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By Michael Gray

Table of Contents

• Corporate insiders stuck with big tax bills for option exercises
• Register for our telephone seminar on November 12
• Questions and Answers
  • Can I challenge California's tax laws?
  • Which forms do I use for AMT?
  • Does a stock split affect incentive stock options?
• Consult with a tax advisor

Corporate insiders stuck with big tax bills for option exercises
(no relief for lock-outs)

Technical advice memos issued by the IRS national office based on a recent court of appeals ruling affirming a Tax Court decision are bad news for corporate insiders subject to restrictions connected to IPOs and other "lock-out" restrictions.

Private letter rulings 200338011 and 200338011 are technical advice relating to amended returns filed based on the same issues. Corporate insiders exercised incentive stock options, resulting in big alternative minimum tax liabilities for the related tax preference. The options were exercised more than six months after the ISOs were granted.

The taxpayers pointed out they were only able to sell the shares during three weeks of the year of exercise. The company subsequently declared bankruptcy. The taxpayers claimed that, since they weren't able to sell their shares on the stock market, the fair market value of the shares received should have been reported as zero.

The IRS responded that the only stock restriction, aside from vesting, recognized by the Internal Revenue Code is Section 16(b) of the Securities Exchange Act of 1934. Section 16(b) was modified during 1991 so the six-month restriction period begins on the date the options are granted. The six-month statutory period can't be volutarily or contractually extended by the taxpayer.

In this case, the restriction period under Section 16(b) was over when the options were exercised.

In order to avoid current taxation for AMT, the stock received must meet two conditions. 1) It must be non-transferable; and 2) it must be subject to a "substantial risk of forfeiture." The risk that the value of peoperty will decline during a certain period of time does not constitute a substantial risk of forfeiture.

The IRS also pointed out that restrictions that lapse with time are disregarded when determining the fair market value of the stock received on the date of exercise. Therefore, the taxpayers' claims for refund were denied.

The IRS cited a ruling by the Fifth Circuit Court of Appeals on March 26, 2003, Tanner v. Commissioner, affirming a ruling by the Tax Court (117 T.C. 237) with similar conclusions for ordinary income from the exercise of non-qualified options. (Incentive stock options are taxed under the rules for non-qualified options when computing the alternative minium tax.) In that case, Paul and Beverly Tanner had the statute of limitations extended to six years for substantially under-reporting their income. They didn't report $728,000 of ordinary income from the exercise of non-qualified options that were subject to restrictions, including a two-year lockup agreement relating to an initial public offering. The Tanners reported $161,067 of other gross income, so their understatement was more than 25%.

How should insiders or employees subject to lockouts who have ISOs or NQOs plan to protect themselves from these consequences? My response is to focus mostly on managing risk instead of maximizing returns. We have seen that market results of companies are unpredictable. The value of most companies a year after an IPO is below the price when the stock is introduced to the market. (How much is WebVan stock worth now?) Even companies that were once a "sure thing", like Montgomery Ward, K Mart and Pacific Gas and Electric company are either out of business or on the ropes. Other companies, of course, increase in value. The future is uncertain.

The advantage of an employee stock option is you can control a certain number of shares of employer stock without making a cash outlay until the option is exercised or expires. You can simply wait to exercise the option until the restrictions have lapsed and there is a lockout "window" when the shares can be sold. Then sell the shares immediately after exercise. Hold onto enough cash to pay your income taxes, and diversify the rest.

What about the tax benefits of holding onto ISO stock? With the changes of the Jobs and Growth Tax Relief Reconciliation Act of 2003, those tax benefits aren't likely to be realized. The tax applying will probably be the alternative minimum tax, especially in states with high income taxes, like California. The potential rewards from holding the stock aren't enough to justify the risk of a decline in value.

What if the stock isn't publicly traded, so you effectively can't sell it? The tax to be paid can be viewed as an additional investment required to buy the stock. Can you afford it? If you have to borrow the money to pay the tax, will the potential reward justify the risk that you can't repay the debt? Maybe you should let this "opportunity" go instead of risking financial distress or even bankruptcy.

The area of lockouts, stock of non-publicly traded companies and other restrictions on selling stock is one that cries for legislative relief. I urge you to write to your representatives in Congress to propose that the taxpayer should not be required to report income from a stock exercise until the stock can be sold.

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Register for our telephone seminar on November 12

The Jobs and Growth Tax Relief Reconciliation Act of 2003 has changed the tax environment for planning with employee stock options. Also many of our readers could use a "refresher" about the tax rules that apply for incentive stock options, non- qualified stock options and employee stock purchase plans. Michael Gray, CPA will be presenting a ninety-minute seminar, Secrets of Tax Planning For Employee Stock Options Under the New Tax Laws, at 1 p.m. Pacific Time on Wednesday, November 12. For details and to register, go to stockoptionadvisors.com/newtaxlaw.shtml.

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Questions and Answers

Question

Can California's rule about taxing options both on "moving into" and "moving out" of the state be challenged successfully? I must admit to a significant amount of ignorance regarding taxing on the income source. I'm now faced with a huge tax bill from California three years after an exercise. The source of the options was California and the residency when exercised was Colorado (where I paid full taxes on the gain.)

Answer

California's rules are actually similar to the various states. You should consult with a tax attorney, but I think it's unlikely you will succeed in challenging California on this issue. There is a long history of court cases favoring the government on this issue. Depending on your facts, you might be able to establish that some or all of the income was earned outside of California, such as if you worked outside of California as the options vested.

You might be able to qualify for a state tax credit for the California tax as a reduction of your Colorado tax, but you should file an amended Colorado return immediately because the statute of limitations for amending your Colorado income tax return might be coming up. (I hope it hasn't passed.)

Question

I exercised an ISO during 2001. The exercise price per share was $11.67 and the FMV was $27.80. I reported the excess of the fair market value of the shares over the option price on line 10 of Form 6251, resulting in $19,933 of AMT.

Since Uncle Sam did not make this simple and allow me to change the stock basis per share from $11.67 to $27.80, so everything could be handled on Schedule D, I'm lost.

I assume, if I sell the shares in 2003 for $30, I get credit for the $19,933 of taxes already paid by somehow using Form 8801 and Form 6251, and somehow the gain on Schedule D is offset. What goes on what line?

Answer

Have you considered using a paid tax return preparer?

Read the instructions for Form 6251 and Form 8801 carefully.

You should prepare a second Schedule D, labeled "Alternative Minimum Tax". The capital gain on that form is computed using the AMT basis of $27.80 per share.

The negative adjustment for a lower gain on Schedule D for AMT versus regular tax is reported on line 16 of Form 6251. The AMT tax using the maximum capital gains rates is computed at Part III of Form 6251.

The credit for prior year minimum tax is computed on Form 8801. First, compute any minimum tax for exclusion items, like state income taxes, at Part I of the form. You arrive at the potential credit available at line 21 in Part II of the form. (If all of the credit was related to exercising the ISOs, your amount would be $19,933.)

Enter your 2002 regular income tax liability, minus allowable credits, at Line 22. Enter the 2002 tentative minimum tax from Form 6251, line 33 at Form 8801, line 23. The limitation for the credit is entered at Form 8801, line 24 and equals line 22 minus line 23. The minimum tax credit allowed for 2002 is entered at Form 8801, line 25 and Form 1040, line 53 and equals the lesser of Form 8801 line 21 or line 24. Any unused minimum tax credit is entered at Form 8801, line 26 carried forward to 2003 and equals Form 8801 line 24 minus line 25.

If your gain is taxable as a long-term capital gain, you may not be able to use the entire minimum tax credit, because the AMT rate that applied when the option was exercised was 26% or 28%, but the maximum rate for long-term capital gains is 20%.

Question

For an ISO, does a stock split or a reverse stock split effect the option at all? For example, if you had an option for 1500 shares granted in 1997 and then the stock split in 2001, would this have an effect on the option?

Answer

The option would be adjusted for the split. Using your example, if the original option was granted for 1500 shares at $1 per share and the stock split 2:1, the option would be adjusted to 3000 shares at 50¢ per share.

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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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