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By Michael Gray

Table of Contents

• Watch Estimated Tax and Withholding for New Tax Law
• Corporate deduction for NQOs after acquisition analyzed
• Employer gets deduction for income not reported on employee's tax return.
• Questions and Answers
  • How do I value a stock grant in a new company?
• Consult with a tax advisor

Watch Estimated Tax and Withholding for New Tax Law

Remember a new tax law was enacted during May, 2003. Under the new law, individual income tax rates were reduced (the maximum rate changed from 38.6% to 35%) and the maximum rate for most long-term capital gains and some dividends were reduced to 15%.

The IRS has issued new withholding tables that all employers should have implemented by now. The federal withholding tax rate for bonuses and exercises of non-qualified stock options was reduced from 27% to 25%.

Taxpayers who are expecting a higher income tax for this year, such as from a disqualifying disposition of ISO stock, may need to increase their withholding over the IRS table amount. To avoid a penalty from underpayment of estimated tax, the taxpayer must pay the lesser of (1) 90% of the current year tax or (2) for taxpayers who had adjusted gross income up to $150,000 ($75,000 for married persons filing a separate return) for 2002, last year's tax; for taxpayers who had adjusted gross income over those amounts for 2002, 110% of last year's tax.

Other taxpayers will find they will have a lower tax for this year and should either reduce their estimated tax payments or their withholding.

It may be a worthwhile investment to visit a professional tax advisor to make the computations and find out what adjustments you should make for 2003 tax payments and planning strategies, especially considering more high-income taxpayers will be subject to alternative minimum tax under the new tax law.

Corporate deduction for NQOs after acquisition analyzed

The IRS has analyzed several scenarios relating to the deductibility of employee income relating to the exercise of a non-qualified stock option after an acquisition. In all of the scenarios, options to acquire stock of the acquiring corporation "N" were issued to replace options of the target corporation "M".

The IRS concluded that only the corporation to which services were provided by the employee is entitled to deduct the amounts reported as compensation by the employee when the replacement options are exercised or cashed out. In the examples where M survived as a subsidiary of N, M receives the tax deduction. In the example where M is merged into N by liquidation, N receives the tax deduction.

(Revenue Ruling 2003-98)

Employer gets deduction relating to stock transfer for income not reported on employee's tax return

Gary Barber, the former chief financial officer of Morgan Creek, an S corporation, made a Section 83(b) election for stock granted to him relating to services by the employer corporation. He disputed the value of the stock received and claimed the value was the same as the amount he paid, claiming taxable income from the stock grant of zero.

After Barber's termination, the corporation issued a corrected Form W-2 reporting an increase in wages of about $20 million for the transaction. Mr. Barber is still litigating the valuation with the IRS.

Morgan Creek amended its income tax return to claim a deduction for the $20 million of additional compensation. The IRS disallowed the deduction because this amount wasn't yet included in Barber's taxable income since the matter was still in dispute.

The United States Court of Appeals for the Federal Circuit held in favor of Morgan Creek, reversing a decision in favor of the IRS by the United States Court of Federal Claims.

According to the Court of Appeals, the key issue is whether an employer is entitled to a deduction for an amount includible in the employee's gross income as a matter of law or only the amount that is actually included in the employee's gross income. According to the IRS regulations, the amount actually included in the employee's gross income (satisfied by reporting on a timely Form W-2) is the deductible amount. The Court of Appeals decided the legislative history, including the Congressional Committee reports, supported the contention that the position that employer can deduct the amount includible in the employee's gross income as a matter of law is statutory as part of the Internal Revenue Code and thus supercedes the IRS regulatory interpretation.

In response to the IRS argument that this decision creates a "whipsaw" situation for the IRS when there is a dispute between the employer and employee, the court observed that "the IRS can at least participate in the cases involving both the employer and the employee and thus can take steps to protect itself against an inconsistent result. The employer, however, has no standing to participate in a dispute between the employee and the IRS regarding the amount claimed by the employee as gross income from the section 83 transfer."

A decision of the Court of Appeals for the Federal Circuit can be relied on by taxpayers in all Circuits, so this will be a very helpful decision for employers throughout the United States. Employers should review back years for potential claims for missed deductions and cite this case in disputes now in progress.

(James G. Robinson v. U.S., CA Fed Cir., 7/15/2003, 92 AFTR 2003-5080.)

Questions and Answers

Question

I am receiving a grant of stock in which I will be 100% vested in 2004. I will still have restrictions on how or if I can sell the stock until a major liquidity event (merger, IPO, etc.)

For tax purposes, how do I value the company that is in its very early stages? We have received investor money. There has been no income because the invested amounts have been used for development.

Answer

Your employer is responsible for providing a value to you and should include this amount on your Form W-2 based on the value of the stock when it vests.

For you to properly value the stock would be an expensive proposition, requiring that you hire a business appraiser. Sometimes it's worth it when the resulting tax liability is very high. It seems to me the value of stock representing a minority interest in a non-publicly traded company that has never generated income shouldn't be very high.

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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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