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Table of Contents

• Swap exercise of ISOs clarification
• Will accounting changes become required for financial reporting?
• Payroll tax issues for NQSOs transferred in a divorce.
• Questions and Answers
  • Can I get a tax deduction for worthless stock options?
  • Can my company allow early exercise of ISOs?
  • When are taxes due on non-qualified stock options?
  • Am I required to pay estimated taxes on ISOs?
• Have you subscribed to Michael Gray, CPA's Tax and Business Insight?
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Swap exercise of ISOs clarification

Thanks to Brad Pulliam, CPA of Mellott & Mellott, PLL in Cincinnati, Ohio, I am revisiting a question in our last newsletter about swapping shares to exercise an ISO. My answer to the question was incomplete.

The question was: "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 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?"

My original answer was: "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."

Here's more information about this issue.

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.

Sorry for the incomplete answer I gave before. We are working hard clearing up our backlog of extended income tax returns and helping clients with tax planning. I have had fewer clients make swap exercises than I can count on one hand.

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Will accounting changes for employee stock options become required for financial reporting? A political hot potato

With the accounting scandals at Enron and Worldcom, the Financial Accounting Board had an opening and political pressure to require reporting some cost for grants of employee stock options.

Thanks to unrelenting lobbying by the high technology industry, Congress is considering legislation to require expensing only for the chief executive officer and the next four highest-paid employees of publicly-held companies. Small companies would be exempt from reporting. The Stock Option Accounting Reform Act has passed in the House Financial Services Committee. So far, the Senate seems less supportive of this proposal.

The Financial Accounting Standards Board has indicated it is considering postponing the effective date for its new statement requiring expensing.

The high tech industry may at least buy some additional time for executives and employees to cash in their options before the new rules become effective, if they ever do.

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IRS explains payroll tax issues for non-qualified options transferred in a divorce

During 2002, the IRS issued Revenue Ruling 2002-22, concluding that the transfer of non-qualified stock options to a former spouse relating to a property settlement for a divorce is not currently taxable. The IRS also published Notice 2002-31, explaining payroll tax reporting when the option is exercised.

Now the IRS has issued more definitive payroll reporting rules in Revenue Ruling 2004-60.

When the nonemployee spouse exercises the NQO, the exercise is subject to income tax withholding. The rate of tax for withholding is the rate for supplemental income, currently 25%. The nonemployee spouse is not required to submit a Form W-4 to the employer. The ordinary income and income tax withholding are reported on Form 1099-MISC.

The exercise of the NQO is subject to employment taxes for the employee. The employer is required to withhold the appropriate FICA and Medicare tax based on the year-to-date facts for the employee. The FICA and Medicare income and related withholding are reported on the employee's Form W-2. The employer is also subject to any related unemployment taxes for the income amount.

The IRS has explained its procedural requirements. As part of their property settlement agreement, the former spouses should define whether the employee spouse is required to reimburse to nonemployee spouse for employment taxes paid to the employer, or whether the employee spouse should pay those taxes directly to the employer.

In order for the financial arrangements to work for the exercise of a NQO by a nonemployee spouse, it appears the stock will have to be sold. This may be a real problem when the stock isn't publicly traded.

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Questions and Answers

Question

A former employer gave me both incentive stock options and nonqualified stock options and then filed chapter 11. The company will probably soon file chapter 7. I didn't exercise the options. Is there any way I can claim a tax deduction for the worthless stock options?

Answer

No. Since you never reported any taxable income for receiving the options and made no cash investment in them, you have no tax basis or investment to deduct.

Question

I currently work for a pre-IPO company. I have received an initial grant of ISO stock options. The current plan does not include a clause allowing early exercise of unvested options.

Is it possible and/or legal for a company to add such a clause to its stock option plan retroactively for previously-granted options? Is there any precedent for this sort of addendum?

Answer

I believe a change like this is permissible. Your company's counsel should refer to Internal Revenue Code Section 424(h)(3)(C).

Remember that accelerating the ability to exercise ISOs can result in the $100,000 per year limit being exceeded, converting some of the ISOs to NQOs.

Question

My husband has non-qualified stock options. Do you have to pay taxes at the time you exercise the options, or can you elect not to and pay the balance of the taxes when you file your income tax returns?

Answer

If your husband is an employee, his employer is required to withhold income taxes and employment taxes (like Social Security and Medicare) when he exercises the options. Since the required federal withholding is 25%, he may owe some additional taxes in April and should also determine whether he should make estimated tax payments.

If your husband is not an employee, withholding is not required and he should review the estimated tax rules to determine whether he needs to make estimated tax payments for the income to be reported.

Question

I exercised some incentive stock options and the company withheld no taxes from my cashless exercise. Am I required to pay estimated taxes? Will I owe AMT?

Answer

I recommend that you meet with a tax advisor to compute your individual tax amounts. Remember that no penalty will apply for underpayment of estimated tax provided you pay through your withholding at least the tax on last year's income tax return, or 110% of the tax on last year's income tax return if your adjusted gross income for last year was more than $150,000. Federal estimated tax payments are made using Form 1040ES. You can get the forms at the IRS web site, http://www.irs.gov. California estimated tax payments are made using Form 540ES. You can get those forms at the FTB web site, http://www.ftb.ca.gov.

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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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