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By Michael Gray

Table of Contents

• A one-time election might help some option holders
• For advisors, how to become a member or buy study courses
• For option holders, how to get our self-study course
• Questions from readers

  Planning for AMTNOL

  Disputing fair market value

  How stock swaps work

  Expiration dates

  Employer reporting requirements

A one-time election might help some option holders

A sleeper election in the Taxpayer Relief Act of 1997 may be of some benefit to option holders for 2001. The purpose of the election was to qualify capital assets and business assets for lower tax rates for long-term capital gains that are "phasing in" under the legislation. Long-term capital gains for assets held more than 5 years, acquired after December 31, 2000, will be subject to a maximum federal income tax rate of 18%.

A one-time election may be made to treat capital assets and business assets held as of December 31, 2000 as sold as of January 1, 2001 (January 2, 2001 for publicly-traded securities.) Gains will be recognized for the deemed sale of these assets, but no deductions will be allowed for losses. The tax basis (cost for determining gain or loss for income tax reporting) of the asset will be adjusted to the fair market value as of January 1 or 2, the deemed sale price. Assets that are sold before the end of the year do not qualify for the election. A sale of a personal residence that would otherwise be tax-free also doesn't qualify.

All taxpayers except for C corporations can make the election.

In most cases, the future tax benefit won't be worth the accelerated payment of tax, but there are some situations the election will be advantageous.

First, if the fair market value of the asset is close to the tax basis as of December 31, 2000, there will be little tax cost for making the election.

Second, if there are tax attributes that can be used to minimize the tax cost of making the election, it will be advantageous. For example, many taxpayers will have capital losses for which they have no offsetting capital gains. Making the election might enable the taxpayer to use those losses on his or her 2001 income tax return. If there were enough capital losses, no tax would result from making the election.

For ISO stock, there could be unused minimum tax credits that could be recovered when there are capital losses for AMT but not for regular tax when ISO stock is sold. A deemed sale of non-ISO stock could help to recover those minimum tax credits.

Another example is unused passive activity losses. The taxpayer may have losses from a "tax shelter" partnership or a rental property that otherwise couldn't be deducted. By electing to treat the partnership interest or a rental property as sold, if there were sufficient otherwise unused losses, no tax would result from making the election.

Losses can also be limited because of an insufficient investment under the at-risk rules. If the entity for which the loss is limited (such as an S corporation or partnership) makes a deemed sale of one of its assets, the gain could result in an increase in investment qualifying the deduction of offsetting losses.

Remember the deemed sale of ISO stock could result in a disqualifying disposition.

For details about making the election, see page D-2 of the instructions of Schedule D.

For advisors, write about becoming an ESOAA member and our study courses for advisors

For an information package, send your name, company, address, email address, telephone number and fax number to Dawn Gray at info@stockoptionadvisors.com.

For option holders, write for information about our self-study course about tax planning for employee stock options

For an information package, send your name, company, address, email address, telephone number and fax number to Dawn Gray at info@stockoptionadvisors.com.

Questions from readers

Question - Has Mike seen the October, 2001 article in the Tax Adviser, page 665 (a magazine published by the American Institute of Certified Public Accountants) about Planning for AMTNOL. I'd like to know what he thinks about it. Thanks.

Answer - I think someone needs to edit the Tax Clinic articles more carefully. The article suggests that an AMT net operating loss can result from selling ISO shares after the year of exercise for a selling price less than the fair market value on the date of exercise. This is in error.

According to Internal Revenue Code Section 56(b)(3), the provisions relating to incentive stock options do not apply when computing the alternative minimum tax. Consequently, incentive stock options are treated the same as non-qualified options for AMT reporting. This is the reason for the AMT "ordinary income" adjustment for AMT reporting. Additional compensation is being reported for the exercise. The additional compensation is added to the tax basis of the stock for AMT reporting. When the stock is sold, the capital gain or loss is recomputed using the AMT basis, resulting in gain or loss adjustments in the year of sale. The instructions for AMT Form 6251 make it clear an "AMT" Schedule D should be separately prepared and included with the tax return.

The capital loss that is computed on an AMT basis is subject to its own $3,000 limitation.

The IRS has been more specific about how to report ISO transactions in the 2001 instructions for Form 6251, Alternative Minimum Tax - Individuals, including emphasizing the application of the $3,000 capital loss limitation for AMT reporting.

Finally, according to Internal Revenue Code Section 172(d)(2), capital losses are only deductible up to the amount of capital gains when computing net operating losses. Excess capital losses are added back to taxable income when computing net operating losses.

The article is especially frightening because the author is discussing an AMT NOL of over $2 million! This type of revelation can result in sleepless nights!

From the taxpayer's perspective, what do you do when the professional advisor gives incorrect advice or prepares a tax return incorrectly, resulting in penalties? The answer - you can sue the preparer for malpractice. A preparer's or advisor's liability can far exceed the fee for the services. This is a benefit of using a professional tax return preparer that a taxpayer can't get when preparing his or her own income tax returns. (However, I think companies that produce and sell tax return preparation software may be subject to lawsuits for losses suffered when the taxpayer has penalties as a result of relying on the software to produce the correct results in the "interview mode". See an attorney if this applies to you.)

Question - If I disagree with the fair market value that my private company has set for the exercise date of my options is there any way to dispute this or claim a lower price? Since the company claims they were giving out options at the same time I exercised for some value $X.XX. This to me has no bearing on the fair market value since it is a private company and they are semi- randomly raising the option price themselves.

In my case the difference of $1.50 in the FMV of the options is the difference between no AMT and a few thousand dollars of extra tax!

Answer - The employer is given considerable latitude in determining the fair market value of its stock when it isn't publicly traded. When the employee reports income using a different value, especially when the information is reported on a Form W-2 by the employer, the stage is set for a tax dispute, because the IRS is being "whipsawed" about the deduction the employer is entitled to and the income the employee must report.

This means the employee should have some proof that that the value he or she is using is correct and the employer is in error. Ideally, the employee should get a value determined by a qualified appraiser. This is an expensive proposition, and will probably require the cooperation of the employer's accounting department.

First, go to your employer to see if you can get it to agree to use a lower value for determining your tax preference. This is much less expensive than getting an appraisal or litigating a tax dispute. Also, reporting inconsistently with your employer's representations will not make you popular with your employer.

If you are only talking about a couple of thousand dollars of tax, it's probably not worth the trouble to dispute the value. Just pay the tax.

Question - I have to exercise my option through a broker designated by my company. Also I heard about "stock swap" (swap regular shares from my portfolio for option shares. How does it work? Do you have any information on it?

Answer - Consider investing in our new course - Secrets of Tax Planning For Employee Stock Options. There is a detailed explanation of stock swaps. As far as the procedure and whether your employer permits them, see your company's department that handles the administration of the company's stock option plan.

Question - Do executive stock options generally have an expiration date that would cause the tranche to "expire worthless" if not exercised by that date?

Answer - I wasn't able to find the word "tranche" in my dictionary. Most options do have an expiration date, at which point the option will become worthless. Since there is generally no income when an option is granted, there is generally no tax consequence when the option expires.

Question - As an employer, we have an employee that exercised her stock options at the end of 2001. This is a first occurrence for our company and we did not have the reporting set up with our payroll company. Can we report the information of a 1099-MISC? If so, should it be reported in Box 3?

Answer - No. Assuming this was a non-qualified stock option, the income should be reported on Form W-2. The ordinary income is subject to payroll taxes. You might need to prepare amended payroll tax returns and Form W-2c (corrected Form W-2). See your accountant for help.

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

The answers to most questions can be found in our course, "Secrets of Tax Planning For Employee Stock Options". For details write Dawn Gray at info@stockoptionadvisors.com.

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.

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. We intend to eventually publish a directory of ESOAA members who are committed to helping clients with employee stock option issues.

Tax advisors should view the newsletter as an alert to become aware of issues relating to employee stock options for further research and study.

(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 http://www.amazon.com or http://www.barnesandnoble.com/ or buy it at Stacey’s Books.)

P.S.

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