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Subject:   Capital loss on reduced NQSO FMV
Date:   Wed, 20 Nov 2002
From:   David

I am a unitholder in a private LLC. We have an NQSO plan that we developed to attract, incent, and retain all employees.

Many of our employees exercised options at fair market values above the current fair market value for the company. During the lifetime of the company, there have never been any "liquidity" events or opportunities to realize the previously higher fair market value. It was a notional value that was not heavily discounted for liquidity risk.

The company is now going through a restructuring where all contributed capital will be returned, units will be retired, and capital losses will be created for anyone who had ordinary income gains when they exercised options. This seems to be a troubling tax scenario as it may take many years for employees to fully "realize" the capital losses given the "offsetting gains + $3k" annual limit. Are there any other tax alternatives available? Can the company reverse the tax credit previously received from the NQSO exercises and pass it through to employees?

Answer

Hello David,

I will warn you this is an expensive approach. The company could hire an appraiser to re-value the membership units at the dates of exercise, and file amended returns for the deductions claimed based on the new amounts. The company will also have to re-issue amended Forms W-2 to the employees. The employees could then amend their income tax returns based on the new information.

Filing all of these amended returns could result in IRS scrutiny of the situation. The appraisal, legal and accounting fees could be very substantial.

Good luck!

Mike Gray

For more information about non-qualified stock options, request our free report, Non-Qualified Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer 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.