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By Michael Gray

Table of Contents

• Second estimated tax payment due June 15
• Transportation Bill Includes Option Provisions
• Options Expensing Deadline Extended
• Cisco Offers Options Valuation Alternative
• Questions and answers.
  • Can I offset a stock option gain with capital losses?
  • How do AMT exemption phase-outs impact capital gains?
  • What happens to stock options when a company is bought out?
  • Do I need to indicate an early exercise on my tax returns?
  • Are option right sales long term capital gains?
  • Which tax form do I use to report NQSO sales?
• Do you know about our other newsletter?
• Consult with a tax advisor.
• Subscribe to Michael Gray, CPA's Option Alert.

Second estimated tax payment due June 15

If you have exercised employee stock options or sold stock received during the first five months of 2005, consider seeing a tax consultant about your estimated tax situation. The federal income tax withholding when non-qualified options are exercised is 25% of the ordinary income, unless the income reported exceeds $1 million.

Since the maximum federal tax rate on ordinary income is 35%, many taxpayers are shocked to find they owe additional income taxes on April 15.

Another consideration is whether state income taxes should be paid in to "match" the deduction with the ordinary income for alternative minimum tax planning.

If we can be of service to you in reviewing your estimated tax or withholding situation, please call Dawn Siemer at 408-918-3162 for an appointment.

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Transportation Bill Includes Option Provisions

Senator Charles Grassley, who is the chairman of the Senate Finance Committee, has submitted tax legislation to be included in the Safe, Accountable, Flexible, Efficient Transportation Equity Bill of 2005 (SAFETEA) (HR3). The purpose of the tax changes is to raise revenue for transportation spending.

One of the proposed changes is to eliminate a loophole where an employee surrenders his or her stock options in exchange for deferred compensation. The proposed legislation would require the value of the option be included in the employee's gross income for the taxable year of the exchange. The change would be effective on the date of enactment.

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Options Expensing Deadline Extended

The SEC has delayed the date by which FASB Standard No. 123, Share Based Payment, must be implemented in financial statements for listed companies.

The FASB rule requiring an expense be reported for options granted to employees was scheduled to be in effect for large firms in the first quarter starting after June 15, 2005 and for small firms in the first quarter starting after December 15, 2005. The SEC is allowing companies to implement the new rule at the beginning of their next fiscal year after June 15, 2005, instead of the first fiscal quarter after that date. This will give calendar-year corporations an additional six months to implement the new rule.

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Cisco Offers Options Valuation Alternative

Cisco Systems has developed an alternative method to determine the value of option grants to employees.

The management of Cisco believes that the mathematical models that have been prescribed by the FASB to value options result in too high a value being determined. As an alternative, the company is designing a derivative option investment for company shares to be used by institutional investors on Wall Street. The investment would closely simulate the characteristics of options granted to employees. Cisco believes these investments can be used to determine a value for employee stock options based on actual market trades instead of mathematical formulas.

Cisco has submitted this proposal to the SEC for approval as a method of determining the fair market value of employee stock options for financial reporting as an alternative to the methods proposed by the FASB.

Only large companies with publicly traded stock will have the right environment and resources for using this method of valuation.

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Questions and Answers

Question

I have some non-qualified stock options. When I exercise them, I understand that the gain is taxable as ordinary income. I have some long-term capital losses I'm trying to use. Is there any way to offset the stock option gain with my capital loss carryover?

Answer

Capital losses can only be applied to capital gains plus $3,000. Since the income from the exercise of non-qualified stock options is taxed as additional wages and assuming you have no other capital gains, the $3,000 limit applies and any excess loss is carried over.

Question

Tell the truth of the AMT impact on dividends and long-term capital gains. The federal AMT tax rate is effectively 22% above $175,000 AMT income due to the phase out of the $58,000 exemption for married persons, $40,250 for singles and $29,000 for married, filing separately.

Answer

It's true the phase out of the AMT exemption can result in a higher effective marginal tax rate (the tax for each additional $1 of long-term capital gains or qualified dividends.) The exemption is reduced by 25¢ for each $1 over $150,000 for married individuals filing a joint return, $112,500 for singles and $75,000 for married persons filing separate returns. The phase out is completed at $382,000 for married joint, $273,500 for singles and $191,000 for married, separate.

Question

What happens to vested stock options that are "under water" if the company is bought by a public company?

For example, company A granted options to purchase 1,000 shares @ $20 which are vested. The trading price for the stock is $17. If company B buys company A and the company B stock price is $25, what will happen with the employee stock options of company A?

Answer

It depends.

If company B simply buys out company A or buys out the assets of company A, the options may simply disappear.

If the transaction is structured as a reorganization, a ratio may be determined to convert the employee stock options to options for company B shares.

If you are in this situation, your company should tell you how you will be affected.

Question

I was at a company that went public last October. Before going public, we employees were given the opportunity to exercise our options early. I exercised all of my options, filled out an 83(b) election and mailed it to the IRS.

I left the company this year, and they repurchased the unvested shares.

I just prepared my income tax returns and neglected to indicate that I exercised the options early and that some of the shares have since vested. Was I supposed to indicate this on my income tax return? If so, where was I supposed to indicate this and how can I rectify the situation?

Answer

I am assuming your options were non-qualified options. The 83(b) election is only effective for AMT reporting for ISOs.

Any ordinary income should have been included in your wages on your W-2 form and reported on your income tax return for the year of exercise.

There is no box to check or form to report exercising the option. You should have attached a copy of the 83(b) election to your income tax return and provided an executed copy to your employer. Otherwise, you notified the IRS about the transaction when you filed the 83(b) election.

I suggest that you file a Form 1040X with a copy of the 83(b) election attached "for information."

Once you have filed a Section 83(b) election for exercising an non-qualified option, vesting has no tax effect.

Question

I am about to be forced to exercise NQSOs with immediate sale of the stock in a cashless transaction due to a company sale. The ordinary income will be substantial. If I sell the option rights (the option) back to the company or a majority shareholder of my company just prior to the company sale, will I be able to report a long-term capital gain? I have had the options for more than one year. Also, will this avoid the AMT?

Answer

Non-qualified stock options are not capital assets. Since they are "loaded" with ordinary income, ordinary income is reported when you (the employee, service provider, transferee spouse or beneficiary) sell them. There is no adjustment for AMT for the exercise of a non-qualified option like for ISOs, because the same income is reported for regular tax and AMT.

Question

I have been granted non-qualified stock options. Here are the facts:

Grant date: March 1, 2000

Exercise date: December 14, 2003

Market price at exercise: $49.90

Option price: $21.28

Number of shares: 400

My Form W-2 includes income from exercising the option in column 1. This income was reported as wages on Form 1040. I was sent a 1099 form from my brokerage company for the sale of the stock. Should I report the sale on Schedule D? What will be the sale and cost price on Schedule D? I know that it is a long-term gain. Should I eliminate the income from wages and report a long-term gain, which will result in a lower tax?

Answer

I don't think you've read much of the material on my web site. Maybe you should pay to get some professional help preparing your income tax return.

I'm assuming you sold the stock when you exercised the option. You should not change the income reported as wages. The sale price for the stock is the amount from the 1099B form that you received. The tax basis for the stock is the market price at exercise, $49.90 per share. This is not a long-term transaction. The acquisition date for the stock is the date of exercise of the option (assuming it was fully vested, which is reasonable with a same-day sale.)

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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.