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By Michael Gray

Granting an employee stock option can result in a wash sale

Sometimes I wish people wouldn't ask me certain questions. It seems like it would be nice to "let sleeping dogs lie." Unfortunately, the issues raised can be raised in an audit, so let's be prepared. Also, planning means being aware of the traps to avoid them in the first place.

Until recently, the wash sale rules were not a concern. Stock values just kept increasing. With the market decline starting in 2000, the wash sale rules became critically important, especially for incentive stock options.

What is a wash sale? A wash sale is when a taxpayer sells a security at a loss, but replaces it with the same ("substantially similar") security within the period beginning 30 days before the date of the sale and ending 30 days after the sale. When there is a wash sale, a loss is disallowed for income tax reporting and the disallowed loss is added to the tax basis of the replacement security.

The reason the loss is disallowed is there has been no economic change in the position of the taxpayer.

In order to avoid taxpayers manipulating their transactions too blatantly, Internal Revenue Code Section 1091 also provides that when a taxpayer enters a contract or option to acquire identical stock during the option period, that transaction will also result in wash sale treatment.

Well, what if an employee (or service provider) is granted a stock option? Can that result in a wash sale?

It appears so. In ancient Revenue Ruling 56-452 the IRS said the grant of an employee stock option can result in a wash sale.

In addition, when the employee exercises the option and the stock is issued, the transaction is treated as a purchase of the stock, which can also result in a wash sale. But, there can only be one wash sale relating to the option. In other words, if a loss is disallowed relating to the grant of the option, a loss will not be disallowed when the option is exercised.

Remember, ESPPs are also considered employee stock options. With ESPP, ISO and NQO grants and exercises happening at intervals, sometimes automatically, any employee would have his or her head spinning trying to avoid a wash sale of employer stock.

For example, Joe Taxpayer bought 3,000 shares of employer stock on the open market. On October 15, 2XX1, Joe sells the 3,000 shares for a $30,000 capital loss. On October 31, 2XX1, Joe is granted an option to purchase 2,000 shares of employer stock. $20,000 of the loss relating to 2,000 shares of stock sold will be disallowed as a wash sale. The options for employer stock will have a tax basis of $20,000, the disallowed loss.

Second example. Jane Taxpayer receives an incentive stock option. She exercises the ISO for 1,000 shares of Employer stock on January 15, 2XX1, resulting in an AMT adjustment of $200,000. The price of the stock falls, so Jane sells the stock on December 1, 2XX1. She was planning on claiming a disqualifying disposition, using the "escape hatch", resulting in only $20,000 of ordinary income and avoiding the AMT adjustment. Jane's employer grants her another ISO for 1,000 shares of Employer stock on December 15, 2XX1. If Jane sold the stock at a loss, it would result in a wash sale. According to Internal Revenue Code Section 422(c)(2)(b), the ordinary income will only be limited based on the sale price in a disqualifying disposition if the disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized. A wash sale would fail this test. Jane must report $200,000 of ordinary income for a disqualifying disposition. The loss for the wash sale would be disallowed. Jane's second ISO will have a tax basis equal to the disallowed loss.

When Congress enacted the wash sale rules, it could never have visualized that they would apply to employee stock options, or that employee stock options would be granted to rank and file employees.

This is another item to add to our list of items for tax reform. Be sure to write your representatives in Congress.

And, for goodness sake, be careful when you sell your stock!

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.

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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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