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By Michael Gray

Table of Contents

• IRS issues audit guide for stock-based compensation
• Letter ruling a roadmap for handling community property
• Proposed regulations for employment taxes withdrawn
• How change of ownership is determined for golden parachute
• Questions and answers
  • Should I sell stock to recognize losses after exercise?
  • How do I exercise options from overseas?
  • How can I sell stock co-owned with my ex-wife?
  • How can I sell stock that has declined in value?
  • How is FICA determined for employee stock options?
  • How do I report a partial sale of option stock?
  • What are the AMT consequences of early exercise?
  • Are stock options adjusted for stock splits?
  • What types of taxes are required to be withheld on exercise of stock options?
• Do you know about our other newsletter?
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

IRS issues audit guide for stock-based compensation

As part of its Market Segment Specialization Program, the IRS has issued an audit technique guide for stock-based compensation. The guide is designed to alert the IRS auditor who is examining tax returns of companies that issue stock options and stock grants to their employees.

Items that auditors are told to give special attention to include "insider" employees subject to SEC rule 16b, employment agreements including plan documents for stock-based compensation plans, same day exercise and sale transactions, Section 83(b) elections by employees, income tax withholding and employment tax payments for stock grants and exercises of non-qualified options and whether income has been properly reported on employees' W-2 forms.

Examining employee compensation plans could be a lucrative way for the IRS to generate additional revenue if it can determine based on the employer's records that employees haven't reported their income from stock-based compensation.

This is a wake-up reminder that, according to the Treasury regulations, a copy of the Section 83(b) election must be provided to the employer in order for it to be effective.

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Letter ruling a roadmap for handling community property employee stock options in a marital dissolution

The IRS recently published a private letter ruling detailing the consequences of a property dissolution including non-qualified stock options and incentive stock options. The ruling is very taxpayer-friendly and provides a roadmap for handling the division of community property stock options. Remember that private letter rulings can't be cited as authority and relied on by taxpayers. In order to get "audit insurance", taxpayers must apply for their own rulings. Hopefully the IRS will codify this guidance in a revenue ruling or treasury regulations at a later time.

In the facts of the ruling, non-qualified options were to be transferred directly to the non-employee spouse. Incentive stock options continued to be held in the name of the employee spouse ("E"), but the non-employee spouse ("X") will retain all legal and beneficial ownership of the X's share of the ISO. The intention was to protect the status of the option as an ISO by avoiding transferring the nominal title to X. After the ISO is exercised, the shares will be transferred to X. The advantages of preserving the status of the options as ISOs include avoiding employment taxes (social security, medicare and SDI) and avoiding the regular tax when the option is exercised if the stock isn't sold at that time.

The IRS ruled these transfers qualify as a non-taxable division of marital property under Internal Revenue Code (IRC) Section 1041. When X exercises the non-qualified options, the taxable income will be taxable to X and income tax withholding will be applied for X.

When E exercises the ISO, there will be no "regular tax" consequence. The AMT adjustment for the excess of the fair market value of the stock over the option price will be reported on X's income tax return, thus enabling X to offset the AMT credit against the regular tax which will be reported by X when the stock is ultimately sold.

This is the first time I can recall the IRS stating the AMT adjustment will be reported on the non-employee spouse's income tax return despite the title remaining in the name of the employee spouse.

Again, this is a very favorable ruling that should be carefully studied when planning a division of community property interests in employee stock options. (LTR 200519011.)

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Proposed regulations for employment taxes relating to statutory options withdrawn

Since the American Jobs Creation Act of 2004 amended IRC Sections 3121(a) and 3306(b) to exclude statutory employee stock options (ISOs and ESPPs) from employment taxes, the IRS has withdrawn its proposed regulations that would have imposed these taxes when statutory options were exercised. (REG-142686-01.)

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How change of ownership is determined for golden parachute when a Section 83(b) election is made

The IRS has ruled that, when determining whether there has been a change of ownership in applying the "golden parachute" rules, unvested stock for which a Section 83(b) election is made is counted as outstanding, but unvested stock for which a Section 83(b) election has not been made is not counted as outstanding.

When the golden parachute rules apply, the corporation is denied a deduction for any excess parachute payment and a non-deductible 20% excise tax is imposed on the recipient of any excess parachute payment.

The golden parachute rules usually apply when a company has adopted a "poison pill" to avoid unfriendly attempts to acquire control of the company.

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Questions and Answers

Question

If I want to hold the stock after exercising ISOs, should I sell some stock to recognize losses to offset the gain from the exercise? Is the $3,000 capital loss deduction allowed when computing the alternative minimum tax?

Answer

Yes. Remember the additional income reported relating to the exercise of an ISO is ordinary income and not capital gain eligible for offset by capital losses. Capital losses are deductible when computing the regular tax and the AMT up to the amount of capital gains plus $3,000.

Question

I am American citizen located in Egypt. Years ago, I received some employee stock options while working for a company in California. I want to exercise them, but have been frustrated in my efforts to do so. What should I do?

Answer

Try to find out who is responsible for administering the plan. You should write to the company about your election to exercise the options. They are obligated to comply, unless there was a misunderstanding and the options lapsed after you left the company.

Question

I have a one-half (formerly community property) interest in 53 shares of Xerox stock. My ex-wife owns the other half. The title is still in both our names. How can we get the stock in a saleable state?

Answer

If you want to sell the stock anyway, see a stock broker. Maybe you can just sell it and divide the proceeds. If the sale proceeds are reported under your social security number, file a Form 1099B to show one-half of the sale proceeds are taxable to your ex-wife.

Question

I own about 600 shares of Paper Converting Machine Company. The value has declined from over $150,000 to $60,000 over a period of a few years. I need to sell the stock, but nobody will buy it because of the drop in value. How can I sell it?

Answer

I am not a stock broker. From your explanation, it appears this company is not traded on a public market. If it is, see a stock broker about how to sell it. If it is a private company, you need to find a shareholder (maybe the president?) who is willing to buy it privately, or find out if the company will redeem the shares.

It can be very hard to the sell the stock of private companies. I think it's not usually a good idea to buy a minority share of stock in these companies unless the value is very small, a public offering is imminent or there is some other compelling reason.

Question

In the June 10, 2005 Option Alert, this question and answer perplexed me:

"As a retired person, will I pay only the employee part of the FICA tax?"
(Answer - Yes.)

Was this out of context?

Answer

Yes. The whole question was, "When I exercise an NQSO as a retired person, will I pay only the employee part of the FICA tax?" Sorry for the mix up.

Question

I exercised 2,000 stock options during March, 2004. The fair market value of the shares was $45 and the option price was $13. I sold 610 shares to pay the option price. How should I report these transactions on my 2004 income tax returns?

Answer

Your employer should have included 610 X ($45 - $13) = $19,520 on your W-2 as additional wages. If not, I suggest reporting it as additional income. Report the sales proceeds (about $27,450) and $27,450 tax basis of the shares in the short-term gain or loss section of Schedule D. Report 1,390 X ($45 - $13) = $44,480 at line 13 on Form 6251.

If you have many more of these transactions and need help, hire a tax return preparer.

Question

If I take advantage of an early exercise of an ISO, what are the AMT consequences? Do I report the AMT adjustments as the options vest?

Answer

Yes, unless you make a Section 83(b) election for AMT reporting purposes. When you make the Section 83(b) election, the stock is treated as vested for AMT reporting on the date of exercise. Be very careful when you sell the stock. The ordinary income for a disqualifying disposition for regular tax reporting is determined based on the excess of the fair market value over the option price on the later of the vesting date or the date of exercise.

Question

Is an incentive stock option adjusted for a stock split when a company is privately held?

Answer

Yes.

Question

I am a brand new stock plan administrator for a company that went public six months ago. We are having an issue with taxes and same-day sales of ISOs. It is our policy to withhold taxes for all employees who exercise in a same-day sale for both ISOs and NQOs, unless the employee asks us not to for an ISO. What types of taxes are required to be withheld?

Answer

Your company should have a CPA firm that can answer these questions. NQOs are subject to income tax withholding and employment taxes (including social security, medicare and unemployment taxes) for the excess of the fair market value of the shares over the option price for vested shares. No withholding or payment of employment taxes are required when "qualified options", including ISOs and ESPPs, are exercised. (The American Jobs Creation Act of 2004 resolved the issue of employment taxes for 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.

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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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