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By Michael Gray

Table of Contents

• Extensions – and when you don't have the money to pay the tax.
• First individual estimated tax payment is due April 15.
• Tax relief proposed for ISO losses.
• California Representatives fight expensing.
• Plant a fruit tree for the future.
• Questions and Answers
  • Am I eligible for an installment sale?
  • Should my employer report NQSO exercises on a 1099 or W-2?
  • Where can I find information on paying contractors with stock?
• Consult with a tax advisor.

Extensions - and when you don't have the money to pay the tax

(This is a reprint from last year's March newsletter.)

What do you do when you don't have the money to pay the tax?

My first recommendation is to file your income tax returns, certified mail, by the initial filing date. One of the nastiest penalties in the IRS's arsenal is for late filing - 5% per month to a maximum of 25%. Some people who owe money don't file their returns because they are afraid. THIS IS A HUGE MISTAKE! The best approach is to be honest about your situation and work with the tax authorities to resolve it.

When your file an extension, any balance of tax due when the tax return is filed represents an exposure for the late filing penalty.

Please don't misunderstand me. I regularly use extensions for my clients and myself as a workload "safety valve". We often don't have the information to complete a return by the due date. They just aren't appropriate when there will be a significant balance due that won't be paid by the original filing due date.

According to the Treasury regulations for the requirements to file a valid automatic extension request, "an application for extension must show the full amount properly estimated as tax for the taxable year." (Reg. § 1.6081-4(a)(4).) The regulations relating to reasonable cause for failure to file a tax return state that if a taxpayer satisfies the requirement of showing the full amount estimated as tax, the taxpayer has a reasonable cause for failure to file during the extension period provided (1) the excess of the amount of tax shown on the return over the amount of tax paid by the original filing date (including the amount paid with the extension form) is no greater than 10 percent of the amount shown on the return (restated - 90% of the tax is paid by the due date), and (2) any balance due shown on the return is paid with the return. (Reg. § 301.6651-1(c)(3).)

(For California taxpayers, the extension is paperless so the amount of the tax need not be stated. You are still required to pay at least 90% of the tax by the original due date to avoid the late filing penalty.)

If you have filed an income tax return for 2001, you can process your federal extension electronically or by telephone - call 888-796-1074 by April 15. Better call early to beat the rush! Mailing a paper form is still acceptable and is the only way a person who didn't file a 2001 income tax return can request an automatic extension.

A taxpayer can still avoid the late filing penalty by demonstrating a "reasonable cause," but this can be a hassle and the taxpayer is at the mercy of the subjective judgment of a representative of the tax authority.

Remember you may now pay income taxes using a credit card. Call 800-272-9829, or try the web site, www.officialpayments.com The extension for California is 1555. You can also call 888-729-1040. Maybe you can find a card offering a low interest rate promotion that will work for your situation.

Should you borrow using a margin account? In most cases, this is not a good choice because of the exposure to margin calls if the market declines.

Should you use an equity advance loan, secured by your principal residence? In some cases it might be to your advantage, if you can get a favorable interest rate. Remember interest for an equity loan not used for a home improvement is only deductible on a loan amount up to $100,000. This interest is not deductible when computing the alternative minimum tax.

Remember that IRA accounts and even other retirement accounts can be temporary sources of funds. Distributions from IRAs which aren't minimum required distributions can be rolled over to another IRA or returned to the same IRA within 60 days after a withdrawal. This exception only applies to one rollover per year. (You must wait more than one year after a rollover is completed before making another one.)¹

Certain distributions from other qualified plans can also be rolled over within a 60-day period to an IRA or another qualified plan.² Using IRAs or qualified plans as a temporary source of funds to pay taxes can be useful if the funds to complete the rollover will soon be available, such as when there is a lockout "window" that will soon be open. The cost of an error can be high, because if the rollover isn't completed before 60 days have expired, the distribution may be subject to tax as ordinary income plus a 10% early distribution penalty.³

The IRS has a form for installment agreements, Form 9465. They would prefer that you submit the form with your income tax return. You can take up to five years to pay off your tax liability. An advantage of arranging an installment agreement is the penalty for late payment of tax is reduced from 1/2% per month to 1/4% per month. In addition to penalties, interest is charged for late tax payments. The interest rate is adjusted quarterly. Recently, the rate has been five percent.

Another alternative is to make an Offer in Compromise, Form 656. With this procedure, the IRS actually can reduce your tax based on your ability to pay. You don't have to wait until you have owed the tax a long time to use this procedure. I think it's best to work with an attorney, CPA or enrolled agent when making an Offer in Compromise. If the amount is large, an attorney is probably the best choice.

Although it may provide relief from your other creditors, bankruptcy doesn't offer much help for recent debts for income taxes. When you make payments on your tax bill, be sure to specify to apply the payments to taxes due. Penalties and interest are dischargeable in bankruptcy, but income taxes aren't.

It may be to your advantage to plan how to use regular tax or alternative minimum tax capital loss carryovers or minimum tax credit carryovers. You might need to generate capital gains, which can be difficult when you're in financial distress.

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First individual estimated tax payment is due April 15

(This is a reprint from last year's March newsletter.)

Remember to review your estimated tax situation for 2003.

There is no estimated tax penalty provided the taxpayer pays at least 90% of the tax (including AMT) on the current year's tax return through withholding and/or equal quarterly estimated tax payments.

For taxpayers who have no more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁴ For taxpayers who have more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least, for 2003, 110% of the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁵

Taxpayers who have uneven income and deductions may also compute their estimated tax on an "annualized" basis. You multiply the year to date income and deductions to arrive at amounts for a year, compute the tax for that amount, then pay amounts to cumulatively pay in 1/4, 1/2, 3/4 and 100% of those amounts. You should probably get help from a professional tax return preparer to do this.

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Tax relief proposed for ISO losses

Senators Kerry, Grassley and Lieberman have introduced Senate Bill 503, which would allow an increased minimum tax credit when incentive stock options are sold for a price less than the fair market value on the date of exercise.

Under the proposed legislation, the minimum tax credit for a tax year beginning after December 31, 2002 would not be less than the lesser of (A) the incentive stock option tax, or (B) the greater of $3,000 or 50% of the regular tax for the taxable year. The "incentive stock option tax" would be the amount of alternative minimum tax paid with respect to ISO stock for all prior taxable years if the stock is sold or exchanged during the taxable year or any prior taxable year, and a loss is recognized on the sale or exchange over any amount such credit amount allowed for previous taxable years.

Since the alternative minimum tax is sometimes a big bulge of tax when options are exercised, the limitation at (B) is a significant limitation for this benefit. At least the proposal is a step in the right direction.

With President Bush's tax proposal in process, there is a good chance of some tax legislation being passed this year that this proposal could be added to. Call or write your representatives in Congress to support it.

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California Representatives fight expensing

Representatives David Dreier of Glendora and Anna Eshoo of Palo Alto plan to introduce legislation requiring companies to give investors "plain English" information about the financial impact of employee stock options. The legislation would forbid the Securities and Exchange Commission from recognizing any new accounting standards for stock options for three years while it evaluates the effectiveness of new disclosure requirements.

The required disclosures include:

• Providing illustrations or graphs on options' dilutive effects on share value.
• Showing a summary of options granted to the five highest-paid executives.
• Expanding disclosure of options' dilutive effect on earnings per share.

Under the proposed legislation, the Commerce Department would be required to study the impact employee stock options have on the U.S. economy and report back to Congress in one year.

Silicon valley companies are backing this effort to stop the movement toward recognizing an expense for granting employee stock options.

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Plant a fruit tree for the future

My wife, Janet, is my personal psychic. She sees rough times ahead and suggests that each of us should plant a fruit tree. If there are hard times in five years, the fruit from our trees will sustain us. If times are good, we'll have fruit to share with our neighbors to establish better relationships and with those less fortunate. Sounds like a win-win to me. Pass it on.

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Questions and Answers

Question

I exercised an ISO for a lot of shares in a privately-held company during 2002. Then I left the company. The company bought my stock and gave me a promissory note. They reported ordinary income on my Form W-2 for disqualifying dispositions. Am I eligible for an installment sale? Can I adjust the income reported on W-2 without IRS problems?

Answer

It appears to me that this is not a transaction that qualifies for installment sale reporting, because the income is compensation instead of income from "a disposition of property." I know this is pretty technical and doesn't seem to make sense. Since there is a recharacterization of the income from capital gain to compensation, it doesn't qualify for installment sale reporting.

An alternative question is whether the transaction qualifies for deferred compensation treatment. Since you received "property" - a note - instead of an unsecured promise contract, I don't think it qualifies as deferred compensation, either.

I think your best bet is to have the note appraised. Private party notes typically have a fair market value far below the face amount. You could then redetermine your ordinary income based on the fair market value of the property received. The excess collected over the fair market value would be reported as interest income as the payments are collected.

Yes, changing the amount reported on Form W-2 can result in IRS scrutiny, so you should include full disclosure with your income tax return. Look at the amount of tax you postpone from following this method to decide if it's worth the expense involved.

Question

I left my employer during 2001. I exercised NQSOs during 2002 and was issued a Form 1099. My tax person tells me the income should have been reported on Form W-2 and my employer should have paid the employer taxes for Social Security and Medicare.

My former employer says that since I wasn't an employee at the time of exercise, they were correct to report the income on Form 1099.

Who is right?

Answer

This is a difficult issue that has confused me, too. I think your tax person is right. Here's the authority for my conclusion.

For income tax withholding, under Treasury regulations section 31.3401(a)-1(a)(5), "Remuneration for services, unless such remuneration is specifically excepted by the statute, constitutes wages even though at the time paid the relationship of employer and employee no longer exists between the person in whose employ the services were performed and the individual who performed them."

A similar rule applies under Treasury Regulations Sections 31.3121(a)-1(i) and 31.3306(b)-1(i) for FICA withholding and FUTA taxes.

There is an exception when an option is exercised after the year of death of a deceased employee. (Revenue Ruling 86-109.)

Try giving this information to your former employer and have them discuss it with their accountants. Let me know if they disagree and why.

Question

I am trying to find information about using stock, in lieu of money, to pay contractors at our company. Do you know where I can find something on this?

Answer

I'm sorry I can't give you a specific reference. There are books available on employee benefits from various publishers that can give you some information. There are also some web sites oriented to employers. You can save a lot of time if you consult with a tax advisor who is familiar with the area.

Here is a start. The two principal alternatives for compensating independent contractors are stock grants and non-qualified stock options. Assuming these items are fully vested, a stock grant is taxable to the contractor at the time of grant based on the fair market value of the stock; a non-qualified stock option is taxable on the date of exercise, based on the excess of the fair market value of the stock over the option price. The company receives corresponding tax deductions according to the amount taxable to the contractors. The taxable income should be reported to the contractors as non-employee compensation on Form 1099-MISC. Some states are now requiring withholding for compensation of non-resident contractors. (For example, a Nevada resident engineer works as an independent contractor on software development at a California business location. The California business should withhold California income taxes for the California-source income.)

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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.

1 Internal Revenue Code § 408(c)(3)
2 Internal Revenue Code § 402(c)
3 Internal Revenue Code § 72(t)
4 Internal Revenue Code § 6654(d)(1)
5 Internal Revenue Code § 6654(d)(1)(C)