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By Michael Gray

Table of Contents

• Tax Reform Panel Report and Option Holders
• Year-end planning for employee stock options seminar
• Thanksgiving celebration call-in day
• It's time for year-end planning
• Questions and answers
  • Should I avoid AMT by exercising ISOs in small amounts?
  • Do I have to use the market price for my stock options?
  • Do companies notify employees when options are expiring?
• Do you know about our other newsletter?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Tax Reform Panel Report and Option Holders

The President's Advisory Panel on Federal Tax Reform issued a 272-page report on Monday, November 1. The panel is wrestling with a very difficult problem. By 2013, less revenue would be lost by repealing the regular tax than by repealing the alternative minimum tax. President Bush asked the Panel to develop alternatives to make our tax code simpler, fairer and more conducive to economic growth, while recognizing the importance of home ownership and charity in American society.

The panel developed two alternatives. One is called the Simplified Income Tax Plan and the other is called the Growth and Investment Tax Plan. Having two alternatives makes it more confusing to discuss the proposals.

The provision most discussed in the press is the reduction of the benefit for the home mortgage deduction. The home mortgage deduction would be replaced with a tax credit equal to 15% of interest paid for a mortgage, limited to the average regional price of housing - about $227,000 to $412,000. It's proposed the change would be phased in over a five-year period. It's obvious this provision will severely hurt taxpayers who recently bought homes in high cost areas like here in Silicon Valley, where "starter homes" cost about $750,000.

The proposals go farther than that. The itemized deduction schedule would be eliminated. The deductions for state income taxes and property taxes would be eliminated. The casualty loss deduction and deductions for miscellaneous itemized deductions like employee business expenses would be eliminated. Special deductible Save For Family accounts, like health savings accounts, would be created to replace the medical deduction and provide for education needs. Medical insurance would be deductible up to limitation amounts (about $5,000 for an individual and $11,500 for a family).

Charitable contributions would be deductible for all taxpayers for amounts paid over 1% of income. Taxpayers could sell non- cash assets tax-free when the proceeds are donated to a charity within 60 days after a sale. Charities would be required to issue information returns for donations with a value over $600. Taxpayers would no longer be able to rely on "do it yourself" receipts to value charitable contributions. The Panel recommends the status of different types of charities should be re-examined to determine whether they should qualify as charities for tax- deductible donations.

The alternative minimum tax would be repealed. (With all of the base-broadening, the regular tax will look much more like the alternative minimum tax looks now.)

Under the Simiplified Income Tax Plan, there would be four tax brackets with a maximum tax bracket of 33%. Under the Growth and Investment Tax Plan, there would be three tax brackets. with a maximum tax bracket of 30%.

Under the Growth and Investment Tax Plan, investment in business- use land, building and equipment could be expensed, but business interest wouldn't be deductible, except for banks. The tax rate for dividends, taxable interest and long-term capital gains would be 15%. (The tax situation for real estate investors would be radically changed, with reliance on debt financing discouraged.)

There are many more details that I don't have space to discuss. This is a very difficult problem. Every tax benefit or deduction has a group that sees it as a "sacred cow". If we are going to keep the current system but eliminate the alternative minimum tax, income tax rates will probably have to be raised. With current and projected federal deficits, tax rates may be forced up in any case. The $50,000 questions are: "How high?" And, "Will a bigger underground economy develop as a result of higher tax rates?"

This report should initiate debates in Congress about how best to reform our tax system. Many of us believe it should be reformed, but disagree about what our tax system should look like. From the comments in the press, it appears Congress isn't embracing the proposals, and, as a lame-duck President facing many challenges, President Bush probably doesn't have enough influence to push this proposal through Congress in its current form.

To see the entire report, visit http://www.taxreformpanel.gov.

What are significant points for holders of employee stock options?

• Holders of employee stock options tend to be high-income individuals who buy homes. They will be hurt by the reduction of the mortgage interest deduction and the elimination of deductions for real estate taxes.
  
  
• The biggest tax deduction for many option holders is state income taxes. That deduction would be eliminated.
  
  
• Since the alternative minimum tax would be repealed, benefits could be restored to holders of incentive stock options because the adjustment for exercise of those options would be eliminated. The report doesn't say what would happen to unrecovered minimum tax credits. Some holders of ISO stock could find they are subject to tax a second time when the stock is sold.
  
  
• Under the Simplified Income Tax Plan, 75% of corporate capital gains from U.S. companies would be excluded from taxable income, resulting in capital gains tax rates of 3.75% to 8.25%. Under the Growth and Investment Tax Plan, long-term capital gains would be taxed at a 15% maximum tax rate.

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Year-end planning for employee stock options seminar

Michael Gray, CPA will be presenting a lunchtime seminar on Year- End Tax Planning for Employee Stock Options on Friday, December 9. The seminar will take place from noon to 1:30 p.m. at Hobees Restaurant in the Pruneyard in Campbell, California (1875 S. Bascom Ave., next to the Camera Theaters in the back of the shopping center. The telephone number for Hobees is 408-369- 0575.) The investment, which includes lunch, is $50 per person. For reservations, call Dawn Siemer at 408-918-3162. Seating is very limited, so reservations are required. See http://stockoptionadvisors.com/seminar.pdf for a fax-in registration form.

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Thanksgiving celebration call-in day

As a client and reader appreciation event, we will have a call-in day on Tuesday, November 22. You may call in for a 10-minute "consult" at no charge. To prepare, you may fax information in advance to 408-998-2766. The calls will be handled on a first- come, first-served basis. We will not return calls at no charge for which messages are left during these times. If we don't answer, try calling again until we are connected.

In such a short period, we will be unable to answer complex questions requiring research. Be reasonable with your expectations.

The telephone number is 408-918-3161.

From 9 a.m. to 10 a.m. PST, we will take calls only from clients who have paid us for services during 2005.

From 10 a.m. to noon PST, we will take calls from clients and readers of our newsletters.

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It's time for year-end planning

Less than two months left in the year, and they are the two busiest and seem like the shortest months of the year. Considering the holidays, the times available for year-end planning consultations will be limited. Why not call for your appointment now? Michael Gray's telephone number is 408-918-3161.

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Questions and Answers

Question

I have been using a strategy whereby I attempt to avoid AMT by only exercising and holding small amounts of ISOs, because I was led to believe that AMT once paid was forever gone.

If AMT can be recovered via a carryover, that might change what I want to do.

Answer

There is a minimum tax credit for "timing differences". See IRS Form 8801 and instructions, and request our special report, "Executive Tax Planning For Incentive Stock Options".

The strategy of making small exercises of ISOs can be letting the tax tail wag the dog. You can suffer a much bigger loss from a decline in the market value of the stock than the tax that you have to pay from exercising and selling the stock.

Our business is helping people walk through the minefield.

Question

If non-qualified stock options are for a small "public" stock that does not trade (illiquid), would you have to use the "market" price, even though you could never sell out at that price (without being responsible for destroying the stock price)?

Answer

The company is supposed to determine the market value of the stock in order to determine the amount to be reported as additional wages on your W-2 form and the related withholding. If you disagree with that value, you should document how you determined a different amount. The best way to do this is to hire an appraiser, but that is very expensive and requires the cooperation of the company.

Illiquid stock for companies like the one you describe and non- publicly traded stock is a very tough problem for employees who receive employee stock options. Sometimes employees are better off just walking away from exercising options when the result can be putting themselves in financial distress.

I know. This sucks.

Question

My sister had valuable employee stock options expire about 9 months before she discovered it. (She was ill and absent from work.) She was not informed about the impending expiration and is now trying to build a case to get the options reinstated or at least get some compensation.

Do companies generally notify employees when options are about to expire? Are options automatically exercised when they are "in the money".

Answer

I don't have a database of company practices. Employers are not required to shepherd their employees through the option process.

Your sister should have received paperwork at the time the option was granted showing all of the details, including when the options would expire. She was responsible to calendar this information.

Some employers maintain web sites showing the details, including expiration dates, for outstanding employee stock options.

Employers do not automatically exercise "in the money" stock options that are about to lapse. Some employees have good reasons for not exercising those options. An example is when the stock isn't publicly traded and the employee can't raise the money to pay the taxes resulting from exercising the option.

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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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