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Table of Contents

• Happy holidays!
• Not much time left for year-end tax planning!
• Year end planning reminders
• Watch accrued compensation for employees and independent contractors
• Section 83(b) election valid for non-vested stock
• Questions and Answers
• Do I have to exercise my stock options right away?
• Will limited transferability reduce the value of my ISOs?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Happy Holidays!

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Not much time left for year-end planning - make your reservation now!

Thi and I have a number of activities coming up. We will be at a Dan Kennedy program on December 1 and 2 and tax update classes on December 18 and 19, and Christmas is Monday, December 25. Our office will also be closed Friday, December 22.

That leaves a very limited calendar for tax consultations. If you need a tax consultation appointment, call Thi Nguyen at 408- 918-3163 or call me at 408-918-3161 to reserve your time now.

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Year end planning reminders

If you exercised an incentive stock option early in 2006 and the value of the stock has declined, consider selling the stock before the end of the year to take advantage of the "escape hatch", limiting ordinary income to the excess of the sales price over the option price and eliminating the alternative minimum tax adjustment when the stock is sold before the end of the year of exercise. Watch out for the "wash sale" rules. You should not purchase additional shares of employer stock during the period starting 30 days before the sale and ending 30 days after the sale, including exercising other stock options or purchasing through your company's ESPP plan.

If you itemize deductions, you can claim 2006 tax deductions for your final California estimated tax payment and the second property tax installment if they are paid by December 31, 2006. Be careful, because these items aren't deductible for the alternative minimum tax, so you could lose your tax benefit. (A good reason to schedule a year-end planning meeting!)

Rules of thumb - match the deduction for California taxes with ordinary income (like wages and interest). Since the tax rate for long-term capital gains and qualifying dividends are the same for the regular tax and the alternative minimum tax, you usually won't get a tax benefit by prepaying the California tax for these items.

If you have big capital gains to report for 2006, consider selling "loser" investments before the end of the year to offset the gains.

Consider making gifts of appreciated property before the year end. Remember that appraisals may be required. (Not required for donations of publicly-traded stock.)

Donations paid using a credit card during 2006 will be deductible on your 2006 income tax return. Be sure to give the charity enough time to process your donation, so don't wait until the last minute.

Remember that interest expense for a margin account isn't deductible unless it is paid, so be sure it was in fact paid and not just added to your margin loan balance. (Sales proceeds applied to an account balance is a "payment".)

Watch your federal and state income tax withholding to be sure it will be sufficient to avoid penalties for underpayment of estimated tax.

These are just a few of the major year-end planning considerations. See your tax advisor relating to your own situation.

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Watch accrued compensation for employees and independent contractors

The new deferred compensation rules are very strict and complex. Any payments for accrued wages due to employees and independent contractors should be made by the fifteenth day of the third month after the year end (March 15 for a calendar year business) in order to avoid having it deemed to be deferred compensation and subject to the deferred compensation rules.

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Tax Court days Section 83(b) election is valid for non-vested stock

Anthony Kadillak exercised an incentive stock option, including some non-vested shares, for Ariba stock on April 5, 2000. He timely filed a Section 83(b) election during May, 2000.

His employment with Ariba was terminated on April 4, 2001. Ariba repurchased unvested shares at the option price.

Mr. Kadillak filed an amended return for 2000, claiming the Section 83(b) election was invalid for the nonvested shares, based on the theory he did not receive a beneficial ownership in the stock until it vested. He also claimed the limitation of capital losses to the amount of capital gains plus $3,000 should not apply when computing the AMT, so he should have a net operating loss available to apply against the income reported in the year of exercise.

The Tax Court held against the taxpayer. According to Internal Revenue Code Section 56(b)(3), the regular tax special rules for incentive stock options don't apply when computing the alternative minimum tax. Therefore, Section 83 applies for the exercise of these options on the AMT schedule, and the Section 83(b) election is valid for AMT reporting.

The Tax Court followed its previous reasoning in Merlo v. Commissioner (126 T.C. 205 (2006).) and other cases in holding the capital loss limitation applies when computing the alternative minimum tax. Since the capital loss limitation applies, there is no net operating loss available to carry back to the year of exercise.

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Questions and Answers

Question

My wife received a NQSO for 600 shares at $29, with an expiration date of 12/6/2015, and they are becoming exercisable on 12/6/2006, 2007 and 2008, at 200 shares per year. The stock price is now $31.

Does this mean I have to buy 200 shares by 12/6/2006, and for which the option price is $29 X -200 = $5,800, resulting in $400 of ordinary income on which income and social security taxes must be paid?

Answer

The consequences of an exercise is correct. However, you don't have to exercise the option during 2006. It doesn't expire until 12/6/2015, so the last day you can exercise this option is 12/5/2015.

Question

I can exercise ISOs for a public company, but after the exercise I still can't transfer the shares to anybody without the approval of my employer. "Limited transferability" is part of the ISO contract. Is the excess of the fair market value over the option price still subject to the AMT at exercise?

Answer

If you can keep the shares when you leave employment with the company, they are considered vested and the AMT will still apply. If "limited transferability" is a condition that will never lapse, it may be you are entitled to a reduction in the value of the shares that you receive.

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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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