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By Michael Gray

Table of Contents

• IRS warns against aggressive refund claims
• Extensions – when you don't have the money to pay the tax
• First individual estimated tax payment is due April 15
• Stock option expensing requirement progresses
• Questions and Answers
  • Can I avoid AMT by donating my stock?
  • When do I have to pay AMT?
  • Is the basis of stock adjusted for AMT reporting even if I don't pay AMT?
  • How do I present a stock swap on my tax return?
  • Which state is entitled to taxes on my ISOs?
  • Should an ISO sale be reported as wages on form W-2?
• Michael Gray, CPA's Tax & Business Insight
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

IRS warns against aggressive refund claims

The deadline to file amended returns for many taxpayers who suffered a tax hit from the 2000 market decline is April 15, 2004. The IRS has been receiving many claims for refund based on very aggressive theories.

In an apparent attempt to discourage a flood of claims that will create an administrative nightmare, the IRS has issued IRS Notice 2004-28 warning that penalties may be asserted against taxpayers and tax return preparers for frivolous claims.

Five examples listed in the Notice of theories that the IRS believes may be frivolous are:

• The options should have been taxed at their grant date, rather than their exercise date.
  
  
• The fair market value of stock purchased under an option is reduced by any restriction placed on the stock by the employer that prohibits the employee from selling the stock for a specified period of time.
  
  
• When, due to a margin call, a broker sells a taxpayer's stock that was purchased under a nonstatutory option, the stock having been pledged as security for a loan to pay the exercise price, that sale is a forfeiture of the stock that causes an ordinary loss rather than a capital loss.
  
  
• The purchase of the stock using borrowed funds was not in substance a purchase because the employee did not have the ability to repay the loan.
  
  
• Options should have been viewed as the economic equivalent of the underlying stock and are thus not subject to any taxation of the spread on exercise.

In addition to civil penalties, the IRS listed potential criminal penalties that could apply for tax evasion (for the taxpayer) or for assisting or advising about the preparation of a false income tax return (for tax return preparers).

Although an IRS notice like this is not the "final word" on these issues, the IRS has "raised the stakes" in contesting the tax laws relating to employee stock options. Tax advisors and taxpayers should be well prepared to show they have a reasonable basis for the theories under which their tax returns are prepared. The courts have been unsympathetic to "tax protestors."

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Extensions - and when you don't have the money to pay the tax

(This is a reprint from past newsletters.)

What do you do when you don't have the money to pay the tax?

My first recommendation is to file your income tax returns, certified mail, by the initial filing date. One of the nastiest penalties in the IRS's arsenal is for late filing - 5% per month to a maximum of 25%. Some people who owe money don't file their returns because they are afraid. THIS IS A HUGE MISTAKE! The best approach is to be honest about your situation and work with the tax authorities to resolve it.

When your file an extension, any balance of tax due when the tax return is filed represents an exposure for the late filing penalty.

Please don't misunderstand me. I regularly use extensions for my clients and myself as a workload "safety valve". We often don't have the information to complete a return by the due date. They just aren't appropriate when there will be a significant balance due that won't be paid by the original filing due date.

According to the Treasury regulations for the requirements to file a valid automatic extension request, "an application for extension must show the full amount properly estimated as tax for the taxable year." (Reg. § 1.6081-4(a)(4).) The regulations relating to reasonable cause for failure to file a tax return state that if a taxpayer satisfies the requirement of showing the full amount estimated as tax, the taxpayer has a reasonable cause for failure to file during the extension period provided (1) the excess of the amount of tax shown on the return over the amount of tax paid by the original filing date (including the amount paid with the extension form) is no greater than 10 percent of the amount shown on the return (restated - 90% of the tax is paid by the due date), and (2) any balance due shown on the return is paid with the return. (Reg. § 301.6651-1(c)(3).)

(For California taxpayers, the extension is paperless so the amount of the tax need not be stated. You are still required to pay at least 90% of the tax by the original due date to avoid the late filing penalty.)

If you have filed an income tax return for 2002, you can process your federal extension electronically or by telephone - call 888- 796-1074 by April 15. Better call early to beat the rush! Mailing a paper form is still acceptable and is the only way a person who didn't file a 2002 income tax return can request an automatic extension.

A taxpayer can still avoid the late filing penalty by demonstrating a "reasonable cause," but this can be a hassle and the taxpayer is at the mercy of the subjective judgment of a representative of the tax authority.

Remember you may now pay income taxes using a credit card. Call 800-272-9829, or try the web site, www.officialpayments.com. The extension for California is 1555. You can also call 888-729-1040. Maybe you can find a card offering a low interest rate promotion that will work for your situation.

Should you borrow using a margin account? In most cases, this is not a good choice because of the exposure to margin calls if the market declines.

Should you use an equity advance loan, secured by your principal residence? In some cases it might be to your advantage, if you can get a favorable interest rate. Remember interest for an equity loan not used for a home improvement is only deductible on a loan amount up to $100,000. This interest is not deductible when computing the alternative minimum tax.

Remember that IRA accounts and even other retirement accounts can be temporary sources of funds. Distributions from IRAs that aren't minimum required distributions can be rolled over to another IRA or returned to the same IRA within 60 days after a withdrawal. This exception only applies to one rollover per year. (You must wait more than one year after a rollover is completed before making another one.)¹

Certain distributions from other qualified plans can also be rolled over within a 60-day period to an IRA or another qualified plan.² Using IRAs or qualified plans as a temporary source of funds to pay taxes can be useful if the funds to complete the rollover will soon be available, such as when there is a lockout "window" that will soon be open. The cost of an error can be high, because if the rollover isn't completed before 60 days have expired, the distribution may be subject to tax as ordinary income plus a 10% early distribution penalty.³

The IRS has a form for installment agreements, Form 9465. They would prefer that you submit the form with your income tax return. You can take up to five years to pay off your tax liability. An advantage of arranging an installment agreement is the penalty for late payment of tax is reduced from 1/2% per month to 1/4% per month. In addition to penalties, interest is charged for late tax payments. The interest rate is adjusted quarterly. Recently, the rate has been five percent.

Another alternative is to make an Offer in Compromise, Form 656. With this procedure, the IRS actually can reduce your tax based on your ability to pay. You don't have to wait until you have owed the tax a long time to use this procedure. I think it's best to work with an attorney, CPA or enrolled agent when making an Offer in Compromise. If the amount is large, an attorney is probably the best choice.

Although it may provide relief from your other creditors, bankruptcy doesn't offer much help for recent debts for income taxes. When you make payments on your tax bill, be sure to specify to apply the payments to taxes due. Penalties and interest are dischargeable in bankruptcy, but income taxes aren't.

It may be to your advantage to plan how to use regular tax or alternative minimum tax capital loss carryovers or minimum tax credit carryovers. You might need to generate capital gains, which can be difficult when you're in financial distress.

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First individual estimated tax payment is due April 15

(This is a reprint from past newsletters.)

Remember to review your estimated tax situation for 2004.

There is no estimated tax penalty provided the taxpayer pays at least 90% of the tax (including AMT) on the current year's tax return through withholding and/or equal quarterly estimated tax payments.

For taxpayers who have no more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁴ For taxpayers who have more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least, for 2003, 110% of the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.⁵

Taxpayers who have uneven income and deductions may also compute their estimated tax on an "annualized" basis. You multiply the year to date income and deductions to arrive at amounts for a year, compute the tax for that amount, then pay amounts to cumulatively pay in 1/4, 1/2, 3/4 and 100% of those amounts. You should probably get help from a professional tax return preparer to do this.

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Stock option expensing requirement progresses

The Financial Accounting Standards Board has announced that companies will be required to start reporting an expense when employees are granted stock options, effective for companies with fiscal years starting after December 15, 2004.

The announcement includes a different method of valuing the options from past proposals, called the "lattice model". The lattice model can result in a lower value than the Black-Scholes method previously endorsed.

Meanwhile, representatives of the high technology industry are lobbying in Washington, D.C. for limiting the expensing requirement to options granted to key executives. The comment period ends June 30, so write your comments to Congress and the FASB soon.

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Questions and Answers

Question

I exercised ISOs and paid the AMT a couple of years ago. I would like to now donate those stock shares with the intention of:

1. getting the write off for current market value for the stock
2. getting back the prepaid AMT tax on them (since I donated them and therefore had no real taxable gain.)

Is this doable? My tax advisor tells me that we can't get back the AMT without selling the stock.

Answer

Your tax advisor is correct. It is the sale of the stock that creates the difference between the tentative alternative minimum tax and the regular tax that enables you to apply the AMT credit. See Form 8801 and the related instructions.

The donation of appreciated ISO stock only makes sense when the tax benefits of the donation dwarf the potential benefit lost for the AMT credit. This will apply when the stock has increased dramatically in value after the ISO was exercised, and the taxpayer has met the holding period requirements for the stock.

Question

I read your article on "The Amazing Disappearing AMT Credit" dated 7/28/99 and got even more confused than I was before with ISO issues. Has anything changed for the better since that time?

I was granted an ISO during September, 2000 at $2.50. Now the value is $35. I have not exercised my option yet and would like to know what you recommend for me to do.

1. If I exercise now, would I have to pay AMT right away or can I wait until 4/15/05 and pay it then?
   
   
2. Will I be penalized by the IRS if I don't pay the AMT in quarterly installments?
   
   
3. If I exercise before April 10, 2004 and sell on April 12, 2005, could I use the proceeds from the sale to pay the AMT for 2004?
   
   
4. What is the best option to make everybody happy and not regret afterwards that I didn't do the right thing?
   
   
5. A lot of people in my company are frustrated with IRS issues and overpaying too much. Could you suggest what to do to make it simple?

Answer

Things haven't changed for the better since I wrote that article. The AMT situation is worse. More and more people are becoming subject to the AMT.

I can't give you a "correct" answer to your question. It requires individual analysis based on your situation. As a blanket statement, high income individuals who are residents of high tax states like California are probably better off selling the shares when they exercise their ISOs.

1. As long as you pay the required estimated taxes or withholding based on your 2004 income tax liability (for high income taxpayers, 110% of last year's tax), there is no penalty for paying the balance on April 15, 2005.
   
   
2. See 1.
   
   
3. You need to be able to have enough time to receive the proceeds from the sale to pay the tax on April 15.
   
   
4. Get a crystal ball. Mine is broken. What is your tolerance for risk?
   
   
5. Get out of "civilization" and live in a commune on a desert island. Alternatively, get a good tax advisor to help you manage the complexity.

Question

If ISOs are exercised, but not enough to incur an AMT, is the cost basis of the stock for AMT reporting still adjusted to the market price at exercise?

Answer

Yes.

Question

I exercised an ISO of 25,000 shares at 20¢ per share, or $5,000. I swapped 2,222 shares at $2.25 per share. How do I present this on my tax return?

Answer

You don't.

You will still report the AMT adjustment for the options that you exercised, but there is no other information required to be presented.

I recommend that you get a tax return preparer to help you handle this correctly. Accounting for swaps is tricky.

Question

I worked for a Colorado-based, publicly-traded company until October 2001. I relocated to California in January 2002. During my tenure with the company, I received incentive stock options. When I attempted to exercise the options in March 2002, the company refused to allow the exercise. An attorney and many dollars later, the company paid out the options in 2004, and collected state taxes for Colorado. Is this correct? Shouldn't taxes have been collected based on my resident state of California and reflected this way on my W-2?

Answer

No. Since you received the options and they vested based on services performed as an employee in Colorado, the income is Colorado-source income, taxable in Colorado. You are also required to report the income on your California income tax return, but you claim a state tax credit for taxes paid with respect to double-taxed income in Colorado.

Question

I am working with a client that exercised ISOs 2 1/2 years after the grant date and performed a sale of those options on the same day. The gain on the sale is being reported on his W-2 as wages and considered a disqualifying transaction. Is that correct?

Answer

Yes. Look at Internal Revenue Code Section 422.

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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.

To receive the next issue of Michael Gray, CPA's Option Alert with more employee stock option tax developments and answers to questions from our readers automatically via email, subscribe by filling out the form below.

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1 Internal Revenue Code § 408(c)(3)
2 Internal Revenue Code § 402(c)
3 Internal Revenue Code § 72(t)
4 Internal Revenue Code § 6654(d)(1)
5 Internal Revenue Code § 6654(d)(1)(C)