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By Michael Gray

Table of Contents

• Reminder--second estimated tax payment due June 15
• California changes estimated tax rules for AMT
• Sorry for any inconvenience…
• Be careful with "off the shelf" tax return preparation software
• IRS clarifies settlement initiative
• Questions and answers.
  • Are same-day sales wash sales?
  • Have the tax laws changed since your FAQs were written?
  • What is the definition for retirement for ISO exercises?
  • What part of the FICA do I need to pay?
  • Should I donate stock from ISO or ESOP exercises?
  • What are the tax consequences of a company giving stock?
  • Do I need to sign a lock-up agreement for an IPO?
• Do you know about our other newsletter?
• Consult with a tax advisor.

Second reminder--second estimated tax payment is due June 15

For those of you who make estimated tax payments, remember the second installment is due June 15. If you have had any changes in your tax situation compared to last year, or your estimated tax or withholding isn't based on last year's tax, you should get in touch with your tax advisor. Our clients can call Thi Nguyen at 408-918-3163 to tell us about their changes.

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California changes estimated tax rules for AMT

Effective January 1, 2005, California requires that estimated tax payments include the alternative minimum tax (AMT). California didn't update its estimated tax forms and instructions to show this. Also, some tax preparation software wasn't updated to include the 2004 AMT when basing estimated tax on last year's tax. Be sure to check your 2005 California estimated tax vouchers to be sure the AMT has been included. (AB 967.)

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Sorry for any inconvenience...

Dawn Gray, who manages our email and web site, has been "drafted" to be on the Santa Clara County Grand Jury for three months. For a small firm like ours, this is a major inconvenience and means we will be less responsive to email. For a faster response, fax your request to 408-998-2766 or call 408-918-3161. Thanks!

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Be careful with "off the shelf" tax return preparation software

One of our new clients brought us a preliminary income tax return he used to prepare his 2004 extension requests. He used "off the shelf" tax return preparation software to prepare the returns.

There were some significant errors. For example, the capital gains on his preliminary income tax returns were about $163,000; we computed about $15,700. The wages on his preliminary income tax return were about $1,110,000; it should have been about $980,000. He had paid about $56,000 in state income taxes, but the state income tax deduction on federal Schedule A was over $400,000. A $54,000 extension payment was erroneously entered on the California income tax return. The withholding for sales of securities that was included on his W-2 form was evidently entered again from the sale of securities confirmations, resulting in a $67,000 overstatement of federal withholding.

Needless to say, he substantially underpaid the tax with his extension requests and could be penalized for late filing.

We are not "blaming" the software. Users need to be aware they can't rely on the "interview mode" to automatically generate correct income tax returns. You have to "sanity check" the output.

In this particular case, we think it was well worth the fee to have us prepare his income tax returns.

Another client tried preparing his own income tax returns using off the shelf software. He did a pretty good job. He computed a $40,000 reduction of his federal AMT credit carryover to 2005; we computed about a $2,000 reduction.

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IRS clarifies settlement initiative

The IRS has issued additional guidance for taxpayers who are filing amended returns for transfers of compensatory stock options or restricted stock to a related person. In the guidance, the IRS explains how to compute the accuracy-related penalty (IRC Section 6662) and the penalty for underpayment of estimated tax for these transactions. (Announcement 2005-39.)

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Questions and Answers

Question

I exercised stock options through a brokerage account. The shares were bought and sold on the same day. Were these wash sales?

Answer

To be a wash sale, shares are sold at a loss and identical shares are purchased during the period starting 30 days before the sale and ending 30 days after the sale. The loss is disallowed and a basis adjustment is made for the replacement shares. There are more serious consequences for incentive stock options that I won't explain here.

If you can keep other transactions outside of the wash sale "window" most same-day sales shouldn't be wash sales.

Question

Have the tax laws changed since your FAQs on non-qualified stock options were answered? Is the excess of the fair market value of the stock over the option price still taxed as additional wages when the options are exercised?

Answer

The basic rules are unchanged. Some of the details, including the tax rates, might have changed and more clarifying information has come out over time.

Question

I hold vested ISOs. The option plan states that the option expires 3 months after termination if I leave the company. In addition, the option does not expire for 3 years if I retire from the company. The rules for retirement are not spelled out in the plan.

If I leave the company, are there rules that determine whether the departure is a "retirement" as opposed to simply a termination. I am 47 years old, so I am not at classical retirement age.

Answer

There is nothing in the tax laws relating to employee stock options relating to retirement.

Your company's definition of retirement should be spelled out in its personnel manual and, possibly, its retirement plan.

Please be aware that, three months after your retirement, your incentive stock options will be converted to non-qualified stock options.

Question

When I exercise an NQSO as a retired person, will I pay only the employee part of the FICA tax?

Answer

Yes.

Question

We exercised ISOs in June, 2004 by swapping shares obtained through an ESOP and held for the required period. Now we would like to donate some of the stock to a qualified charity. Rather than donate the ESOP shares, it seems smarter to donate the ISO shares once we pass the required holding period in June, 2005. Then we will hold ESOP shares with a high basis (resulting in a lower tax when we sell them) and receive a tax deduction at fair market value for low basis ISO shares. Have I missed anything?

Answer

If you paid an AMT relating to the exercise of the ISOs, you won't be able to recover the AMT credit if you donate or otherwise give away the ISO shares. Also, company shares distributed from an ESOP typically have a low carryover basis, which is the amount the ESOP paid for the shares.

Question

I have a client who has an S corporation. He owns 100% of the shares. He has an agreement with the shop manager that, after one year of service, the manager would own 80% of the corporation.

For example, the owner owns 1000 shares and he agrees to give 800 shares to the manager. Is this a taxable transaction? Also, what are the tax consequences if the manager gives back 700 shares in five years?

Answer

The transfer to the manager by your client is treated as a contribution of stock to the corporation and a stock grant by the corporation to the manager. The manager will have taxable W-2 income based on the fair market value of the stock, subject to income tax withholding and employment taxes like a cash bonus.

I'm not sure what the consequence will be for the transfer by the manager to your client in five years. It depends on the motivation for the transaction. This is a very unusual arrangement for which I recommend your client and the manager should get legal and tax counsel.

Question

I have exercised all of my stock options from my previous employer, which is planning to go public soon. The underwriters are requiring all of the company's equity holders to sign a lock up agreement lasting 180 days after the closing of the IPO. Since I am no longer an employee, why should I sign the lock up agreement?

Answer

If your refusal to sign the lock up agreement results in the company not being able to make its public offering, you won't have a market to sell your stock. If you aren't willing to wait the 180-day period, ask if the company is willing to negotiate to redeem your shares or if another employee is willing to make a private purchase of the shares.

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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.