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By Michael Gray

Table of Contents

• Happy Thanksgiving!
• Last chance for year-end planning
• Working Families Tax Relief Act of 2004
• American Jobs Creation Act of 2004
• Repeal of AMT adjustment for ISOs proposed
• IRS issues paper about transfers of ESOs to related persons
• CRS issues updated report on accounting issues for ESOs
• Questions and answers.
  • Do we have to pay cash to exercise non-qualified options?
  • What is available for financial planners studying ESOs?
  • What are the tax consequences of ex-wife exercising warrants?
  • How is tax basis determined for incentive stock options?
  • What is the correct treatment for swapped ISO shares?
  • Why can't I exercise an ISO in an IRA?
  • How will the ISO gain from a purchased company be taxed?
• Do you know about our other newsletter?
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Happy Thanksgiving!

This is a time of year for reflection and remembering the blessings in our lives. I hope you have a wonderful Thanksgiving celebration with your family. We had a "preview" celebration the Saturday before last at my sister's home in Folsom. Thanks to you, my clients, readers and friends for your financial and emotional support of our CPA firm.

Last chance for year-end planning

The year is rapidly coming to a close and, with the holidays, I'm not going to be very available. Call 408-918-3161 to reserve your year-end planning appointment.

The final individual estimated tax payments are due on January 15, but state income taxes have to be paid by December 31 in order to deduct them on your 2004 federal income tax return. Instead of deducting state income taxes, there is an alternative deduction for state sales taxes this year. This may be a good time to buy a car so that you can deduct the sales tax. Remember, neither of these taxes are deductible for the alternative minimum tax, so the tax consequences need to be figured in detail.

People who exercised incentive stock options (ISOs) where the stock has declined in value need to determine whether they should sell the stock before the end of the year. (Watch the wash sale rules as they apply to incentive stock options.)

Working Families Tax Relief Act of 2004

The Working Families Tax Relief Act of 2004 was signed by President Bush on October 4, 2004. The Act mostly consists of extensions of certain expiring tax breaks, like the child tax credit, marriage penalty reduction, and 10 percent tax bracket increase.

One of the provisions extends an increased alternative minimum tax (AMT) exemption that was scheduled to expire after 2004 for one year. The AMT exemption amount for an unmarried individual remains at $40,250. The exemption for married joint is $58,000 and $29,000 for married, filing a separate return.

(When a taxpayer has significant alternative minimum taxable income, the AMT exemption is phased out. The exemption is meaningless for many employees with big AMT adjustments for the exercise of an ISO or other highly-paid executives.)

American Jobs Creation Act of 2004

President Bush signed the American Jobs Creation Act of 2004 on October 22, 2004.

An important provision for employees with Incentive Stock Options or participating in Employee Stock Purchase Plans (ESPPs) exempts the exercise of these "statutory options" from employment taxes and income tax withholding. (Act Section 251(a) (1).) The IRS had previously suspended requiring these tax withholding and payment items, but this settles the issue.

Under the new tax law, the transfer of stock received from the exercise of an ISO or ESPP because of a certificate of divestiture will be treated as meeting the holding period requirements for statutory employee stock options. The employee would therefore be entitled to report all of the income from the sale of the stock as a capital gain, and the employer will not be entitled to a tax deduction with respect to those shares. (The certificate of divestiture would be issued to eliminate a potential conflict of interest when an individual becomes a federal employee.) (Act Section 905.)

Retroactively effective March 4, 2003, expatriated corporate employers of certain insiders are required to pay an excise tax when the executive realizes income with respect to non-qualified compensatory options when the shareholders recognize gains on any stock in the corporation by reason of a corporate inversion. (This applies when domestic corporations move their headquarters offshore.) The excise tax is not deductible by the corporation and the $1 million limit on deductible compensation is reduced by the amount of excise tax paid. (Act Section 802.)

Effective for amounts deferred after December 31, 2004, non- qualified deferred compensation plans are being dramatically affected by the new tax law. Distributions won't be available until 1) separation from service, death or disability; 2) a date specified at the time of the deferral election; 3) at the time of a change of ownership for the employer; or 4) the occurrence of an unforeseen emergency. In order to qualify for deferral, the employee must elect the deferral before the end of the year preceding the year the services are performed. The new rules are so complex that I think we should call these plans "qualified non-qualified deferred compensation plans. Note that stock-based deferred compensation, including phantom stock and stock appreciation rights, are covered by these new rules. (Act Section 885.)

Repeal of AMT adjustment for ISOs proposed

Representative Zoe Lofgren has introdued a proposal to repeal the AMT adjustment for ISOs, effective for ISOs exercised in 2000 or thereafter. This proposal probably won't pass this year and may be re-introduced next year.

IRS issues coordinated issue paper about transfers of employee stock options to related persons

The IRS has released a coordinated issue paper discussing issues that arise when a compensatory stock option or a restricted stock option is transferred to a related person. In some cases, these transfers are considered to be "listed transactions", requiring special disclosure, in Notice 2003-47.

These transactions have been held to be incomplete because they are not arm's length. The transferor employee may be required to report ordinary income based on the amount of any consideration received for the transfer, plus an additional ordinary income amount when the option is exercised by the transferee. The employer should withhold any required income and employment taxes (for non-qualified options or restricted stock) for the initial transfer and for the later exercise.

If the employee does not report the taxable income as required, the transferee will not be entitled to the related basis adjustments for the stock.

CRS issues updated report on accounting issues for 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 accounting issues for employee stock options. The main addition is a report that the Financial Accounting Standards Board (FASB) has postponed the effective date for FASB Statement 123, requiring an expense being reported on corporate financial statements, until the first reporting period after June 15, 2005. The FASB is expected to offer additional guidance on the issue before that date.

The CRS report cites another report issued by Bear Stearns & Co. during the spring of 2004 that estimates the value of the Nasdaq 100 would have fallen 44% in 2003 if the firms had expensed their stock options.

Questions and Answers

Question

My wife has some non-qualified stock options from her publicly- traded employer company. Do we have to pay the cash for the option price to exercise the options?

Answer

Your wife should talk to the people in her company who are responsible for administering the stock option plan. Usually companies have arrangements with securities brokerage firms for employees to simultaneously exercise and sell their shares. Then you don't have to pay the cash purchase price yourself; it's deducted from the sale proceeds. Alternatively, you can make a "cashless exercise" to sell just enough shares to pay the exercise price plus any employment taxes. Personally, I think it's usually better to sell all non-qualified option shares received.

Question

I am a financial planner and I would like to earn a designation as an expert in Employee Stock Options. What is available?

Answer

Nothing that I'm aware of. We tried creating an Employee Stock Option Advisors Association, but there wasn't enough interest to justify it.

Question

My wife received warrants in a divorce settlement. The warrants are for a start-up company that hasn't gone public. We believe her ex-husband received the warrants as part of an incentive plan. What are the tax consequences when she exercises the warrants?

Answer

Based on what you have told me, the warrants will be taxed as non-qualified stock options. Your wife will be taxed on the excess of the fair market value over the option price as ordinary income when she exercises them. Her ex-husband may be subject to employment taxes at that time.

She should confirm the warrants were received relating to her ex- husband's employment.

When to exercise them depends on the facts in the particular situation. If the company says the shares have significant value over the option price, I wouldn't exercise them until the stock is publicly traded so that I could sell it to raise the cash to pay income taxes.

Question

I am puzzling over your explanation of how tax basis is determined for shares received by exercising an ISO paid for with a swap of company stock. Why do you say the "spread" is taxed as compensation? (From a CPA.)

Answer

Because, according to Internal Revenue Code Section 56(b)(3), the special rules for incentive stock options do not apply for the alternative minimum tax. That means the options are taxed as non-qualified stock options for AMT. From there, just research the regular tax rules for non-qualified stock options.

Question

I exercised ISOs through a stock swap and my company was bought out before the one-year holding period, resulting in a disqualified dispositon. What is the correct treatment of the shares that were swapped?

Answer

The shares for which you didn't meet the holding period and must report ordinary income are considered sold first. You can use the original acquisition date and tax basis for the "swapped" shares. Depending on your facts, they may qualify for long-term capital gains.

Question

My boss wants to know why you can't exercise an ISO in an IRA.

Answer

The IRA is a retirement account that is treated as a "separate taxpayer" from the owner. In order for employee stock options to qualify as ISOs, they must be held by an employee. (Internal Revenue Code Section 422(b).) The IRS has also made it clear that you can't assign ordinary income that you earned in addition to plan contributions to a retirement account.

Question

My wife's company was just purchased by a Japanese company. When the deal closes early in 2005, all ISOs will immediately vest for all employees. The company will no longer be traded on a stock market. My wife has 3500 options that are not under water. The acquiring company has guaranteed a price of $27 per share at close. If my wife exercises and sells her option shares, she will have an estimated profit of $49,000. How will the gain be taxed?

Answer

Since your wife is exercising and selling her option shares at the same time, the gain will be taxed as additional compensation income and should be added to her W-2 wages. No withholding is required when you have a disqualifying disposition of ISO shares. You should consider getting professional help relating to whether any estimated tax payments should be made during 2005.

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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.