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By Michael Gray

Table of Contents

• Happy New Year
• 'Tis the season to exercise ISOs?
• Final 2005 estimated tax payment is due January 16
• Tax organizers and tax notebook instructions are in the mail
• Yes, we do prepare income tax returns!
• IRS relents on SAR and NQO option price before 2005
• Information reporting for non-qualified deferred compensation postponed
• Base date defined for issuing ISOs
• Questions and answers
  • Do successors have any rights to unvested options?
  • How does the ISO holding period work?
  • Can my employer reduce my stock options?
  • Are there any tax consequences after my stock is sold?
• Do you know about our other newsletter?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Happy New Year

We wish you a healthy and prosperous 2006! We'll do our best to help you keep as much as possible of your hard-earned gains.

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'Tis the season to exercise ISOs?

Although we think the risk of holding ISO shares after an exercise often isn't justified by the tax savings when the holding requirements are met, some people decide to go for the "brass ring". It's difficult to recoup the AMT credit when the stock is sold after the holding period requirements are met, so the federal tax rate for the spread at the exercise date ends up being 28% (the AMT tax rate, compared to about 32% regular tax after the tax benefit of the state tax deduction in a state like California).

If you decide to hold the stock, it usually is best to exercise the option early in the year. Assuming the exercise is made more than one year after the grant date, only the second requirement of holding the stock more than one year after the exercise date must be met to realize the tax savings.

There are two advantages of exercising early in the year. These advantages only apply if the stock is publicly traded or the stock can otherwise be sold at the end of the year and during the next year.

1. If you have a lower income tax for the tax year before the year of exercise, you can make estimated tax payments or have withholding based on the previous year's tax (110% of last year's tax if your adjusted gross income for last tax year was more than $150,000), so most of the tax due relating to the option exercise may not be due until April 15 after the year of exercise. By that date, you should have met the holding period requirements so the stock can be sold to generate the cash to pay the tax.
   
   
2. If the market price for the stock has fallen at the end of the year, you can sell the stock before the end of the year of exercise. You pay tax on ordinary income, being the excess of the sales price of the stock over the option price. The alternative minimum tax adjustment for the exercise date is eliminated. I call this the "escape hatch". In order to qualify, the transaction has to qualify for reporting a loss (if a loss was realized). This means you can't sell or gift the stock to a related party and that you have to avoid the wash sale rules. You can't purchase the same type of stock within 30 days before or 30 days after the sale (including other ISO, ESPP or NQO exercises).

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Final 2005 estimated tax payment is due January 16

Remember the final 2005 estimated tax payment for individuals, estates and trusts is due on January 16. If you need help to determine the appropriate payment to avoid underpayment penalties or avoid a big overpayment, consult with your tax advisor.

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Tax organizers and tax notebook instructions are in the mail

If we prepared your 2004 income tax returns, we have mailed paper tax organizers or electronic tax notebook instructions to you. If you haven't received them by January 13, please call Dawn at 408-918-3162. Also, please call Dawn if you would like us to prepare your 2005 income tax returns and would like tax notebook instructions or a paper organizer.

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Yes, we do prepare income tax returns!

With our free newsletters and the information we make available at no charge on the web, some people wonder how we make a living. We prepare income tax returns and provide tax and business consulting services. We are accepting selected new clients and are thrilled when our clients and friends refer their friends, associates and family members to us. To inquire about becoming a client of our firm, please call Dawn Siemer at 408-918-3162 or send an email to her at eso-advisors@stockoptionadvisors.com. We must receive your tax information by March 1 to guarantee delivery by April 15.

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IRS relents (a little) on SAR and NQO option price before 2005

In response to the sea of correspondence relating to the non- qualified deferred compensation rules under new Internal Revenue Code Section 409A, the IRS has announced that it will ease the administrative compliance burden for stock appreciation rights (SARs) and non-qualified stock options (NQOs) granted before 2005.

Under Notice 2005-1 and proposed regulations issued during September 2005, the IRS said that SARs and NQOs issued with an option price below fair market value would be subject to the non- qualified deferred compensation rules, and issued guidelines about how the fair market value could be determined.

Of course, the guidelines didn't exist before the new rules for non-qualified deferred compensation were issued. Companies could have to have appraisals done for years of stock options.

The IRS has announced that, for NQOs and SARs issued before 2005, it would apply the same guidelines that apply for incentive stock options under Internal Revenue Code Section 422(c)(1) and Treasury Regulations Section 1.422-2(e)(2). Under those guidelines, the ISO isn't disqualified because there was a failure in an attempt, made in good faith, to value the option at fair market value on the grant date. Therefore, the option is accepted as having a price of at least the fair market value for the stock.

The IRS has been liberal in applying this rule. I've never heard of an ISO being disqualified because of an incorrect option price that was made in good faith.

This should be great news for companies that haven't been able to have appraisals done and options repriced, provided it was documented in the company records that it was intended to price the options and SARs at the fair market value at the grant date. As always, I recommend that companies should consult with their own tax advisors when deciding whether they can rely on this announcement.

(Notice 2006-4.)

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Information reporting for
non-qualified deferred compensation postponed

The IRS has announced that the requirements to withhold taxes and report on Forms W-2 and 1099 taxable non-qualified deferred compensation payments and the amounts deferred under a non- qualified deferred compensation plan have been postponed for 2005. Employers and payers may be required to issue amended 2005 Forms W-2 and 1099 at a later time.

The reporting requirements were suspended because the IRS is still working on the how the new non-qualified deferred compensation rules should be applied and the proposed regulations were issued late in 2005, making it hard for employers, payers and payroll services to prepare for reporting the required information.

(Notice 2005-94.)

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Base date defined for issuing ISOs

One of the requirements for issuing ISOs is that new ISOs may not be granted after the date 10 years after the earlier of (1) the date the plan is adopted by board of directors or (2) the date the plan is approved by the stockholders. The plan must be approved by the stockholders of the corporation within 12 months before or after the plan is adopted.

On date A, a company amended its plan to increase the maximum aggregate number of shares that could be issued under the plan. On date B, the shareholders approved the plan.

On date C, the taxpayer's board of directors adopted an amendment to the plan extending the period for which ISOs could be issued, but the shareholders didn't approve the amendment.

The IRS ruled that the amendment approved by the shareholders on date B resulted in a deemed re-adoption of the plan, so the options granted within 10 years from the date of the shareholder approval qualify as ISOs under the 10 year rule. According to the IRS, the later date is used when the board's action is subject to a condition (such as a stockholder approval) or the happening of a specific event. In other words, the adoption by the board of directors wasn't completed until the shareholders approved the plan, so the shareholder approval date was also the date the plan was adopted by the board of directors. The later amendment on date C had no effect for the 10 year rule.

(Letter Ruling 200551015.)

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Questions and Answers

Question

Assume that options have been issued with a vesting period of four years. The employee dies after one year. Do the successors of the decedent have any rights to the unvested shares?

Answer

No. Vesting means that conditions must be met in order to have unrestricted ownership of the shares or options. In most cases, this means the options become vested or owned without restriction as the employee meets the "time in service" requirements. When the requirements haven't been met, the options haven't been "paid for" with the employee's required labor.

Question

The holding period for ISOs is confusing the way you explain it. (Hold the stock for two years after grant and one year after exercise.) I believe it should state exercise the option two years after grant and sell the stock 1 year after exercise.

Answer

I'm sorry you find this confusing. The requirements are spelled out in the Internal Revenue Code.

I think it might help if I give you an example, which shows your suggested explanation is in error.

John was granted an ISO for 100 shares of Supercorp stock on April 1, 2004.

He exercised the option on January 1, 2005.

In order to meet the holding period requirements, John must hold the stock until after April 1, 2006. The stock would be held more than two years after the grant date after April 1, 2006 and more than one year after the exercise date after January 1, 2006. The later date is April 1, 2006.

Question

I was granted stock options upon joining my current company. One year later they are changing my position within the company. The CEO is now telling me they have to lower the amount of options provided to me when I joined. Can they do this? I see nothing in my option paperwork that says they can lower the amount at will.

Answer

An option grant is a contract that can't be easily changed without the consent of both parties. There may be some additional information in your situation that you haven't told me, so I suggest that you get a lawyer and ask for a better explanation for this adjustment.

Question

I was with a privately held company in 2000. I joined in January and left in September. I had exercised all my options by June, 2000 and filed Section 83(b) elections for all of them. After I left, the company repurchased all of my ISO shares. The company is still privately held.

Do I need to do anything as a next step? Am I still on the hook for any taxes on gains, should the company go public, since the IRS only has my 83(b) elections and nothing else from me?

Answer

From your explanation, the company repurchased your unvested shares at the option price. You should have reported the sale on your 2000 income tax return, but the statute of limitations has expired and there was no gain or loss on the transaction.

Since you no longer owned the shares after 2000, you have no tax exposure if the company is sold or goes public.

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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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