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By Michael Gray

Table of Contents

• Tax season is half over
• Yes, we do prepare income tax returns, too!
• IRS makes settlement offer for NQO issue
• Remember California amnesty applications due March 31
• Last chance to claim refunds for unfiled income tax returns
• Questions and answers.
  • Do I need to report NQO income on schedule D?
  • Should my option exercise withholding show on my 1099-B?
  • How do I prepare Form 6251?
  • Is there any reporting necessary if I received no income?
  • Will my ISOs become NQSOs three months after retirement?
  • Do I have to pay tax on the price of my options?
  • Is the exercise of my private stock options taxable?
• Read our new article!
• Do you know about our other newsletter?
• Consult with a tax advisor.

Tax season is half over.
Do we have your information yet?

For the most part, we prioritize processing of income tax returns on a first-come, first-served basis. If we receive the information after March 15, we will probably be preparing an extension request for your income tax returns. 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.

Yes, we do prepare income tax returns, too!

Sometimes, people call or write to me, wondering if we offer tax consultation or preparation services. So, to make it clear, I'm not writing this newsletter as a hobby or for my health. I'm writing it to promote my business. If you need help, call me at 408-918-3161 or make an appointment through Dawn Siemer at 408-918- 3162.

IRS makes settlement offer for NQO issue

Back in 2003, the IRS issued Notice 2003-47, notifying taxpayers that certain related-party sales of non-qualified options wouldn't be respected. Some tax consultants were promoting a scheme to avoid ordinary income from future appreciation of option stock by having clients sell their unexercised options to family members or family limited partnerships, usually in exchange for an unsecured note. The IRS also now requires special disclosure of these transfers as "listed transactions."

The IRS said these related-party transfers don't qualify for an exception under Internal Revenue Code Section 83 for the employee to be treated as having sold the option, cutting off any future gain from tax as ordinary income. Therefore, when the option is exercised, the excess of the fair market value of the stock received over the option price is still taxable to the employee as ordinary income.

In Announcement 2005-19, the IRS offers for taxpayers who previously made these transfers an opportunity to "come clean" and avoid litigation. If the option was exercised by December 31, 2004, the employee should report the ordinary income in the year the related person disposed of the stock. If the stock wasn't sold by December 31, 2004, the income should be reported on the employee's 2004 income tax return.

Employers can only claim the deduction for additional wages in the year the employee reports the income, and must treat its employees consistently. (If one employee reports under the offer, so must the rest of the company's employees.)

If this situation applies to you, you should consult with your tax advisors immediately. You must notify the IRS if you intend to participate in this settlement initiative by May 23, 2005.

Remember California amnesty applications are due March 31

Taxpayers who have unfiled California income tax returns or have liabilities for disputed or unreported items for years before 2003 should consider making an amnesty application. The application has to be filed by March 31, 2005. The payment of estimated liability due to the Franchise Tax Board also is required to be paid by March 31, 2005. Alternatively, installment agreements may be made as long as the balance is paid off by June 30, 2006. The income tax return or amended income tax return must be filed by May 31, 2005.

The amnesty issue is a tough call for many people who exercised incentive stock options but never reported the AMT income when the value of their stock fell, or who made a "wash sale" of ISO stock when the stock market was falling back in 2000. If your tax returns aren't audited, the tax authorities may never discover those issues. If they do, the California penalties will be draconian. Consider consulting with a tax attorney before you decide not to make an amnesty application if you had this situation.

Spidell Publishing has posted amnesty applications and information at www.caltax.com. Also, the Franchise Tax Board web site is www.ftb.ca.gov.

Remember, amnesty does not apply to federal tax penalties and California does share information with the IRS.

Last chance to claim refunds for unfiled income tax returns

When taxpayers don't file income tax returns within three years of the original due date, the IRS gets to keep the unclaimed refund. This means to claim a refund for an unfiled income tax return for the year 2001, you must file the tax return no later than April 15, 2005.

Questions and Answers

Question

During 2004, I exercised a NQO and sold the shares on the same day, for a net $18,000 of income. There was $7,000 of federal tax withheld from the sale proceeds. The company included the income in my total wages.

I also received a 1099-B for the sale proceeds. Am I also required to report this transaction on Schedule D?

Answer

Yes. Since you were issued a 1099-B form, you should report the sale for matching purposes. The tax basis for the stock is the option price plus the ordinary income included in your wages on Form W-2. This should be close to the selling price for the stock. In most cases, people report a loss of a few dollars for the sale on Schedule D.

Question

The 1099-B that I received from my broker doesn't show federal withholding for the sale of my option shares. The ordinary income is included with my wages on Form W-2. Is this an error?

Answer

No. The withholding for the transaction should also be included on your W-2 form. The broker withheld taxes as an agent for your employer.

Question

When preparing Form 6251, the amount that I calculate for line 16 (gain or loss adjustment) exceeds the amount used on line 13 (adjustment for exercise of ISO) when I bought the stock. When I try to understand the changes for lines 37-39, I'm totally lost. The instructions talk about "AMT Schedule D" and "AMT Qualified Dividends and Capital Gain Tax Worksheet", neither of which exist on the IRS web site. I have no clue how to calculate these lines.

How do I find someone to help me with this?

Answer

Your instincts are right. The adjustment at line 13 shouldn't be more than the original adjustment when you bought the stock.

When the instructions say "AMT Schedule D" and "AMT Qualified Dividends and Capital Gains Tax Worksheet", they mean that you use the "regular tax" forms with AMT amounts for the basis of the stock, etc. Mark the form "Alternative Minimum Tax" at the top of the page.

You can't claim you don't know anyone who understands this when you read this newsletter. My telephone number is 408-918-3161.

Question

Last year, I held expiring NQSOs in a privately-held Canadian firm. Despite the FMV being less than my exercise price, I chose to exercise my options because I expect the shares to be worth more if and when the company goes public. The company didn't send me any document for income to be reported.

Is there anything to report when the FMV is less than the option price? Is there negative income?

Answer

No. You only report income when the fair market value of the stock exceeds the option price. There is nothing to report when you exercise an "underwater" option. Couldn't you have made a private purchase of the stock from somebody as an alternative to buying the stock for more than FMV?

Question

I recently terminated my employment with my former employer by retiring. My employee option plan document says that "In order to retain the favorable income tax treatment of ISOs, the ISOs must be exercised on or before three months after retirement." Under the Code, do ISOs revert to NQSOs after some period after term of employment? What is the reference? If they do, then income tax withholding and employment tax withholding would apply on exercise, correct?

Answer

According to Internal Revenue Code Section 422(a)(2), in order to qualify as an ISO, at all times during the period beginning on the date of the granting of the option and ending on the day 3 months before the date of the exercise, the individual holding the option must have been an employee of the corporation granting the option or a parent or subsidiary of the corporation, or a successor corporation.

If the option isn't "qualified" as an ISO or an employee stock purchase plan, it is a "non-qualified" option, and taxed accordingly. As a former employee, the exercise will be subject to income tax withholding and employment tax withholding.

Question

My husband exercised 5,000 options at the end of 2004. I know we have to pay tax on the difference between the value of the options when he was issued them and the value of the stock at the time of exercise and sale, but does he also have to pay taxes on the value of the options at issue at the same time? To explain it better:

2004 stock value at the time of exercise and sale @ $52 per share,	520,000
2001 stock option grant of 10,000 shares at $22 per share,	220,000

Taxable gain is $300,000. Do we also have to include the $220,000 as ordinary income?

My accountant says yes, but my husband's panicked colleagues are saying that's impossible.

Answer

If I'm understanding you correctly, here's how this works. I'm assuming you didn't come up with any cash to exercise the options. The exercise price was paid from the proceeds of the sale. That means you received $520,000 - $220,000 less any taxes withheld.

The ordinary income that should have been included in your husband's W-2 wages is $300,000. The tax basis of the shares sold to be reported on Schedule D (assuming you received a 1099-B for the sale) is $220,000 (option price) + $300,000 (additional wages) = $520,000. The only way the $220,000 option price would be taxable is if the employer gave you the money to exercise the option.

Question

I quit my previous job in December, 2004. On my last working day, I exercised my Incentive Stock Option, which was granted more than four years ago. I didn't sell the shares. The company is privately held and will not go public in 2005. There is no information about the exercise on my W-2 form.

Is the exercise taxable? If so, how do I calculate the tax?

Answer

Please read our report, Executive Tax Planning For Incentive Stock Options.

Your employer should have given you a document, Confirmation of Exercise of Incentive Stock Option, disclosing the excess of the fair market value of the shares over the option price. This item is reported on Form 6251, Alternative Minimum Tax, line 13. Consider getting professional help for dealing with this issue.

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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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Read our new article!

• The future of employee stock options after Statement of Financial Accounting Standards No. 123

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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 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 www.amazon.com or www.barnesandnoble.com/ or buy it at Stacey’s Books.)

P.S.

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