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By Michael Gray

Table of Contents

• Early year planning for ISO exercises
• Time to review fourth quarter estimated tax
• Questions and Answers
  • Does my company have to vest stock options for those who have been laid off?
  • Are my options still ISOs if I no longer work for the company?
  • Can long-term capital losses reduce AMT income from ISOs?
• Michael Gray, CPA's Tax & Business Insight
• Consult with a tax advisor

Early year planning for ISO exercises

With the tax law changes enacted during 2003, employees exercising ISOs in high income states like California may find their benefits have been reduced for exercising ISOs and holding the stock until the holding period requirements have been met. The reason is it is hard to reduce the federal tax on the excess of the fair market value on the date of exercise or vesting over the option price below the alternative minimum tax. The 35% maximum regular federal tax rate is close to the 28% maximum federal AMT rate, especially when you consider that state income taxes aren't deductible for the AMT computation.

To find out how this applies to you, an advisor who is familiar with these rules should make tax planning projections with your own estimated income and deduction figures. Then you can see what the potential benefit of holding the stock really is.

If you decide to hold the stock after exercise until the holding period requirements are met, it may be most advantageous to exercise early in the year. By exercising early in the year, you will have the benefit of nearly meeting the holding period requirements at the end of the year when deciding whether to sell the shares by the year-end if the value goes down. Selling before the year-end, provided the sale is not a wash sale, eliminates the alternative minimum tax adjustment and reduces the ordinary income based on the actual selling price of the stock. (The wash sale rules may apply if you purchase the same stock during the period starting 30 days before the sale and 30 days after a sale, including a regular purchase, exercise-sale, exercise of an employee stock option or buying shares through an employee stock purchase plan.)

Since there is no income tax withholding when an ISO is exercised and in some situations the tax isn't due until April 15 of the year after exercise, you may also be able to sell the stock after the holding period requirements are met, but before the tax is due to get the cash to pay the tax.

Tax planning early in the year is especially advantageous for incentive stock options.

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Time to review fourth quarter estimated tax

Remember the fourth quarter estimated tax payment for 2003 is due January 15, 2004. If you need to have your final payment reviewed, call your tax advisor for an appointment now!

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Questions and Answers

Question

My husband is being laid off from his company and has not fully vested his stock options. Since his company is letting him go, do they have to allow him to purchase all of his options?

Answer

No. Vesting is based on the period worked for the company. Your husband should have received a copy of the stock option agreement. Be sure to read it to understand its terms. You might want to consult with an employment law attorney to be sure your husband understands his rights.

Question

I was granted ISOs in a publicly traded company, and I was allowed to keep my options upon leaving the company two years ago. I recently exercised the options and sold them in a "cashless" same-day sale. Are those options still considered ISOs, since I am no longer an employee? Can I offset the profit from this sale against capital losses?

Answer

The options were no longer ISOs. In order to qualify as an ISO, the option holder must have been an employee of either the corporation granting the option, a parent or subsidiary corporation of the granting corporation, or a qualifying predecessor corporation during the period beginning on the grant date and ending the day 3 months before the date of exercise. (IRC § 422()(2).)

The income from the exercise of the option is ordinary income, not eligible for offset by more than $3,000 of other capital losses.

Question

Can long-term capital losses on open market equity (stock) transactions be used to reduce AMT income from an ISO exercise?

Answer

The AMT income from an ISO exercise is ordinary (wages) income. Capital losses are deductible first to the extent of capital gains. Capital losses in excess of capital gains are deductible for up to $3,000 of other income, and any excess is carried over to future years.

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Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter.

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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.

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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