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By Michael Gray

Table of Contents

• IRS issues proposed deferred compensation regulations
• Final individual tax return deadline is October 17
• IRS abused discretion in allowing option expenses
• Taxpayers not allowed to revoke Section 83(b) election
• Taxpayer required to report income from option exercise
• Questions and answers
  • Can we avoid taxes by transferring shares to our children?
  • Will I have to pay taxes on stock grants?
  • Are payroll taxes due for disqualified ISO or ESPP shares?
  • How are warrants taxed?
  • What taxes apply when exercising and selling ISOs?
  • What's my termination date determining the final exercise date for my ISOs?
  • Can the 83(b) election be filed late?
• Do you know about our other newsletter?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

IRS issues proposed deferred compensation regulations

On September 29, 2005, the IRS issued proposed regulations for nonqualified deferred compensation plans. The proposed regulations implement changes in the rules adopted in the American Jobs Creation Act of 2004, signed by President Bush on October 22, 2004. The proposed regulations provide additional guidance to an earlier release by the IRS, Notice 2005-1.

Some of these changes affect stock-based compensation plans, including certain non-qualified stock options and stock appreciation rights. Amounts deferred before January 1, 2005 are grandfathered, providing there is no material modification of the plan after October 3, 2004. Material modifications include the addition of any benefit, right or feature, such as accelerating vesting.

Non-qualified stock options and stock appreciation rights are not considered to be deferred compensation provided the option price or SAR base price on the grant date is at least equal to the fair market value of the stock on that date and the plan doesn't include any other deferred compensation features. Under a transitional rule, the elimination of other deferred compensation features from a non-qualified stock option plan or a SAR is not a material modification of the plan. The proposed regulations extend the deadline to make this modification from December 31, 2005 to December 31, 2006.

In some cases, employers will decide to terminate grandfathered plans. The proposed regulations and Notice 2005-1 provide this will not be considered to be a material modification, provided the termination is completed by December 31, 2005 and that all amounts deferred under the arrangement are distributed in the taxable year of termination. This date was not extended by the proposed regulations.

Since failing to meet the requirements for non-qualified deferred compensation plans will result in immediate acceleration of deferred income for the current and previous years, employers should have their non-qualified stock options and other stock- based compensation plans reviewed for compliance. Incentive stock options and employee stock purchase plans are exempt from the non-qualified deferred compensation rules, provided they don't have other deferred compensation features.

Some non-qualified stock option and restricted stock plans intentionally included deferred compensation features. Modifications for future grants under these plans must be in place by December 31, 2006, and the new rules for distributions are much stricter than under the old rules. If you have such a plan, you should definitely review it with your attorney before the end of 2005.

Under the new rules, compensation may only be deferred at the service provider's election if the election to defer the compensation is made not later than the close of the service provider's taxable year next preceding the service year. (The election has to be made in the year before the services are provided.)

Compensation that is paid by the 15th day of the third month after payer's year end is generally not subject to the non- qualified deferred compensation rules.

Deferred compensation can only be paid for one of the following:

1. The service provider's separation from service (after a six- month waiting period)
2. The service provider becoming disabled
3. The service provider's death
4. A time or pursuant to a fixed schedule specified under the plan (under guidelines specified in the regulations)
5. A change of ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation
6. The occurrence of an unforeseen emergency (under guidelines specified in the regulations)

This is only a brief sketch of the new requirements and transitional rules. Employers should consult with legal counsel that regularly deals with deferred compensation to review their compensation plans and determine any appropriate actions to take.

(REG-158080-04, 70 FR 57929)

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Final individual tax return deadline is October 17

October 17 is the final extended due date for non-corporate calendar year taxpayers, including individuals, estates, trusts and partnerships. If you haven't given the information to prepare your returns to your professional tax return preparer yet, do it now. (Katrina and Rita victims, see the October issue of Michael Gray, CPA's Tax & Business Insight about extension of time under emergency relief legislation.)

The penalties for late filing are becoming more severe, especially in California, where penalties apply even when there is no balance of tax due. Real hassles can be avoided by simply filing your tax returns and paying your taxes on time.

Tax return preparers should be aware that they can be disbarred from practice before the IRS under Circular 230 if they fail to file their tax returns on time.

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IRS abused discretion in allocating option expenses

The Tax Court ruled the IRS abused its discretion in reallocating costs incurred by a domestic corporation and its controlled Irish subsidiaries related to the issuance or exercise of stock options by its employees who performed research and development in the U.S.

The IRS claimed that those expenses should be allocated under the corporation's cost-sharing agreement. (By allocating the expenses overseas, taxable income subject to U.S. tax will increase.)

The court found that unrelated parties would not explicitly share the spread resulting from exercising employee stock options, so the allocations by the IRS would not have an arm's length result. Allocations of costs should result in allocating costs in a way that would be similar in result to what unrelated taxpayers would experience.

If you are involved in intercompany pricing subject to Internal Revenue Code Section 482 and your company has employee stock options, you will want to study this case.

(Xilinx Inc. and Subsidiaries v. Commr., Xilinx Inc. and Consolidated Subsidiaries v. Commr., 125 TC ___, No. 4, August 30, 2005.)

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Taxpayers not allowed to revoke Section 83(b) election

A U.S. District Court in California issued a summary judgment rejecting an attempt by taxpayers to revoke his Section 83(b) election.

The taxpayers asserted several reasons why his Section 83(b) election should be held invalid or allowed to be revoked.

The taxpayers claimed the transaction was open because the shares were subject to a repurchase option. The court found the repurchase option would only affect the validity of a Section 83(b) election if it never lapses.

The taxpayers claimed they didn't understand the consequences and restrictions of the option. The court found those consequences and restrictions were spelled out in the Stock Option Exercise and Repurchase Agreement.

The taxpayers claimed their Section 83(b) election with respect to incentive stock options was invalid because it didn't specifically reference the alternative minimum tax. The court found a reference to the alternative minimum tax wasn't required and that the election by the taxpayers fulfilled the requirements of the IRS regulations.

Since the Section 83(b) election can only be revoked with the consent of the IRS, taxpayers should get advice before making the election and consider the election will probably be irrevocable.

(Gamiel C. Gran and Gail K. Gran v. U.S, U.S. District Court, Northern District of California; 04-4605-SC, August 26, 2005.)

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Taxpayer required to currently report income from financed option exercise

The Tax Court issued a summary judgment against a taxpayer who claimed he shouldn't have been taxed when he exercised his non- qualified stock options.

The taxpayer claimed the purchase of shares under exercise of the option was incomplete because the shares were purchased using a nonrecourse note. The court found the purchase was complete because the taxpayer received the funds as a recourse loan from a third-party lender, Comerica Bank-California (which resulted in the taxpayer filing for bankruptcy.)

The taxpayer also claimed his gain shouldn't be taxable on the date of exercise because the shares were nontransferable and subject to a substantial risk of forfeiture. The court found that is the reason a Section 83(b) election is made.

The taxpayer claimed the income should not be taxable on the date of exercise based on the authority of Robinson v. Commr. The court found the facts were different in this case. Robinson was subject to a sellback provision. This taxpayer was not. Further, the taxpayer had sufficient control of his shares to use them as collateral for the purchase loan.

The taxpayer claimed he should be able to deduct his loss from the subsequent decline in value of the shares as an ordinary loss. The IRS regulations allow an ordinary loss to the extent that the basis has been increased as a result of the recognition of income by a taxpayer under Section 83(b) when otherwise vested property is forfeited pursuant to a lapse restriction. The court found there was no forfeiture of shares under a lapse restriction. The taxpayer sold his shares to pay his loan to Comerica when he filed for bankruptcy.

(Keith D. Hilen v. Commr., T.C. Memo 2005-226, September 29, 2005.)

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Questions and Answers

Question

We have employee stock options to purchase shares that currently are selling for $50 for $26. Can we avoid income taxes by transferring the shares to our children?

Answer

Although you can have favorable estate planning results from making such a transfer, you won't be able to avoid the income. This is called an assignment of income, which isn't allowed under the income tax laws. If the options are non-qualified options, you will have additional compensation income when your children exercise the options. Incentive stock options only qualify as such provided they are non-transferable other than by will or the laws of descent and distribution (IRC Section 422(b)(5)).

Question

I work for a startup company. I received 60% of last year's bonus in cash and 40% as stock grants. My employer estimated the value of the shares as $1 per share.

Will I have to pay taxes on the stock grants?

Answer

Assuming the grant was fully vested, it is taxable. Your employer should include the value of the grant on your W-2 form as part of your wages.

Question

Are payroll taxes (FICA and Medicare) due for ordinary income relating to the disqualified disposition of ISO shares? How about ordinary income from the disqualified disposition of ESPP shares?

Answer

ISOs and ESPPs are both "qualified stock option plans" under the Internal Revenue Code. The additional compensation resulting from a disqualifying disposition of shares purchased using these options are not subject to employment taxes like FICA and Medicare.

Question

I joined an investment banking firm where part of our compensation includes warrants. How are these taxed?

Answer

If the warrants can be traded on a public market, they are taxable based on the market price.

If the warrants are personal and can't be traded, they are taxed as non-qualified stock options. See our special report, Executive Tax Planning for Non-Qualified Stock Options.

Question

My husband was awarded some ISOs in 1997. Now we are looking at exercising ISOs and selling shares.

1. Do we have to pay Federal or State taxes on this?
2. Will the AMT apply?

I believe from all my reading that all we will have to pay is capital gains tax. Is this correct?

Answer

See our special report, "Executive Tax Planning for Incentive Stock Options".

The AMT will probably apply if you exercise the options and hold the shares. If the shares are sold before holding period requirements are met, your husband will have ordinary income taxed as additional wages.

Maybe you should consult with a tax advisor to help walk you through this. (Like us.)

Question

I was terminated from my job. I will receive severance pay for one year plus benefits. What is my termination date to determine the final exercise date for my ISOs?

Answer

The date you discontinue providing services to your employer, which should be reflected in your employment records.

Question

An officer of a closely-held corporation is granted an option to purchase 1,500 shares (50% of the outstanding stock) in the corporation, which has a history of losses at 1¢ per share. He fails to file the Section 83(b) election and report the income.

Can the 83(b) election be filed late, together with an amended income tax return for 2003? Does the Section 83(b) election even apply when the option relates to 50% of a company's stock?

Answer

First, if the shares were vested when the option was exercised, no election is required. The transaction is taxable on the date of exercise of the option, assuming the option was a non- qualified stock option. Section 83 applies any time property is paid in exchange for services. The Section 83(b) election can be made when the property received was nontransferable and subject to a substantial risk of forfeiture.

Once the time period has passed to make a timely election (30 days after receiving the property/exercising an NQO), the opportunity is lost. No late election is allowed.

If the election isn't made, ordinary income is reported for the excess of the fair market value of the stock over the option price when the stock becomes vested.

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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.)

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P.S.

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