regulations clarifying that a Section 83(b) election has no tax effect for regular tax purposes when an ISO is exercised before it is vested. The election is effective for AMT reporting. See the last issue of this newsletter for details at http://stockoptionadvisors.com/optionalert/2004-08-18.shtml.

Please disregard old material about this matter for your planning and let us know where you see obsolete discussion about this so we can delete or fix it.

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CRS issues updated report on employee stock options

The Congressional Research Service (CRS) issues reports from time to time to inform Congress on issues for which legislation may be proposed or is under consideration. The CRS issued an updated report on the tax treatment and tax issues relating to employee stock options on September 1. It's a good summary, if you can get your hands on it.

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Questions and Answers

Question

Does an exercised option become stock? If yes, and if I think a stock might split pre-IPO or shortly after, would it be beneficial to exercise some options?

Answer

Yes, when you exercise a stock option you receive company stock. And yes, in many cases, employees have found it's to their benefit to exercise their stock before an IPO because then they hope to receive capital gains for the appreciation after the public offering. (Be careful with early exercises of ISOs. See caution above.)

Question

When I left my company, I got a letter saying I had three months after my termination date to exercise my options. I terminated 4/30/04. That meant my options were good until 7/31/04. I put in an order to exercise my options on Friday, 7/30 at 6pm. My options canceled the next day.

Should my company reinstate my options because I tried to exercise within the three month period? Don't companies give until the next business day if the three-month date falls on a weekend?

Answer

There is no requirement that the employer give a grace period when you exercise your options. For incentive stock options, the Internal Revenue Code provides that, in order to qualify as an incentive stock option, the person must have been an employee on the date three months before the date of such exercise. There is no grace period stated in the code.

I'm afraid you're out of luck. I think there's also a reasonable person requirement that you should file during normal business hours, and 6pm is after business hours. So, next time, don't wait until the last minute.

Question

Are there any taxes due if I roll my pension from a previous employer into an IRA and use those funds to purchase my stock options within the IRA account?

Answer

The option is personal to you, so you're not permitted to exercise the option within your IRA account. The IRA doesn't qualify for receiving the stock related to exercise of an employee stock option.

Question

If a person was to consider swapping $50,000 of X company stock to exercise his ISOs, assuming the stock was obtained through a past NQ option, does the 50,000 worth of stock need to have been held for one year and held from two years since it was granted? Or does this only apply to stock that was previously obtained through an ISO?

Answer

The holding period rules don't apply to stock acquired from a non-qualified option, so you don't have to hold that non- qualified option stock for that period in order to do the swap. If the non-qualified option was vested and the stock was vested, then when you exercise the non-qualified option, the acquisition date for the NQO stock is the date of exercise of the non- qualified option.

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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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Do you know about our other newsletter?

For general tax developments, tax planning ideas, business development ideas and book reviews, subscribe to Michael Gray, CPA's Tax & Business Insight at http://www.taxtrimmers.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.

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.