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Table of Contents

• SEC investigates timing of grants of employee stock options
• Repricing options allowed under reasonable compensation rules
• Exercising a non-qualified option using a margin account doesn't defer income
• Carryback of AMT capital loss not allowed for ISO shares
• Capital gains rate extended by new tax law
• Questions and answers
• Is my capital loss adjustment included on form 8801?
• How do I sell shares in private bank stock?
• Can ISOs be issued to independent contractors?
• Can I write off a stock loss without selling the shares?
• Can I still exercise options given to me in 2000 and 2002?
• Do I have to pay Connecticut taxes since I moved to Florida?
• Can I use my AMT credit when I don't have to pay AMT?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

SEC investigates timing of grants of employee stock options

The SEC is inquiring into whether employee stock option grants for many corporations were backdated. Many of the options were reported as granted just before the market value of the stock increased.

So far, transactions for more than 35 companies are being investigated nationwide. Twenty of the companies are headquartered in Silicon Valley, including KLA-Tencor.

No charges have been asserted by the SEC. Some pension funds have filed lawsuits, represented by William Lerach's law firm.

If the grants were priced in error, the financial statements for the companies could have to be restated and tax returns of the companies and their employees corrected. According to Senator Grassley of Iowa, the Justice Department could file criminal complaints against executives resulting in jail sentences.

The transactions in question happened before the enactment of new Sarbannes-Oxley corporate governance rules and new non-qualified deferred compensation tax rules that would require pricing non- qualified stock options at or above fair market value on the grant date. Other rules, including reasonable compensation rules, golden-parachute rules and the terms of the employee stock option agreements, could apply to require pricing options at fair market value on the grant date.

The corporate environment has changed dramatically since the heyday of employee stock options during the stock market boom of the 1990's. Corporations (including start-up corporations) should be very careful when implementing employee stock option plans. With so many tax and financial reporting compliance hassles associated with granting employee stock options, start-up corporations may find they are just too expensive to continue.

It's a shame. We may be killing the goose that laid the golden eggs.

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Corporation allowed to reprice options under reasonable compensation rules

The IRS has privately ruled that an employer may reprice a non- qualified stock option when it paid a one-time extraordinary dividend. The options were repriced so that employees holding the options would not experience a decrease in the value of their options since they weren't eligible to receive the extraordinary dividend.

Under the rules that limit the deduction of publicly-held companies to $1 million per year, employee stock options are generally considered performance-based compensation that isn't subject to the limit. However, the number of stock options that may be granted to an employee is limited according to the terms of the employee stock option plan. In most cases, when an option is repriced, it is treated as cancelled and reissued, which would reduce the number of shares for which an employee can receive additional options.

There is an exception when a change is made to the option price relating to a change in corporate capitalization, such as a stock split, dividend or a merger or split up. The IRS ruled this taxpayer met this exception. Therefore, the option is just considered as continuing with the price adjustment and the employee won't suffer a decrease in the number of shares for which options may be granted.

Although employers can't rely on this ruling, they can apply for their own rulings when they have a similar situation.

(Letter Ruling 200617019.)

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Exercising a non-qualified option using a margin account doesn't defer income

Jean-Remy Facq exercised a non-qualified employee stock option for InfoSpace stock during February, 1999. The funds came from a margin account at Hambrecht and Quist, secured by the stock. Mr. Facq was personally liable for repayment of any shortfall.

In addition to paying for the options, Mr. Facq used the margin account to pay his tax withholding and to purchase personal items, including two cars, a boat, and three houses.

The market value of InfoSpace crashed during 2000 and 2001, so all of the stock was sold to pay off the margin account and Facq had to borrow more funds from other sources to pay off the account.

On his 1999 income tax return, Facq claimed a reduction of the amount reported on his Form W-2 issued by InfoSpace. He said the shares were subject to a substantial risk of forfeiture and non- transferable.

At trial, Facq argued that exercising an option through a margin account is properly treated as the grant of another option to buy the shares, so they weren't taxable when he exercised his options. He cited Treasury Regulations Section 1.83-3(a)(2) and 1.83-3(a)(7), example 2, which says "when the amount paid for the transfer of property is an indebtedness secured by the transferred property, on which there is no personal liability to pay all or a substantial part of such indebtedness, such transaction may be in substance the same as the grant of an option." Mr. Facq believed the ordinary income should be determined based on the actual selling price of the stock to pay off the margin account.

In a memorandum decision, the Tax Court found against Mr. Facq. The Court held that, in order to qualify for the exception, the debt would have to be a nonrecourse debt to the company. Mr. Facq was personally liable on a debt to a third-party lender.

The Court gave Mr. Facq a break by not imposing the accuracy- related penalty. Mr. Facq was not knowledgeable about the tax laws and relied on his accountants and tax attorneys to prepare his income tax returns, which included disclosure of the issues on a Form 8275. There was no case law on this issue before Mr. Facq's income tax returns were prepared for 1999.

(Facq v. Commissioner, T.C. Memo 2006-111, May 23, 2006.)

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Carryback of AMT capital loss not allowed for ISO shares

Robert Merlo exercised incentive stock options of Exodus stock on December 21, 2000, for which the excess of the fair market value on the date of exercise over the option price was $1,066,064. Mr. Merlo reported $452,025 as the alternative minimum tax (AMT) adjustment for the exercise of his ISO stock on his 2000 income tax return. That was the excess of the fair market value of the stock on April 15, 2001 over the option price.

In 2001, Exodus filed for bankruptcy and the stock was worthless.

Merlo claimed that the capital loss limitations that apply for regular tax reporting do not apply for AMT, and he should be able to apply his 2001 capital loss relating to the worthless stock to reduce the AMT income reported in 2000.

The Tax Court found that Merlo should have reported the excess of the fair market value of the stock on the date of exercise over the option price on his AMT schedule for 2000.

The Court also found the regular tax limitations for capital losses must be applied for AMT reporting, citing Treasury Regulations Section 1.55-1(a), "Except as otherwise provided by statute, regulations or other published guidance issued by the Commissioner, all Internal Revenue Code provisions that apply in determining the regular taxable income of a taxpayer also apply in determining the alternative minimum taxable income of the taxpayer."

The Court used similar reasoning in concluding the loss from the worthless stock was not eligible to be carried back as a net operating loss.

Merlo argued that under principles of equity, he should be allowed to carry back his AMT capital loss to reduce his AMTI. Applying the capital loss limitations to the calculation of his AMTI results in harsh and unfair tax consequences.

The Court responded that despite the hardships resulting from the AMT, challenges based on equity have been uniformly rejected.

(Merlo v. Commissioner, 126 T.C. No. 10, April 25, 2006.)

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Capital gains rate extended by new tax law

President Bush signed the Tax Increase Prevention and Reconciliation Act on May 17, 2006.

Here are a few of the provisions enacted:

• Extension of reduced tax rates for long-term capital gains and qualified dividends through 2010.
• Extension of alternative minimum tax relief (increased exclusions) for 2006.
• Extension of increased limit for expensing business assets through 2009.
• Changes in requirements for offers in compromise, including required tax deposits and potential for automatic approval, effective for offers submitted on or after July 16, 2006.
• More children up to age 17 subject to Kiddie Tax, effective 2006.
• More taxpayers eligible to convert regular IRAs to Roth IRAs for tax years beginning after 2009.

You should consult with your tax advisor about how you are affected by this new tax law. Also, be aware that more tax legislation may well be passed during 2006.

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Questions and Answers

Question

I have a large AMT capital loss carryover from selling ISO shares in one year for much less than the exercise price in another year, and a large AMT credit. Each year, the credit has been unused and reduced on Form 8801. I believe I should be including the amount from Form 6251, line 16 (the usable part of my AMT loss carryover) in the calculation of Form 8801, line 2.

Is the capital loss adjustment included on Form 8801, line 2?

Answer

No. Line 2 is for exclusion items, which are items reportable for regular tax purposes, but not for AMT purposes. See the instructions for line 2. These items include the AMT "add backs" of the standard deduction, medical expenses, taxes, mortgage interest (usually from equity lines of credit), and miscellaneous deductions.

I suggest that you simply follow the instructions for the form.

The main way to recover your AMT credit is to generate capital gains. The AMT capital loss carryover will reduce the capital gains on your AMT schedule, thus enabling you to use the AMT credit carryover.

Consider hiring a tax return preparer. That's what we're here for.

Question

I have some private bank stock that I desperately need to sell. How do you suggest that I do that?

Answer

I'm not an expert on such matters. I suggest that you find another shareholder of the bank who is willing and able to buy your stock. See an officer of the bank about this. You will need a lawyer to do the paperwork.

Question

1. Does the company pay any taxes relating to incentive stock options granted to independent contractors?
2. Can ISOs be issued to independent contractors?
3. Can the company make the ISOs available at a $0 cost, as an incentive for making certain sales goals?

Answer

1. See 2.
2. ISOs can only be granted to employees. Non-qualified options can be granted to independent contractors.
3. No. ISOs and NQOs must be priced at fair market value on the grant date. However, you can make a stock grant as a bonus.

It sounds like you need to consult with an attorney that writes stock-based compensation plans.

It's dangerous to "wing it" when setting up stock-based compensation plans. Look at all of the trouble major companies are having with the SEC. You can have a plan blow up in your face and both the company and your contractors will lose.

Question

I purchased all of the shares allocated to me by company X during 2000. I paid off the loan to pay for the shares, and have since moved to another company.

The company was still privately held during 2005. I would like to write off the loss on the ISO shares to offset capital gains on my 2005 income tax returns.

X was sold during 2006. I know what the loss per share will be.

Can I deduct the loss on my 2005 income tax returns?

Answer

The only way you could deduct the loss on the shares without selling them is to establish that the shares were worthless during 2005. Since the company was sold during 2006, it sounds like the shares weren't worthless during 2005, so you can't take the loss without selling the shares.

Question

I was laid off from a high tech company in December, 2002. I never exercised options granted during 2000 and 2002. Can I still exercise them, or were they cancelled?

Answer

You need to talk to the people at the company responsible for administering the employee stock option plans. Most options lapse shortly after leaving an employer, but some don't. Also, look at the option agreement paperwork you received when the options were granted. You should find the answer in the agreement.

Question

I exercised employee stock options and sold the shares on the same day. I worked in Connecticut and paid federal and Connecticut income taxes.

Now I'm retired and living in Florida. Do I still have to pay Connecticut income taxes for exercising the non-qualified stock options?

Answer

Like most states that have an income tax, Connecticut taxes income from non-qualified stock options that were earned while working in Connecticut. You will need to file a Connecticut non- resident or part-year resident income tax return to report the income (depending on when you moved to Florida).

Question

I exercised ISOs and held the stock during 2004, resulting in an AMT. I still haven't sold the stock.

According to my 2005 tax calculations, I don't have an AMT for 2005. Can I claim a refund for AMT credit from 2004?

On Turbo Tax, line 2 (exclusion items) of Form 8801 includes the amount from exercise of an ISO. Based on the instructions, I'm not sure that's right.

Regardless of the refund, do I have to file Forms 6251 and 8801 for 2005?

Answer

The amount from exercise of an ISO should not be included on Form 8801, line 2.

I recommend that you include Forms 6251 and 8801 to correctly compute your AMT credit carryover to 2006. Since you don't have an AMT for 2005, you might get a little AMT credit on your 2005 income tax return.

Why do employees who exercise and sell ISO stock continue to use Turbo Tax? How complex does a tax return have to be before you decide it's time to get professional help?

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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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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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