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Table of Contents

• Estimated tax reminder
• Are you missing the California AMT Credit?
• Questions and Answers
  • Can I sell private company stock? (and more)
  • If stock is not transferable, do I still owe AMT?
  • Is there any advantage to exercising and holding NQSOs?
  • Do swapped shares keep their acquisition date?
  • Is there a fair market value for private stock?
  • Can I avoid AMT if I can't sell my stock for a year?
• Michael Gray, CPA's Tax & Business Insight
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Estimated tax reminder

The second estimated tax payment for calendar-year taxpayers, including most individuals and trusts, is June 15. If you have an estimated tax payment due, now is a good time to make it. If you have a situation requiring a change to your estimated tax payment, call your tax advisor now.

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Are you missing the California AMT Credit for sales of ISO shares?

You can't depend on "off the shelf" tax return preparation software to automatically handle the California "gains and losses" adjustment for sales of ISO shares.

For California residents, line 9 of Schedule P (California AMT form) should usually be the same as line 16 of Form 6251 (federal AMT form). This should result in AMT credits being used at California Form 3510.

Related to this, a real weakness of many computerized tax return preparation programs is that they don't generate an alternative minimum tax Schedule D, leaving a poor audit trail.

We just helped a new client get the benefit of about $15,000 of AMT credits that would otherwise have been unused for three years tax returns. Maybe you should pull yours out and look again. Consider hiring a tax professional to prepare your amended income tax returns (and maybe to prepare future returns).

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Questions and Answers

Question

I was laid off from my company 2.5 months ago after 3 years of service. I wish to exercise some or all of my vested ISOs before the 90-day period has expired since my termination. The company is privately held and has no near future plans for going public.

1. Can I ever sell these shares to another individual privately if the company doesn't go public?
   
   
2. The company has elected to be an S corporation. Does this have any bearing on the company registering with the SEC?
   
   
3. Would I be taxable on corporate income as an S shareholder?
   
   
4. If I later find the tax burden is too severe, can I disavow the shares at a later time?

Answer

1. You should consult with an attorney familiar with stock options about this question. Call me if you need a referral.
   
   
2. Companies that make S elections can later go public. They will lose their S status at that time.
   
   
3. S shareholders are taxable on their share of the corporation's income.
   
   
4. Disavowing the shares at a later time will be difficult.

If you are really concerned about the tax burden for these shares, maybe you should pass on this opportunity (don't exercise the options).

Question

My company is a private company. If I exercise an ISO, since the stock is not transferable (not publicly traded), I should not owe any AMT. Right?

Answer

Wrong.

The transfer is taxable in the year in which the rights in the property are transferable or not subject to a substantial risk of forfeiture. Since the shares are vested, the transaction is taxable. (Internal Revenue Code Sections 83(a), 56(b)(3).)

Question

I plan to retire at the end of this year and have some non qualified stock options that I haven't exercised yet. Is there any advantage to exercising and holding the stock versus exercising and selling them?

Answer

There is no tax advantage in holding the stock. When you keep the stock, you are in the same position as if you had sold them and bought them back.

Question

My understanding of a stock swap exercise of ISOs is that the exchange shares maintain their original cost basis and acquisition date, while the newly acquired shares receive a basis of $0.

I believe if I were to sell the new new shares before one year after exercising that it would create a disqualifying disposition and I would have to pay ordinary income tax. What happens if I sell the exchange shares? Would that create a disqualifying disposition too?

Answer

No. Only the sale of the "new" shares will result in a disqualifying disposition. The old shares keep their characteristics, including basis and acquisition date.

According to the regulations, for the purposes of determining a disqualifying disposition, the holding period for all of the shares (including the exchanged shares) are considered as starting on the date of exercise. More importantly, according to regulations section 1.422-5(b)(2), "...the optionee's disqualifying disposition of any of the stock acquired through such exercise is treated as a disqualifying disposition of the stock with the lowest basis." In other words, the regulations specify an ordering rule for the disposition of shares. The shares for which ordinary income would be recognized are considered sold first.

Here's an example, loosely based on one in the regulations. On June 1, 2004, X Corporation grants an incentive stock option to employee A to purchase 100 shares of X Corporation common stock at $10 per share. A may swap other shares of X Corporation stock to exercise the option. A owns 40 shares of X Corporation common stock, purchased on the open market on June 1, 2002 for $5 per share. On June 1, 2005, when the fair market value of the shares is $25 per share, A swaps his 40 shares to exercise the ISO.

The tax basis for 40 shares is $5, with an acquisition date of June 1, 2002. The tax basis for 60 shares is zero, with an acquisition date of June 1, 2005.

On September 1, 2005, A sells 75 of the shares for $30 per share. A is considered first selling the 60 "new" shares and recognizing the related ordinary income of $1,500. ($25 FMV at exercise - $0 tax basis = $25 ordinary income per share X 60 shares = $1,500. Note this equals $25 FMV - $10 option price = $15 ordinary income per share X 100 shares for ISO = $1,500.) The short-term capital gain for the "new" shares is $30 - $25 = $5 per share X 60 shares = $300. The long-term capital gain for the "old" shares is $30 - $5 = $25 per share X 15 = $375.

For alternative minimum tax reporting, $1,500 ordinary income is reported relating to the exercise of the ISO. ($25 FMV - $0 cost = $25/share X 60 shares = $1,500.) It appears to me you should follow the shares considered to be sold for regular tax purposes in determining AMT reporting and adjustments. Therefore, the short-term capital gain for the "new" shares is $30 sales price - $25 FMV at exercise = $5 per share X 60 shares = $300. The long-term capital gain for the "old" shares is $30 - $5 = $25 per share X 15 = $375. Note that the regular tax and AMT amounts are the same because the "new" shares were sold during the year of exercise. There are no AMT adjustments.

Now that I've explained this, here's an editorial note. The swap to exercise is a "gee whiz" technique that usually isn't so great. Why? Because you still have to pay the alternative minimum tax for exercising the option. Under the current tax regime, with a 35% maximum federal regular tax rate and a 28% maximum federal AMT rate, it just isn't worth taking much risk to hold onto the shares to meet the holding period requirements when you're dealing with big amounts, especially when your state has a high income tax rate, like California. Throwing in the "ordering rules" that require the "ordinary income" shares to be sold first makes this technique even less attractive. Also, if you expect the value of the shares to increase dramatically, you will benefit more by not swapping shares because you will own more shares without a swap.

Question

If company stock isn't publicly traded, how can there be a fair market value for AMT calculation? My CPA says my stock is worthless until the stock is sold and the price is determined.

Answer

There is a long line of cases and a huge body of work, including societies of professional appraisers, for valuing stock of companies that aren't publicly traded. Adjustments (discounts) are made for lack of control and lack of marketability. This has been a huge area of activity because it is the basis for estate planning using family limited partnerships. I'm sorry, but you (and your advisors) can't just "blow this off."

Question

I have an ISO for 100,000 shares at 25¢ per share in a public company, traded on the Pink Sheets. The current value of the stock is about $7 per share. If I exercise my options, I will be issued restricted stock and must hold it for one year before I can sell it. Can I avoid the AMT until the restrictions lapse?

Answer

No. See the second question above. Also, according to Internal Revenue Code Section 83(b)(a), no adjustment to value is allowed for a restriction other than a restriction, which by its terms will never lapse.

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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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This free email newsletter covers general tax and business issues. To see past issues and to subscribe, visit our web site at http://www.taxtrimmers.com.

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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.