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By Michael Gray

Table of Contents

• Only one week to go to April 15
• Extensions – and when you don't have the money to pay the tax
• First individual estimated tax payment due April 15
• SEC supports expensing options
• Tax Court upholds IRS rejection of offer on AMT from ISO
• Questions and answers.
  • How does AMT paid on ISO exercise affect taxes on sale?
  • Can I get a credit for California AMT in Colorado?
  • What do I do with AMT adjusted income?
  • Do I get the 15% long-term capital gains tax on my ISOs?
  • Is there a typo is "The Amazing Disappearing AMT Credit"?
  • Is there a 10% early distribution penalty on ESOP buybacks?
  • Can I find out if I filed an 83(b) election?
  • Are options from the US subsidiary of a UK company ISOs?
• Do you know about our other newsletter?
• Consult with a tax advisor.
• Subscribe to Michael Gray, CPA's Option Alert

Only one week to go to April 15.

If you want our help and we haven't received your information yet, please send it to us immediately so that we can prepare extensions and estimated tax vouchers for you. If we don't have your information yet and you want an appointment to bring it to us, please call 408-918-3161 to make an appointment now.

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Extensions - and when you don't have the money to pay the tax

(This is a reprint from past newsletters.)

What do you do when you don't have the money to pay the tax?

My first recommendation is to file your income tax returns, certified mail, by the initial filing date. One of the nastiest penalties in the IRS's arsenal is for late filing - 5% per month to a maximum of 25%. Some people who owe money don't file their returns because they are afraid. THIS IS A HUGE MISTAKE! The best approach is to be honest about your situation and work with the tax authorities to resolve it.

When you file an extension, any balance of tax due when the tax return is filed represents an exposure for the late filing penalty.

Please don't misunderstand me. I regularly use extensions for my clients and myself as a workload "safety valve". We often don't have the information to complete a return by the due date. They just aren't appropriate when there will be a significant balance due that won't be paid by the original filing due date.

According to the Treasury regulations for the requirements to file a valid automatic extension request, "an application for extension must show the full amount properly estimated as tax for the taxable year." (Reg. § 1.6081-4(a)(4).) The regulations relating to reasonable cause for failure to file a tax return state that if a taxpayer satisfies the requirement of showing the full amount estimated as tax, the taxpayer has a reasonable cause for failure to file during the extension period provided (1) the excess of the amount of tax shown on the return over the amount of tax paid by the original filing date (including the amount paid with the extension form) is no greater than 10 percent of the amount shown on the return (restated - 90% of the tax is paid by the due date), and (2) any balance due shown on the return is paid with the return. (Reg. § 301.6651-1(c)(3).)

(For California taxpayers, the extension is paperless so the amount of the tax need not be stated. You are still required to pay at least 90% of the tax by the original due date to avoid the late filing penalty.)

If you have filed an income tax return for 2003, you can process your federal extension electronically or by telephone - call 888- 796-1074 by April 15. Better call early to beat the rush! Mailing a paper form is still acceptable and is the only way a person who didn't file a 2003 income tax return can request an automatic extension.

A taxpayer can still avoid the late filing penalty by demonstrating a "reasonable cause," but this can be a hassle and the taxpayer is at the mercy of the subjective judgment of a representative of the tax authority.

Remember you may now pay income taxes using a credit card. Call 800-272-9829, or try the web site, www.officialpayments.com. The extension for California is 1555. You can also call 888-729-1040. Maybe you can find a card offering a low interest rate promotion that will work for your situation.

Should you borrow using a margin account? In most cases, this is not a good choice because of the exposure to margin calls if the market declines.

Should you use an equity advance loan, secured by your principal residence? In some cases it might be to your advantage, if you can get a favorable interest rate. Remember interest for an equity loan not used for a home improvement is only deductible on a loan amount up to $100,000. This interest is not deductible when computing the alternative minimum tax.

Remember that IRA accounts and even other retirement accounts can be temporary sources of funds. Distributions from IRAs that aren't minimum required distributions can be rolled over to another IRA or returned to the same IRA within 60 days after a withdrawal. This exception only applies to one rollover per year. (You must wait more than one year after a rollover is completed before making another one.)¹

Certain distributions from other qualified plans can also be rolled over within a 60-day period to an IRA or another qualified plan.² Using IRAs or qualified plans as a temporary source of funds to pay taxes can be useful if the funds to complete the rollover will soon be available, such as when there is a lockout "window" that will soon be open. The cost of an error can be high, because if the rollover isn't completed before 60 days have expired, the distribution may be subject to tax as ordinary income plus a 10% early distribution penalty.³

The IRS has a form for installment agreements, Form 9465. They would prefer that you submit the form with your income tax return. You can take up to five years to pay off your tax liability. An advantage of arranging an installment agreement is the penalty for late payment of tax is reduced from 1/2% per month to 1/4% per month. In addition to penalties, interest is charged for late tax payments. The interest rate is adjusted quarterly. Recently, the rate has been five percent.

Another alternative is to make an Offer in Compromise, Form 656. With this procedure, the IRS actually can reduce your tax based on your ability to pay. You don't have to wait until you have owed the tax a long time to use this procedure. I think it's best to work with an attorney, CPA or enrolled agent when making an Offer in Compromise. If the amount is large, an attorney is probably the best choice.

Although it may provide relief from your other creditors, bankruptcy doesn't offer much help for recent debts for income taxes. When you make payments on your tax bill, be sure to specify to apply the payments to taxes due. Penalties and interest are dischargeable in bankruptcy, but income taxes aren't.

It may be to your advantage to plan how to use regular tax or alternative minimum tax capital loss carryovers or minimum tax credit carryovers. You might need to generate capital gains, which can be difficult when you're in financial distress.

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First individual estimated tax payment is due April 15

(This is a reprint from past newsletters.)

Remember to review your estimated tax situation for 2005.

There is no estimated tax penalty provided the taxpayer pays at least 90% of the tax (including AMT) on the current year's tax return through withholding and/or equal quarterly estimated tax payments.

For taxpayers who have no more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁴ For taxpayers who have more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least, for 2005, 110% of the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁵

Taxpayers who have uneven income and deductions may also compute their estimated tax on an "annualized" basis. You multiply the year to date income and deductions to arrive at amounts for a year, compute the tax for that amount, then pay amounts to cumulatively pay in 1/4, 1/2, 3/4 and 100% of those amounts. You should probably get help from a professional tax return preparer to do this.

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SEC supports expensing options

The Securities and Exchange Commission has issued guidelines for expensing employee stock options. The guidance supports the option expensing rules issued by the Financial Accounting Standards Board and offers several models companies can choose from to estimate the value of employee options. (Staff Accounting Bulletin No. 107.)

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Tax Court upholds IRS rejection of offer on AMT from ISO

The Tax Court held the IRS did not abuse its discretion in rejecting an offer in compromise relating to an alternative minimum tax liability resulting from exercising ISOs during 2000.

The taxpayer found himself in severe financial difficulty because the value of his stock dropped sharply after he exercised the option. In this case, his AMT liability exceeded $200,000.

After making a partial payment of the tax, the taxpayer submitted an offer in compromise based on doubt as to collectibility. The taxpayer claimed he has insufficient assets to pay the liability.

The IRS revenue officer found the taxpayer had sufficient assets to pay the liability and rejected his offer.

The Tax Court sympathized with the taxpayer's situation, but said the answer lies in corrective legislation, not with the IRS or the courts. The IRS was reasonable in its conclusion that the taxpayer could pay the liability over time.

(Speltz, (2005) 124 TC No. 9.)

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Questions and Answers

Question

If a taxpayer exercises an ISO in 2001 and sells the shares in 2004, is the cost basis of the shares increased by any AMT paid in 2001?

Answer

No. The AMT might be partially recovered through the minimum tax credit. See Federal Form 8801 and the related instructions. The tax basis of the stock is adjusted for the additional income reported on the 2001 AMT schedule to prepare an AMT Schedule D, thus creating an AMT vs. regular tax difference to report at line 16 of Form 6251, so the regular tax will exceed the tentative minimum tax, permitting part of the minimum tax credit carryover to be used.

Question

I exercised and held some ISOs in 2002 and paid Federal and California AMT. In 2003, I moved from California to Colorado. I sold the shares I purchased using the ISOS in 2004.

I am wondering if and how I can claim credit towards my Colorado state taxes for my California AMT paid on the exercise of the ISOs. Am I out of luck on this? Has there been any clarification on this since you wrote about the problem in 2001?

Answer

I haven't seen anything to give you any comfort. To my knowledge, Colorado won't allow a state tax credit for an AMT paid in an earlier year for the exercise of an ISO when the stock is sold for a capital gain in a later year. I'm not an expert on Colorado taxes, so consider consulting with a local CPA.

Question

I was granted some stock options in 2000. I exercised the options and the stock is sitting in a brokerage account. I have a letter from the broker saying that I have AMT adjusted income. What do I do with this income?

Answer

It sounds like you have exercised an incentive stock option. The AMT income is reported on line 13 of Form 6251, Alternative Minimum Tax - Individuals.

You don't seem to have a clue what you are dealing with. Maybe you should hire a professional (like us) to help you.

Question

I exercised some ISOs in 1997 and 1998 and held the shares. The ISOs were granted at least 5 years before I exercised them. I didn't know anything about AMT at the time. Now I'm thinking about selling the shares. I thought that if I held the shares that long, I would just have to pay the 15% long-term capital gains tax. Observations?

Answer

You have met the holding period requirements for regular tax purposes. If the shares were vested when you exercised the options, you should also meet the holding period requirements for AMT. A question could be whether you are entitled to a basis adjustment for the shares for AMT reporting. If you didn't report any AMT adjustment when you exercised the ISOs, probably not. So, you should be entitled to the 15% capital gains rate for the sale.

Question

In reading your article, "The Amazing Disappearing AMT Credit" you state "The minimum tax credit carryforward to 1999 at line 26 of the form is not the amount that will be available to reduce the next year's regular tax. It will be reduced by the net minimum tax on exclusion items in the 1999 income tax return." This implies the calculation mixes last year's credit with this year's net minimum tax on exclusion items. However, as I read the 8801 form, the net minimum tax on exclusions from Part 1 is based on last year's 6251 form. Have I missed something, or has the 8801 form changed since 1999?

Answer

Thanks for pointing out that typographical error. It should have read "It will be reduced by the net minimum tax on exclusion items in the 1998 income tax return." We'll fix the article. Meanwhile, look at the sample Form 8801 included with the article, which illustrates the problem of the reduction of a minimum tax credit carryover by exclusion items in an intervening year.

Question

My husband's company "gave" him stock shares every year in his ESOP. My husband never paid anything to the fund. Now the employer wants to "buy back" the stock and dissolve the ESOP.

When they buy back the stock and my husband doesn't roll over the funds into another plan, is there a penalty of 10%? Also, are the taxes just computed by adding the amount into our regular income? Are there any additional taxes?

Answer

You haven't given me enough details for me to give you a complete answer. Assuming your husband is under age 59 1/2 and isn't terminating his employment, the 10% penalty will apply if he doesn't roll over the distribution. The regular tax will be computed by adding the distribution to his other taxable income.

I highly recommend that you consider a trustee to trustee transfer to an IRA to avoid withholding and to avoid tax on the distribution.

Question

I work for a startup software company in Mountain View and have ISOs granted on 11/10/03 and 11/1/04. On 11/16/04, I exercised options from each grant that were un-vested. I think I forgot to file an 83(b) election. Is there a way to find out?

If I didn't make the election, which of these statements that you made would apply?

• "If the election is not made the preference isn't measured until the restrictions lapse or the stock becomes vested", or
  
  
• "The IRS has said in regulations issued during August, 2004 that for regular tax reporting, Section 83 doesn't apply when an ISO is exercised, so the Section 83(b) election is not effective for regular tax purposes. The holding period starts on the date of exercise for avoiding regular tax ordinary income at disposition under the ISO rules."

In both exercises, the market value and the exercise price were the same, so there should be no current taxable event. My question is, on what date does any sale of these shares become long-term gain? Did my failure to file an 83(b) election change that date?

Answer

If you don't recall filing an 83(b) election, you probably didn't, because you have to sign the form before it is mailed to the IRS. Check with your plan administrator to see if the company helped you with this.

Both of the statements you quoted are correct, the first for AMT reporting, the second for regular tax reporting.

If you hold the stock more than two years after the grant dates and more than two years after the exercise dates, you will qualify for long-term capital gains reporting for regular tax purposes.

Since you didn't make the election, you should report ordinary income for the excess of the fair market value of the stock on the vesting date over the option price as the shares vest on your AMT schedule. The holding period for the shares on the AMT schedule will be based on the dates the shares vest. You have a mess on your hands.

Question

I work for the US subsidiary of a UK-based company. I was issued share options under a UK incentive scheme 5 years ago, but I have been a resident in the US for the last 3 years.

I believe that my option plan follows the requirements for ISO options, but this is not explicitly stated in my plan and there is no reference to any IRS regulations.

Could these options qualify as ISOs?

Answer

No. The plan must state that it is an ISO plan to qualify, and any options that don't qualify as ISOs are non-qualified options.

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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 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.

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.

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1 Internal Revenue Code § 408(c)(3)
2 Internal Revenue Code § 402(c)
3 Internal Revenue Code § 72(t)
4 Internal Revenue Code § 6654(d)(1)
5 Internal Revenue Code § 6654(d)(1)(C)