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By Michael Gray

Table of Contents

• Need for advice for options revives
• IRS issues updated regulations for ISOs and ESPPs
• Sales of employee stock options to related parties under attack
• Questions and Answers
  • Can the various types of stock options be used for an LLC?
  • Is gain from a stock option exercise reported on form W-2?
• Consult with a tax advisor

Need for advice for options revives

With the improvement in the performance of the stock market, many options that were previously "underwater" are recovering their values. (Hooray!) Option holders need to be alert for opportunities to restart diversification planning. Advisors should get in touch with their option holder clients to remind them to monitor their financial situations.

Welcome back!

With the change in the political environment, including the movement to expense grants of options to employees on corporate financial statements, it remains to be seen whether option holder clients will be a "grandfathered" group who were granted options in the past.

The costs of complying with Sarbannes-Oxley requirements are creating an additional hurdle for new or smaller companies to make public offerings and to maintain their status as publicly- traded. This situation will substantially reduce the value of employee stock options for employees of new or smaller companies.

Microsoft has reported it will only make stock grants to employees in the future, but Oracle just announced it will issue a large block of options to employees this year.

By the way, the Microsoft employees are exchanging a considerable amount of risk protection built into options in exchange for the certainty of holding corporate stock. With the past strength of Microsoft, this may not be a big issue. For a start-up company, there is a significant trade off.

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IRS issues updated regulations for ISOs and ESPPs

The IRS has issued updated proposed regulations for incentive stock options and employee stock purchase plans. The old proposed regulations were issued back in 1984. A number of rulings issued since that time have been incorporated in the new proposed regulations. There is nothing in the new regulations that hasn't been in previous IRS procedures, rulings, or regulations. Some new laws were enacted after the old proposed regulations were issued, such as relating to the operation of the $100,000 limitation. Explanations of these provisions are included in the new proposed regulations.

Since the old regulations were issued, limited liability companies have developed as a popular entity form. LLCs may elect to be taxed as corporations. The proposed regulations make it clear that options for interests in an LLC that elects to be taxed as a corporation will qualify as ISOs and ESPPs.

The new proposed regulations retain the interpretation that wash sales of ISO stock are ineligible for the "escape hatch" limiting ordinary income to the sale price of ISO stock if it is sold in the year of exercise.

Notably, the new proposed regulations make it clear that the issuance of unvested stock when an ISO is exercised does not postpone the time for meeting the holding period requirements of more than two years after grant and more than one year after exercise to avoid ordinary income treatment as a disqualifying disposition. (§ 1.421-1(g).)

A public hearing is scheduled on the proposed regulations on September 2, 2003. Written comments must be received by August 12, 2003. Comments may be submitted electronically at the IRS web site, www.irs.gov/regs.

Taxpayers may rely on the proposed regulations for the treatment of any statutory option granted after June 9, 2003.

(REG-122917-02.)

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Sales of employee stock options to related parties under attack

Some employees have been exploiting a loophole to cap the ordinary income potential for their stock options. According to temporary treasury regulations section 1.83-7T(a), an arm's length transfer of an employee stock option will result in ordinary income being determined based on the sales price, equal to its fair market value. The employee could keep the stock option in the family but stop any increase in the ordinary income potential.

The IRS has changed the temporary regulation to clarify the exception does not apply when the option is sold to a related party. The IRS has also identified this type of transaction as a "listed transaction", requiring special disclosure on an income tax return.

The change to the regulations is effective on July 2, 2003.

(TD 9067, Notice 2003-47.)

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Questions and Answers

Question

Can the various types of stock options be used for an LLC?

Answer

See my discussion about the new proposed regulations for ISOs and ESPPs in this newsletter.

If the LLC is electing to be taxed as a corporation, interests in the LLC will qualify for ISOs and ESPPs. Interests in an LLC that is electing to be taxed as a pass-through or disregarded entity probably won't qualify.

Non-qualified employee options could be designed for any type of LLC.

Question

Should gain from a stock option exercise be included as W-2 wages or is it reported as a capital gain?

If gain from an ISO is included as ordinary income on Form W-2, how do you report a loss?

Answer

If you are really this lost about the treatment of ISOs, you really should get help from a professional tax advisor. I have a lot of material at www.stockoptionadvisors.com, including the "Executive Tax Planning For Incentive Stock Options" report that explain how ISO transactions are taxed. There are also some excellent books available on this subject, including the one I co-authored on Employee Stock Options (see bottom of this newsletter) and the Secrets of Tax Planning For Employee Stock Options book and video/audio tapes/CDs at our site.

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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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