Recommend Our Site to Your Friends!

Table of Contents

• Fifth Circuit affirms capital loss limits apply to ISO stock
• Back dated stock options are a high-priority audit issue
• IRS explains issues for stock grants
• Option exercise paid using margin loan taxable
• Sorry, our internet service provider has been down (again!)
• Michael Gray, CPA to be featured in San José Mercury News article
• Dawn Siemer’s telephone number has changed
• Questions and Answers
• Can I claim a stock option restriction discount?
• Can I donate unexercised ISOs to charity?
• Would it make sense to exercise NQSOs with a swap?
• Refundable AMT Credit Available for 2007
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Fifth Circuit affirms capital loss limits apply to ISO stock

The Fifth Circuit Court of Appeals affirmed a Tax Court ruling that the capital loss limitations apply to losses due to the adjustment of basis of ISO stock on the alternative minimum tax schedule.

The taxpayer tried to carry back a 2001 worthless stock loss from ISO stock issued by his employer, who became bankrupt the year after the option was exercised, to recoup AMT paid in 2000, the year of exercise.

Capital losses aren’t eligible for carryback on an individual income tax return and the losses currently are limited to the amount of other net capital gains plus $3,000.

(Merlo, CA 5 7/17/2007) 100 AFTR 2d 2007-5058.)

Return to Table of Contents

IRS says back dated stock options are a high-priority audit issue

The IRS’s Large and Mid-size Business (SMSB) Division has issued a directive that backdated stock options are a LMSB Tier 1 issue. Backdated options are a mandatory examination item for corporate audits of publicly-traded companies.

Items that could apply include the $1 million compensation limit for certain key executives, the disqualification of options as ISOs, and penalties for nonqualified deferred compensation under Internal Revenue Code Section 409A.

(Industry Director Directive on Backdated Stock Options Directive #1)

Return to Table of Contents

IRS explains issues for stock grants

The IRS recently ruled on the consequences of three scenarios for stock grants issued to an employee.

In the first scenario, vested stock was issued to an employee. At a later time, the employee agreed to restrictions on the shares requiring him to sell the shares back to the company at the lesser of the fair market value on the date of termination or the date of forfeiture. If the conditions applied when the stock was originally issued, they would be treated as non-vested. The IRS ruled, the subsequent restriction would have no tax effect, because the stock was vested when it was originally granted. There is no additional compensation income when the shares vest again in a later year.

In the second scenario, after vested stock is owned by the employee, the employer merges with another company, and the former employer stock is exchanged for unvested stock in the acquiring company. The IRS ruled there was no tax consequence to the employee from the merger because the exchange was solely (unvested) stock for (vested) stock. The stock received is not treated as property received relating to employment under Internal Revenue Code Section 83, because the reorganization is not treated as a "transfer".

In the third scenario, both cash and non-vested stock are received in a merger in exchange for vested employer stock. Since the exchange was not solely for stock, it is a fully taxable exchange. Since this is a fully taxable transaction, it is treated as a "transfer" for which unvested property is received by the employee, because the stock received is not "substituted" for the stock surrendered. The stock of the acquiring company received by the employee is subject to the rules for property received in exchange for services under Internal Revenue Code Section 83.

(Revenue Ruling 2007-49, 2007-31 I.R.B.)

Return to Table of Contents

Seventh Circuit affirms option exercise paid using margin loan was taxable

The Seventh Circuit Court of Appeals has affirmed a Tax Court ruling that the exercise of a non-qualified stock option, where the funds to pay for the option price was funded with a margin loan, was currently taxable.

The taxpayer’s argument that the exercise of an option using borrowed funds should be treated as the grant of another option was rejected, because the margin loan was from a third party brokerage company, not the employer. Further, the taxpayer was personally liable for the margin loan.

(Racine v. Commissioner, (CA 7 7/3/2007) 100 AFTR 2d 2007-5020.)

Return to Table of Contents

Sorry, our internet service provider has been down (again!)

Our internet service has been down since Monday, July 30.

We apologize for the deafening silence you have received after sending email messages.

We may be changing providers if a telephone line-based DSL service continues to be troublesome.

Return to Table of Contents

Michael Gray, CPA to be featured in San José Mercury News article

A feature story interview by business reporter Mark Schwanhausser of Michael Gray, CPA is scheduled to be published in the business section of the San José Mercury News this Sunday, August 5.

Return to Table of Contents

Dawn Siemer’s telephone number has changed

Dawn’s (who is our webmaster and office manager) voicemail box was filling up every two hours with unexplained, blank telephone calls, so we had to change her telephone number.

The new number is 408-918-3162.

Return to Table of Contents

---

Questions and Answers

Question

I recently exercised a NQSO with a fair market value of $3.00 per share and an option price of 25¢. Since these are unregistered shares, I must hold the shares for one year and then may be subject to volume restrictions when I sell the stock. I believe I will have taxable income of $2.75 per share. Can’t I claim a discount because of the restrictions on the stock?

By the way, the stock has gone down in value and I am concerned my tax liability could become greater than the value of the stock when I can sell it. I believe the stock has good long-term potential and with future exercises the risk will begin to diminish.

I also believe I will eventually be able to use stock that I already own to pay for future exercises. Any comments on that as a strategy?

Answer

In determining the fair market value of the stock, any restrictions that lapse are disregarded. (Internal Revenue Code Section 83(a)(1).

Since you can’t sell the shares immediately after exercise, you should look at the tax that you have to pay as an additional "investment" required to acquire the stock. (But you can’t add the tax paid to the tax basis of the stock.)

In order to justify the risk you are taking, you have to be extremely confident that the value of the stock will go up, and expect to be able to sell the stock in the near future. Otherwise, I wouldn’t recommend exercising the options – especially if the exercise results in your being in financial distress.

If you would sell shares that you own to get the cash to pay for exercising an option, then exchanging the shares makes sense. You would end up with the most company shares by paying cash when exercising the options.

Question

I am planning on donating a specific amount of equity to a charity.

How does donating ISOs compare to donating stock as a tax deduction?

I usually donate appreciated stock, get a tax deduction for the value of the stock and avoid paying income tax on the appreciation.

Can I donate unexercised ISOs to a charity?

Answer

ISOs can only be held by an employee, so usually the terms of ISOs prohibit transferring them to a non-employee.

The special tax benefit that you mention for stock held for which you would have a long-term capital gain does not apply to ISOs.

Also, if you don’t meet the holding period requirements for shares acquired from an ISO purchase, there would be a disqualifying disposition resulting in ordinary income and possibly an offsetting tax deduction for the donation.

If you are inclined to make charitable gifts, consider making specific bequests of ISOs to a charity in your will or trust. After death, the charity can exercise the ISO and sell the shares without being subject to tax on the disqualifying disposition.

Question

If a taxpayer is in an AMT position for 2007, would it ever make sense to do a stock swap when exercising a non-qualified stock option? Seems like the AMT liability would increase if he were to do so.

Answer

The consequences relating to the exercise itself are the same whether the option is paid for using a swap or cash. For a NQSO, ordinary income would result for both regular and AMT reporting.

The difference is if the previously-owned stock was sold to get the cash to pay for the option, a capital gain or loss would be reported with respect to those shares. The gain or loss would be deferred if the shares were surrendered in a swap.

The AMT consequences are more serious with the exercise of an ISO, whether with a swap or not. Then you have to report the same amount of additional income for the excess of the fair market value of the stock over the option price.

---

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

Return to Table of Contents

Refundable AMT Credit Available for 2007

If you have exercised and held incentive stock options, you may be entitled to a refund for your unused AMT credit! Read our new article at www.stockoptionadvisors.com/refund.shtml.

Return to Table of Contents

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 now offering our real estate tax newsletter, Michael Gray, CPA's Real Estate Tax Letter, free of charge. Like this newsletter, we will talk about new developments, have reports on special tax concerns, and answer questions and answers. To subscribe and read a sample issue, visit realestatetaxletter.com.

Return to Table of Contents

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.

Return to Table of Contents

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.

Return to Table of Contents

(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.