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Table of Contents

• New Tax Law May Decrease Tax Benefits of ISOs
• Questions and Answers

  Who pays social security taxes on NQSOs?

  What happens to my options if the company goes bankrupt?

  Can I sell my ESOP stock in a privately held company?

• Consult with a tax advisor

New Tax Law May Decrease Tax Benefits of ISOs

President George Bush signed the new tax law Jobs and Growth Tax Relief Reconciliation Act of 2003 on May 28. According to the newspapers, it's the third largest tax cut in history, yet it's only seventeen pages long. The Republicans have vowed to pass a tax cut every year during George Bush's presidency. Many tax proposals were not included in this law, which leads me to believe more tax legislation may be passed before the end of 2003.

Here are key provisions that relate to tax planning for employee stock options.

• Decrease in the maximum income tax bracket for individuals from 38.6% to 35% retroactively to January 1, 2003. The decrease is effective for 2003 and 2004.
  
  
• Decrease in the maximum tax rate for long-term capital gains from 20% to 15%, effective for capital assets sold after May 5, 2003. The decrease expires for taxable years beginning after December 31, 2008.
  
  
• Increase the alternative minimum tax exemption to $58,000 (from $49,000 ) for married taxpayers, filing jointly and $40,250 (from $33,750) for unmarried taxpayers for 2003 and 2004.
  
  
• Effective for taxable years beginning after December 31, 2002, most dividends from domestic corporations will be added to long- term capital gains eligible for the 15% and 5% tax rates. In order to qualify, the stock must have been held at least 60 days during the 120-day period beginning 60 days before the ex- dividend date. Dividends from certain foreign corporations eligible for benefits from a comprehensive income tax treaty with the United States will also qualify. Dividends taxed at long- term capital gains rates will not qualify as investment income to determine the limitation of the investment interest expense deduction. Taxpayers may elect to have dividends taxed as ordinary income to make more investment interest deductible. Since the dividends still aren't considered to be capital gains, capital losses in excess of the regular $3,000 limitation won't be available to offset them. (More details apply to these rules that are beyond the scope of this explanation.) Applying the long-term capital gains rate to dividends is scheduled to expire for taxable years beginning after December 31, 2008.

Significantly, the maximum tax rate that applies to compute the Alternative Minimum Tax is unchanged at 28%. Taxpayers with significant alternative minimum taxable income may not receive any benefit from the increased AMT exemptions because they are phased out.

More specifically relating to employee stock options, the decrease in long term capital gains rates will make it harder to recover the AMT credit because the AMT tax at exercise of an ISO is unchanged at 28%. The long-term capital gains rate that applies if the holding period requirements are met (more than two years after grant date, more than one year after exercise) is decreased to 15% from 20%. The recovery of AMT credit may be limited to the tax rates that apply to the capital gain when the stock is sold.

For the deferred gain at exercise, it may be appropriate to use the Federal AMT rate in determining the tax benefit of not selling the stock at exercise and meeting the holding period requirements. Disregarding state income taxes, the benefit has decreased from 38.6% - 28% = 10.6% to 35% - 28% = 7%. For California taxpayers, the decrease is from about 9% to about 5%. Is it really worth the emotional roller coaster you are going to go through to meet the holding period requirements? In many cases, no. You may be better off making a sale-exercise and getting diversified earlier. You can then enjoy long term capital gains rates for the investments you want to hold for a longer term.

Another thing to think about is the change in taxation of dividends as it relates to margin interest that qualifies for deduction as investment interest expense. Investment interest expense is only deductible against investment income, which mostly consists of dividends, interest and short-term capital gains. Interest rates are way down. Most people have capital losses. Under the new tax law, dividends taxed at long term capital gains rates are not included in investment income. That could effectively eliminate the deduction for investment interest expense. Since the price of including dividends in investment income is to forfeit long term capital gain benefits, the tax benefit of the investment interest expense deduction has been dramatically reduced.

It's too bad dividends haven't been reclassified as long term capital gains for all purposes. Many taxpayers could use the capital gains income to use their capital loss carryovers, and possibly recover some of their suspended AMT credit for AMT capital loss carryovers due to AMT basis adjustments. Dividends are taxed at long-term capital gains rates, but are not reclassified as long term capital gains.

Obviously, some taxpayers will benefit more than others from this tax cut legislation. Employees with incentive stock options will generally not benefit as much as other taxpayers.

Questions and Answers

Question

An individual was employed by a company from which he held nonqualified stock options. After terminating employment, the individual exercised some of the nonqualfied options and sold them on the same day. The former employer sent the individual a Form 1099-MISC for "non-employee compensation" for the difference between the fair market value of the stock and the price paid for the stock.

Is the individual subject to self-employment tax for this compensation? Isn't the former employer responsible for the employer portion of social security and medicare taxes as these "wages" resulted from employment at the company?

Answer

This is a confusing area that I last answered in the March 11, 2002 issue of ESOAA Option Alert.

The IRS explanation for proposed regulations issued late in 2001 relating to withholding for ISOs and ESPPs point back to the definition of wages under the regulations.

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.)

I do not work extensively in the area of payroll tax reporting. Employers should be seeking their own counsel in this area.

Question

Say that your total compensation from a privately-held company is $125,000, of which $100,000 is paid in cash and $25,000 is paid in non-qualified stock options.

The options are granted at 50% of the established FMV of the common stock. The FMV at exercise is $8 and the option price is $4. An option is granted for 6,250 shares to arrive at $25,000.

If the company goes bankrupt and ceases to exist, can the individual claim a $25,000 loss? Can it be a long-term capital loss if the options have been held more than one year?

Answer

Since you (presumably) didn't report any taxable income for the grant of the options, you have no tax basis in them. No loss is allowed.

Question

I am currently employed by a privately held company. I am 100% vested in my ESOP plan and have about $50,000 in my account. Is there a way I can sell within or outside the company for cash?

Answer

You might be able to. I don't have enough details to answer your question.

I suggest that you discuss this with the person responsible for administering the plan at your company. ESOPs for privately-held companies usually have a buy-sell agreement attached to them where the company buys the employee's shares.

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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".

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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.

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