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Table of Contents

• IRS tells how to revoke a Section 83(b) election
• Bankrupt taxpayer not allowed to escape AMT for ISO exercise
• Should you submit an offer in compromise before July 17th?
• Big tax increase for U.S. expatriates
• Questions and answers
• Why isn't holding NQSOs after exercise a tax benefit?
• How do I report ISO stock sales on Schedule D?
• How will withholding and reporting work when I retire?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

IRS tells how to revoke a Section 83(b) election

A Section 83(b) election is an important tool for managing employee stock options. The election is generally made when an early exercise is allowed for non-vested stock options. For non- qualified stock options, the default rule is that income is recognized as the options vest. When a Section 83(b) election is made, the options are treated as vested and income is recognized as of the date of exercise for the excess of the fair market value of the stock over the option price.

The election can also be made for income to be reported on the alternative minimum tax schedule for incentive stock options (ISOs), but doesn't apply for regular tax reporting of ISOs.

The election is helpful when the price of the stock is expected to increase dramatically after the date of exercise, but works against the taxpayer when the value of the stock goes down.

The IRS has issued Revenue Procedure 2006-31, explaining how a Section 83(b) election can be revoked. The IRS makes it clear that the election can only be revoked in a narrow situation, when the taxpayer has made a mistake of fact relating to the transaction. A mistake of the value of the property received, what a substantial risk of forfeiture is or misunderstanding the tax consequences of making the election don't qualify as mistakes of fact.

The IRS will accept a revocation request when it is filed before the due date for making the election, 30 days after the exercise of the option.

Under the IRS regulations, a request for revocation of a Section 83(b) election must be submitted within 60 days of the date on which the mistake of fact first became known to the person who made the election.

The request must be made under the procedures for requesting a letter ruling. The request must include a complete description of the facts and other information and documents required for processing a letter ruling under Revenue Procedure 2006-1 or a successor; a description of the mistake of fact as to the underlying transaction; and the date on which the mistake of fact first became known to the person making the election. The request must also state if the request to revoke is being made on or before the due date for making the election.

A Section 83(b) election should be made very carefully. The IRS almost never accepts requests to revoke the election.

(Revenue Procedure 2006-31.)

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Bankrupt taxpayer not allowed to escape AMT for ISO exercise

James and Deborah Pavlosky claimed in a case before a United States Bankruptcy Court in the Southern District of Texas that they should not be liable for the alternative minimum tax relating to stock that fell in value after exercising an incentive stock option. The Pavloskys said the legislative history of the alternative minimum tax indicates that "the amount included in alternative minimum taxable income will not exceed the amount realized on the sale or exchange of the stock over the adjusted basis of the stock."

The taxpayers were citing a rule that applies when stock received from the exercise of an ISO is sold during the same year in which the option is exercised. They sold their stock in a later year.

The taxpayers also claimed the $3,000 limit for capital losses doesn't apply for the alternative minimum tax. The limit was not mentioned in early versions of instructions for Form 6251, and was added later. The taxpayers claimed this change in the instructions constituted a change in the law without action by Congress.

The court rejected both arguments. The court said there was no change in the law relating to the capital loss limitation for AMT reporting, just a correction to the instructions to the form to explain that the limitation applies for both regular tax and AMT reporting.

The court also rejected an argument by the taxpayers that Arrowsmith v. Commissioner, 344 US 6 (1952) should be applied to treat the sale of the stock and receiving the stock as compensation income as one transaction. The court held there were two transactions: the exercise of the option and the sale of the stock.

(James Pavlosky and Deborah Thumann-Pavlosky v. United States, June 15, 2006.)

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Should you submit an offer in compromise before July 17, 2006?

Offers in compromise can be used to reduce federal tax liabilities for taxpayers in financial distress. They can also be used to make settlements in situations when there is a dispute over a tax issue (doubt as to liability). In the past, a feature of offers in compromise was to suspend collection activity by the IRS.

Effective for offers in compromise submitted on or after July 17, 2006, a payment of 20% of the proposed "lump sum" balance due must be paid when the offer is submitted. A lump sum offer is any offer of payments to be made in five or fewer installments.

Any periodic payment offer in compromise (to be paid in six or more installments) must be accompanied by the first proposed installment. The taxpayer must continue to make payments under the proposed schedule, or the offer will be considered withdrawn.

Considering the additional hardship of the requirement of making these payments before the offer is accepted by the IRS, anyone who is considering making an offer in compromise should submit their offer before July 17, 2006.

See your tax advisor or tax attorney. If you would like our help to prepare an offer in compromise, call Mike Gray at 408-918- 3161.

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Big tax increase for U.S. expatriates.

In order to pay for extending certain tax benefits, like low rates for long-term capital gains and qualified dividends, the Tax Increase Prevention and Reconciliation Act includes offsetting revenue raising provisions. A group that will be hit with a big tax increase is U.S. citizens or permanent residents working abroad. Effective January 1, 2006, the methods of computing the foreign earned income exclusion and housing allowance exclusion have been changed. More important, tax rates that apply to compute the regular tax and the alternative minimum tax non-excluded income are computed "as if" excluded income was taxable. In other words, higher marginal tax rates will apply to taxable income.

If you are a U.S. expatriate working overseas, consult with a tax advisor immediately to prepare for a big increase in your tax bill next April.

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Questions and Answers

Question

I saw in your material that there is no tax benefit for exercising non-qualified stock options and holding the shares. According to an explanation at the Turbo Tax web site, if "you exercise the option to purchase the shares, then you sell them more than a year after the day your purchased them" that you will pay long-term capital gains tax.

Isn't the long-term capital gains tax a tax benefit?

Answer

I'm sorry for the confusion. Remember that when you exercise a non-qualified stock option, you report ordinary income for the excess of the fair market value of the stock received over the option price. That ordinary income is currently taxable (in most cases as additional wages) and is not converted to long-term capital gain by holding the stock for more than one year. Any additional gain from the sale of the stock after holding it more than year will be a long term capital gain, eligible for the lower tax rates that apply to long-term capital gains.

My point is, you would receive the same tax benefit if you simply bought the shares outright without exercising a stock option.

If that is true, the correct question is, would you buy this stock at its current fair market value if you received a cash bonus? For most employees, holding a concentrated position in employer stock is not a wise investment decision. There are situations, like when the employer is preparing a public offering with an expected big increase in value, when it may make sense to take the risk. Just recognize what you're doing.

Question

My employer includes my income from the same day sales of my ISO shares on my W-2. How do I report the sales of stock on Schedule D?

Answer

Add the income reported on your W-2 with respect to the option exercises to the cost of the stock to get the tax basis of your stock. You should then report a gain or loss close to zero on Schedule D for these transactions. If you need someone who understands this to prepare your income tax returns, that's what we're here for.

Question

If I exercise my (non-qualified) stock options after I retire, how will withholding and reporting be done, since I will no longer be an employee?

Answer

Since the options were received relating to your employment, your employer will still be required to withhold income and employment taxes and report the income on Form W-2, even when you are no longer an employee.

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Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter.

We do not provide free technical support for TurboTax!

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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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