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By Michael Gray

Table of Contents

• Only 31 days left to file your tax returns
• Extensions - and when you don't have the money to pay
• Exercising NQO using margin loan doesn't postpone tax
• No tax deduction for redemption of ESOP stock
• Questions and answers
  • Can my corporation receive NQSOs?
  • In which state should my stock option income be taxed?
  • Can AMT credit carryovers be lost?
  • The National Board of Certified Option Advisors
  • What are the guidelines for making estimated tax payments?
  • What do I report on schedule D when exercising options?
  • Why doesn't the IRS see option income I reported?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor

Only 31 days left to file your tax returns. Are you ready?

There isn't much time left to prepare income tax returns and extension forms. 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. At this late date, we are preparing extension forms for most new clients.

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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 deadline. 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 2004, you can process your federal extension electronically by April 17. You can also extend your filing date by making a credit card payment at 1-888- 729-1040 or 1-800-272-9829. 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 2004 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 jurisdiction code 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 to pay taxes 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 can actually 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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Exercising NQO using margin loan doesn't postpone tax

Jonathan and Kimberly Palahnuk exercised a non-qualified option during 2000 using third-party margin financing through CIBC Oppenheimer. The Palanucks claimed the transaction wasn't completed until the margin loan was paid off in 2001, so the income from exercise of the option shouldn't be taxable until 2001. The Palahnuks reasoned the money for the option was from a nonrecourse loan secured by the stock, so they didn't have capital at risk until 2001.

In a summary judgment, the Federal Court of Claims held that margin financing by a third party does not postpone the taxability of the exercise of a non-qualified stock option. The Court pointed out the Palahnuks did, in fact, receive the stock which was deposited as security for the third party loan. (Palahnuk v. United States, FedCl, 2006-1 USTC 50,218.)

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No tax deduction for redemption of ESOP stock

Chrysler Corporation created an ESOP as part of its federal bail- out in 1979. At one time, the ESOP owned about 22% of the corporation's stock.

During 1985, Chrysler redeemed most of the stock held by the ESOP as agreed in union contract negotiations. Chrysler claimed the redemption was compensatory, and should be tax deductible.

The Sixth Circuit Court of Appeals upheld the Tax Court in finding the redemption was not tax deductible. Chrysler Corporation received the tax benefit for the compensatory element of the arrangement when it contributed the stock to the ESOP from 1980 through 1984. The price Chrysler paid for the stock was the current trading value on the stock market, so the ESOP could have simply sold the stock for the same price on the stock market.

(Chrysler Corporation, CA-6, 2006-1 USTC 50,155.)

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Questions and Answers

Question

I've been offered some NQOs from a start-up company for providing contract/consulting services. I am part owner of a small consulting company (S corporation) and the start-up company is a client of ours. The client is offering the options to me personally. I'm wondering if there is any restrictions to offering me options in the name of my company instead.

Answer

It's okay if your client gives the options to your company.

If they don't, there might be some legal issues relating to this arrangement for you to discuss with your attorney.

Since the contract is between the client and your corporation, the option could be considered as going to you "by way of" your corporation, as compensation. (Regulations Section 1.83-7(a).) This could be a taxable transfer, but if the option price is the same as or greater than the fair market value of the stock, no tax will probably result.

What do the other shareholders think about being left out? Again, since this is a corporate client, I think you should have their written consent.

Question

If an employee is granted stock options by a corporation headquartered in Maryland and he lives in South Dakota, where is the income taxed?

Answer

This is becoming a big issue because of people telecommuting. I can't get into the nuances here. As a resident of South Dakota, the income is certainly taxable in South Dakota. It could be taxable in Maryland, with an offsetting state tax credit to South Dakota. Income is usually taxable in the state where the services are provided. Your best clue is, where are your wages being taxed?

Many companies have satellite locations in various states, and the wages are usually taxed in the state where the employee is working in a corporate office. With multinational corporations, the issue becomes even more complex.

That's all I can tell you with a "free" answer. For more help, pay a tax consultant.

Question

I have a question about AMT credit carryovers. (See our article on "The Amazing Disappearing AMT Credit.") Are you saying the minimum tax credit carryforward that arises in Year 1 may not be fully recovered in subsequent years that have no AMT? I've run a calculation over and over on a client and some of the credit carryforward is used, but then no carryforward to 2006 for the balance. I didn't think this was possible, so I would like confirmation.

Answer

It's possible.

It depends on the mix of "timing differences" and exclusion items for the particular taxpayer.

Also, many taxpayers are finding they have AMT tax liabilities on an ongoing basis because of disallowed deductions for items like state income taxes and property taxes on their real estate, so they can't use their AMT credit carryover indefinitely.

Question

Your readers might be interested to know the National Board of Certified Option Advisors offers a Certified Option Advisor designation. The web site is www.nbcoa.com. I became certified last year after taking two very comprehensive exams.

Bob Cremarius, CPA/PFS, Memphis, TN

Answer

Thanks for the information Bob. I hope you get some clients from this listing.

Question

When you exercise options during February, what are the guidelines for making estimated tax payments?

Answer

In short, if last year's income was less than $150,000, be sure last year's tax is paid in. If last year's income was $150,000 or more, pay in 110% of last year's tax. I'll have a more lengthy explanation in the next newsletter, or you can find it in last year's April issue.

Question

One of your readers previously wrote about making a same day sale when exercising an employee stock option. $18,000 of income was reported on his W-2 form.

You told him, "in most cases, people report a LOSS of a few dollars for the sale on Schedule D."

Shouldn't he have an $18,000 GAIN on Schedule D.

Answer

No. If he did, he would be reporting income for the same transaction twice.

The income reported on Form W-2 is added to the tax basis (cost to determine tax gain or loss) of the stock when reporting the transaction on Schedule D.

Question

I exercised some non-qualified options in 2004. The gross proceeds from the transaction were $7,005. My employer reported the taxable income on my W-2 Form.

Now the IRS has sent me a letter claiming I should report $7,005 of additional income. Aren't they double taxing me?

Answer

The IRS is simply trying to match what was reported on your income tax return with the documents they received.

The brokerage company sent them a 1099-B form for the sale of the stock, which you evidently didn't report on Schedule D.

Send an explanation to the IRS about what happened. Your tax basis for the stock is the option price plus the income included on Form W-2, which should be close to $7,005, so there should be a minimal amount of income or a small loss on the sale.

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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 newsletters?

For general tax developments, tax planning ideas, business development ideas and book reviews, subscribe to Michael Gray, CPA's Tax & Business Insight.

We are starting a newsletter devoted to real estate tax issues - Michael Gray, CPA's Real Estate Tax Letter. Like this newsletter, we will talk about new developments, have reports on special tax concerns, and answer questions and answers. The subscription rate is $19.95 per month. For a sample issue, visit realestatetaxletter.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)