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By Michael Gray

Table of Contents

• Implementation of proposed employment tax regulations extended
• Our web site operation will be changing
• Information available for live seminar and membership
• Information available for self-study course
• Questions and Answers

  How is income determined when exercising ESPPs?

  How do I qualify ISOs for long-term capital gain treatment?

  What is the difference between "qualified" & "non-qualified" stock options?

  Are employee stock options transferable?

• Consult with a tax advisor

Implementation of proposed employment tax regulations for ISOs and ESPPs extended

The IRS announced yesterday that the proposed regulations about employment tax requirements for ISOs and ESPPs issued on November 13, 2001 will not be implemented on January 1, 2003, as originally planned. According to the IRS, it needs additional time to study the complex issues raised in comments received in response to the proposed regulations. (IRS Notice 2002-47.)

Under the proposed regulations, employers would be required to withhold and pay employment taxes, including social security, medicare and federal unemployment taxes, when an ISO is exercised and when an employee purchases shares under an employee stock purchase plan.

Until the IRS completes its review of the comments received and issues further guidance, employers are not required to withhold and pay employment taxes or federal income taxes relating to the exercise of an ISO or ESPP or a disposition of stock acquired from the exercise of an ISO or ESPP.

However, employers are still required to report ordinary income from the early disposition of ISO or ESPP shares on Form W-2.

Employers will have considerable time to implement any new requirements for employment tax reporting when the final guidance is issued. The IRS says the effective date is expected to be January 1 of the year that follows the second anniversary of the publication of the final guidance.

Employers are sure to be relieved that the proposed employment tax rules are being postponed. When there is so much negative rhetoric going on about stock options, any good news is welcome. The last thing employers need during a recession is another administrative headache.

The postponement also gives Congress time to take legislative action. There are proposals to pass a law excluding ISOs and ESPPs from employment taxes, but it doesn't seem likely to be approved this year.

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Our web site operation will be changing

We have been offering all of the information on our web site for free. In order for ESOAA to be financially viable, we can't continue this practice. The current newsletter, our special reports and a few questions and answers will continue to be free. The rest of the site will be available on a subscription basis.

The details will be posted at the site.

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For advisors, write for information about telephone seminars, live seminar and Advisors Inner Circle Membership

The Secrets Of Tax Planning For Employee Stock Options seminar is scheduled to take place in the San Jose area on July 25 and 26, 2002. The $100 early registration discount expires on June 30, 2002. For information, send your name, company, address, email address, telephone number and fax number to Dawn Gray at info@stockoptionadvisors.com.

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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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Questions and Answers

Question

In the March 2, 2002 issue of the ESOAA Option Alert, you state "Some (ESPP) plans set an option price at the lesser of 85% of the fair market value on the grant date or the exercise date. When the option price is not fixed or determinable at the time the option is granted, then in determining the ordinary income to be reported, the option price is determined as if the option was exercised when granted."

Am I to understand that if the stock is worth $10 as of the grant date and it is worth $5 on the exercise date, then the option price to determine the ordinary income to be reported when the shares are sold would be $8.50 ($10 X 85%)?

Answer

First, remember this rule applies when the holding period requirements have been met. (The stock has been held more than two years after the grant date (sometimes called the subscription date) and more than one year after the exercise or purchase date.)

Yes, the deemed purchase price to compute the ordinary income to be reported would be $8.50. The ordinary income to be reported in the year of sale would be the lesser of (a) $10.00 (FMV on grant date) - $8.50 (option price on grant date) = $1.50 or (b) the excess of the fair market value at the date of disposition (usually the sale price) over the amount paid for the share ($4.25 = 85% X $5.00 in your example). (Internal Revenue Code Section 423(c))

The tax basis of the shares to report on Schedule D would be increased by the amount of ordinary income reported. Assuming the sale price exceeded $5.75, the tax basis in your example would be $4.25 (option price) + $1.50 (ordinary income reported) = $5.75.

Question

Here are some facts relating to incentive stock options that I have:

1000 shares granted. 489 shares vested. Grant date 6/16/2000. Vest monthly starting 6/19/2004. Expiration Date 6/19/2010.

In order to qualify for long-term capital gain treatment, do you measure one year after the grant date or one year after the vesting date?

I also have some incentive stock options granted during June, 1998, of which 900 shares are vested with a vesting date of 2/23/2002 and expiring June 2008. In order to qualify for long-term capital gain treatment, do I have to wait one year after 2/23/2002?

Answer

Your table didn't come through correctly, so I may not have your facts quite right.

In order to qualify for long-term capital gain treatment, you must meet two tests. You must hold the stock (1) more than two years after the grant date and (2) more than one year after the exercise date. In most plans, you can't exercise the option until after the shares are vested. Some employers permit an early exercise before vesting, usually just before an initial public offering.

When an ISO is exercised, the exercise date will be considered to be the later of the exercise date or the vesting date unless the employee makes a timely Section 83(b) election. If the employee makes a timely Section 83(b) election, the vesting date is disregarded and the exercise date will be the actual date of exercise.

It appears you haven't exercised any of your options yet. For your first group of shares, you must hold the shares more than two years after the grant date, which would be 6/17/2002 and more than one year after the exercise date to qualify. For your second group of shares, you must hold the shares more than two years after the grant date, which would be June, 2000 and more than one year after the exercise date to qualify.

I recommend that you consult with a tax advisor to plan for exercising your ISOs. Remember to plan for the alternative minimum tax.

Question

What is the difference between a "qualified" stock option and a "nonqualified" stock option? Is an "incentive" stock option the same as a qualified stock option?

Answer

"Qualified" stock options qualify for special tax benefits. There is no currently taxable income when the option is exercised and, if certain requirements are met, some or all of the excess of the fair market value at exercise over the option price is taxable as long-term capital gain when the stock is sold (limited to the actual gain at sale).

Both incentive stock options and employee stock purchase plans are qualified employee stock options.

Non-qualified stock options are any other stock options granted for services rendered. Generally, the excess of fair market value at exercise over the option price is taxable as ordinary income when the option is exercised.

Question

Are employee stock options transferable (if there is no company imposed restrictions in the original contract)? Can they be transferred (or sold) to other employees in the company or only family members?

Answer

Generally, incentive stock options and employee stock purchase plan options are non-transferable. Transfers to a spouse relating to a division of marital property in a divorce is an exception, but the options are then converted to non-qualified options. (See the May 29, 2002 issue of ESOAA Option Alert relating to the tax consequences.)

The rules for non-qualified options are more liberal, permitting transfers of the options. However, the transfer will usually result in ordinary income being taxable to the employee or service provider.

There are more details about these rules in our Secrets Of Tax Planning For Employee Stock Options reference manual.

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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.

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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. 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.

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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 http://www.amazon.com or http://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.