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By Michael Gray

Table of Contents

• Happy Valentine's Day
• Have you received your organizer?
• Do you need an appointment for a tax return preparation interview?
• New book issued on employee stock options
• California Amnesty program offers a carrot and a club
• New deferred compensation rules can apply to NQOs
• Questions and answers.
  • Is there a rule for federal income tax withholding for ISOs?
  • Can a company offer cheaper options than a previous grant?
  • Who will send me a W-2 with my ISOs listed?
  • How do I avoid getting taxed twice on ISOs?
  • Are private company ISOs taxed?
  • What is the difference between a stock grant and NQOs?
  • What are the results for a cashless NQSO transaction?
  • What are the limitations on exercising ISOs?
  • Will asking HR questions alert them I'm considering leaving?
• Do you know about our other newsletter?
• Consult with a tax advisor.
• Subscribe to Michael Gray, CPA's Option Alert!

Happy Valentine's Day

Monday is Valentine's Day. Remember your dear ones and express how important they are to you. Life is shorter than we think.

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Have you received your organizer or tax notebook instruction letter?

We mailed organizers and tax notebook instruction letters to our clients early in January. If you haven't received yours or it was misplaced, please call Dawn at 408-918-3162.

If you are not a client and would like a paper organizer to help you prepare your own tax returns, we have one available on our Taxtrimmers website.

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Do you need an appointment for a tax return preparation interview?

We schedule most our tax return preparation interviews during February, and expect to file extensions for clients who submit their information after March 1. Many clients simply mail us their tax information, but some prefer a personal interview. If you want to schedule an interview appointment, please call Dawn at 408-918-3162. Appointment time openings are limited, so make your appointment today.

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New book issued on employee stock options

Kaye Thomas has updated his book, Consider Your Options. You can probably get a copy at Amazon or at his web site, www.fairmark.com. For those who are seeking certification as option advisors, try his site for the National Board of Certified Option Advisors, www.nbcoa.com. I hope he has better luck with his association than I did.

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California Amnesty program offers a carrot and a club

California is offering amnesty from tax penalties for unpaid taxes from before 2003. In order to qualify, you must apply for amnesty between February 1 and March 31, 2005. The completed tax returns or amended income tax returns must be filed by May 31, 2005.

If you have a tax liability and you don't apply for amnesty before April 1, the Franchise Tax Board will assert draconian penalties, even if you didn't realize you owed the money.

The Franchise Tax Board is issuing collection notices for very old income tax returns. Even if you believe you have always filed your tax returns, we suggest that you check with the Franchise Tax Board at 800-852-5711 (income and franchise taxes) and the Board of Equalization at 800-400-7115 (sales and use taxes), to determine if tax returns weren't filed or any issues are pending.

If you are undergoing a federal or California audit, you should discuss with your tax advisor whether there are any important decisions to be made right now.

Remember the California amnesty does not apply to federal tax penalties.

Thinking about how tax amnesty could apply to individuals with stock option transactions is like opening Pandora's Box. The implications are frightening. If you have unresolved reporting issues (like wash sales of ISO shares during 2000), consider consulting with a tax attorney for advice on your best course of action.

You can find more information and forms for applying for tax amnesty at the Franchise Tax Board's web site, www.ftb.ca.gov.

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New deferred compensation rules can apply to NQOs

A key provision in the American Jobs Creation Act of 2004 relates to non-qualified deferred compensation plans. The new rules are very complex and broad in their scope. The IRS has issued preliminary guidance for the deferred compensation rules in Notice 2005-1.

If non-qualified employee stock options are "in the money" when they are issued (the option price for the stock is less than the fair market value), NQOs are considered to be non-qualified deferred compensation and are covered by the new requirements. Therefore, employers should take care that the option price for their non-qualified stock options is at least equal to the fair market value on the grant date.

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Questions and Answers

Question

Is there a general rule for federal income tax withholding for ISOs exercised and sold for cash at the same time? Do you use the W-4 rate or the rate that applies for bonuses?

Answer

No federal income tax withholding is required for the disqualifying disposition of ISO shares. Section 251(a)(1) of the American Jobs Creation Act of 2004 "officially" repealed the withholding requirement, which was previously suspended by the IRS.

Question

The company I work for is privately owned. It issued ISOs for 150,000 shares at $.15 per share. Later, the company had 1:25 reverse split, repricing the ISOs for 6,000 shares at $3.75 each.

Then the company made an additional grant of an option for 200,000 shares at $ .06.

How can they have an option price of $3.75 per share for one grant and $ .06 for the other?

Answer

I don't have enough details to answer your question. The option price is supposed to represent the fair market value of the stock on the date the option is granted. The value of a company's stock changes all of the time because of its experience of profits or losses and whether additional investors become involved. Your situation may not be as unusual as you think.

Remember you can exercise the second option first.

Question

I exercised and sold ISO shares on the same day this year [presumably 2004]. My company didn't report the income on my W-2 form. Will I get a W-2 from Merrill Lynch (which administers the plan)?

Also, as I understand it, I need to report both a gain and loss of the same amount on Schedule D and report the net gain from the sale as W-2 income. What happens if Merrill Lynch doesn't send the W-2?

Maybe I'm wrong and the options are non-qualified?

Answer

Income from exercising non-qualified options should also be reported on Form W-2.

Talk to the people in your employer's payroll department. They may be issuing a corrected Form W-2 to include the ISO income. If they don't report the income on Form W-2, you can either adjust your wages with a disclosure worksheet or report the ISO income as "Other Income" at line 21, Form 1040.

If the brokerage firm reports the sale of stock on Form 1099-B, the sale price should be reported on Schedule D. The cost of the stock is the option price plus the ordinary income reported for the disqualified disposition of the ISO stock. It sounds like the sale date and acquisition date are the same day.

Merrill Lynch is not your employer and probably will not issue a W-2 form for this transaction.

Question

If my employer is reporting the ordinary income from my ISO stock sales on Form W-2 and I report the sale on Schedule D, aren't I being taxed twice?

Answer

Not if you compute the cost as I explained for the last question.

Question

We made a cashless exercise of a private company, and received a 1099 for $46,000. The company isn't publicly traded. The exercise price was $2 per share.

How can this be possible? We only exercised because the option was expiring. If I am taxed on the $46,000, they can have the stock back.

Answer

You should have gotten advice about the consequences of exercising the option. Ask the company if you can rescind the transaction. Bear in mind you are giving up an asset that could be of value if the company goes public or is sold.

Question

I have a client who wants to compensate me with stock or options. I'm not an employee, so if I take the stock, it's taxable now, and if I take the options, I'll pay tax on any gain between the exercise price and the market price the day I exercise the options.

Has this changed? Other than having taxable income sooner, is there any other difference between a stock grant and non- qualified options?

Answer

New accounting rules have been issued that make handling stock options more complicated and expensive for the company. Publicly-traded companies will probably eventually have to report an expense for granting compensatory stock options.

A stock grant is more risky than a stock option, because if the value of the stock falls, you will have the additional investment of the tax paid, which may be hard to recover.

The advantage of a stock grant is future appreciation may be eligible for tax-preferred long-term capital gains rates.

Question

What are the results for the following cashless transaction of a NQSO?

Number of shares: 325
Sale price: 56.47
Grant price: 35.65
Purchase expenses: 42.68

My W-2 shows $6,766.50 of income from the transaction.

Answer

Total FMV at exercise: 325 X 56.47 = $18,352.75
Total option price: 325 X 35.65 = $11,586.25
Ordinary income: $18,352.75 - $11,586.25 = $6,766.50

Cost of shares = $11,586.25 + $6,766.50 + 42.68 = $18,395.43
Short term capital loss = $18,352.75 - $18,395.43 = -$42.68

Question

I am fully vested in the following two ISO plans from my employer:

Exercise cost $50,000 (worth $225,000 today)
Exercise cost $100,000 (worth $375,000 today)

It is my understanding that I can't exercise more than $100,000 per year. Is that correct?

Also, after exercising my options, I must hold the stock for a period of one year or more so the tax would be considered capital gains as opposed to ordinary income. Is that correct?

One issue I am not clear about is the "two years from grant" limitation. Both of my plans were granted more than two years ago and I am wondering how that affects me?

Answer

Some of your assertions are not correct.

The $100,000 per year exercise limit is based on the option price and when the options first can be exercised.

Most importantly, you have neglected any discussion of the alternative minimum tax, which is critical in ISO planning.

I recommend that you read our report "Executive Tax Planning For Incentive Stock Options".

Question

I received several thousand shares of stock in my employer a little less than two years ago as an incentive to accept my job. The company will soon go public, but I'm thinking about leaving. I don't understand the stock plan, but I'm afraid to ask questions at the HR department because they will probably suspect I am planning to leave. What would you do?

Answer

I would tell the HR department that I need to have information about the stock plan in order to prepare for the coming public offering. If you actually have unexercised options for company stock, you might want to exercise them before the company goes public - whether you decide to leave or not. GETTING PROFESSIONAL ADVICE FOR THIS SITUATION IS CRITICALLY IMPORTANT.

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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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Do you know about our other newsletter?

For general tax developments, tax planning ideas, business development ideas and book reviews, subscribe to Michael Gray, CPA's Tax & Business Insight at 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 www.amazon.com or 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.