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By Michael Gray

Table of Contents

• IRS says "Lock-out" not a substantial risk of forfeiture
• Tax Court also finds "lock out" doesn't postpone income
• August 15 individual extended deadline is approaching
• September 15 estimated tax payment due soon
• Questions and answers.
  • Should I sell stock options this year or next year?
  • Can I report stock option gains on Schedule D?
  • Can I qualify stock options as long-term capital gains?
  • Can I swap IRA shares for ISOs?
  • If I same-day sell, how much will I have to pay in taxes?
  • Is option income subject to California tax even if I move?
• Do you know about our other newsletter?
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

IRS says "Lock-out" not a substantial risk of forfeiture

In Revenue Ruling 2005-48, the IRS said that a temporary "lock out" restriction under Rule 10b-5 of the Securities Exchange Act of 1934 is a "lapse restriction" that is disregarded in valuing the stock received when exercising a non-qualified stock option, and does not postpone recognition of taxable income, because the stock doesn't meet the conditions as both subject to a "substantial risk of forfeiture" and "nontransferable". The only trading restriction imposed by the securities recognized as meeting the requirements to postpone recognition of income is the rule prohibiting trading by certain corporate "insiders" for the period six months after the grant of an employee stock option under Rule 16(b). Therefore, income is reported on the date of exercise when Rule 10b-5 applies.

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Tax Court also finds "lock out" doesn't postpone income

The Tax Court granted a partial summary judgment in favor of the IRS in Robert J. Merlo v. Commissioner, ruling that a "lock out" agreement did not qualify as a substantial risk of forfeiture.

Merlo incurred a big AMT liability when he exercised an ISO for Exodus Communications, Inc. stock on December 21, 2000. Exodus filed for bankruptcy on September 26, 2001, and on November 21, 2001, Exodus announced the company's common stock had no value. Merlo left employment at Exodus on December 31, 2000. Merlo claimed the shares were subject to a substantial risk of forfeiture under a company "lock out" agreement. The Tax Court found the "lock out" agreement did not qualify as a substantial risk of forfeiture because Merlo was not subject to SEC Rule 16(b) and the agreement did not require surrendering shares sold during the lock out period to the company for the option price. (The right of first refusal restriction was upheld as a subtantial risk of forfeiture in Robinson v. Commissioner, a 1986 First Circuit Federal Court of Appeals case.)

Merlo had a second issue for which the court did not enter a summary judgment, because it didn't have enough information. That was whether Merlo could claim a net operating loss carryback on his alternative minimum tax schedule.

The Merlo case and the above Revenue ruling are helpful because they establish precedents that tax advisors can rely on. In the past, most of the guidance issued by the IRS has been in the form of private letter rulings, which aren't authoritative precedents.

There may be fewer aggressive tax cases in the employee option area because the IRS issued IRS Notice 2004-28, warning that penalties may be asserted against taxpayers and tax return preparers for "frivolous claims" - aggressive positions - for employee stock option transactions. The IRS issued the notice to prevent a flood of refund claims for employees who suffered losses relating to stock received when they exercised employee stock options in the 2000 - 2001 stock market decline. It takes some chutzpah to move ahead with one of these cases.

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August 15 individual extended deadline is approaching

August 15 is the initial extended deadline for individual income tax returns. If you're tax return isn't completed by that date, apply for a second extension to October 15 using Form 2688. Remember to include a reason for the additional extension.

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September 15 estimated tax payment due soon

The due date for the third estimated tax payment for calendar- year taxpayers (including individuals) is September 15. If your income and deductions are much different from last year's, you should have your estimated tax payment amount reviewed by your tax return preparer.

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Questions and Answers

Question

I exercised some ISOs and NQSOs (all vested) in January, 2005. What would be the differences in both if I sold them by December, 2005 versus February, 2006?

Answer

Short question, long answer. See our reports about executive tax planning for incentive stock options and non-qualified stock options.

To obtain more specific advice, schedule a consultation at 408- 918-3161.

Question

I exercised some ISOs and sold the shares on the day of exercise. The gain from the sale was reported on my W-2 form. I had thought based on advice from my accountant that I was going to report the income on Schedule D. I had a large capital loss carryover from the previous year to apply to the gain. Is there any hope that I can report the gain on Schedule D?

Answer

No.

Question

Our company will probably be sold before the end of this year. I had planned to realize capital gains when I exercised my stock options and later sold the stock. Now it looks like I will have ordinary income from cashing out the options relating to the buyout.

Some members of our board believe that, since the U.S. government wants to encourage the investment of capital, earnings from stock options can be reinvested and later qualify to be reported as long-term capital gains.

Are you aware of such an investment program?

Answer

Your board of directors appears to be fantasizing about how they wish the tax laws work according to the laws of logic. We are in a different world.

There are some diversification investment programs requiring transferring the stock received from exercising stock options, usually into a partnership. These are not available when your options are "cashed out".

The rules resulting in regular taxable income when an NQO is exercised or in AMT income when an ISO is exercised aren't defeated by these investment programs.

Question

I have a client who would like to swap IRA shares for his ISO swap. Is this possible?

Answer

No. An ISO is personal to the employee. Technically, the IRA is a separate taxpayer from its "owner".

Question

I have been granted ISOs at 3 different consecutive annual intervals. Since the stock never did much until this year, I just let the options sit unexercised. Now I have a big chunk of vested, unexercised ISOs. Now the price of the stock has increased dramatically. If I exercise now and hold the shares, the risk of the stock price dropping below the current level is high.

Now I think I would be better off just selling the shares immediately after the exercise. Should I assume at least a 50% tax burden? I'm in the highest marginal tax bracket now.

Answer

The maximum federal tax rate is 35%. Add the maximum tax rate for your state. (For California it's 9.3%, 10.3% for taxable income over $1 million.)

There is no AMT adjustment when ISO shares are sold in the year of exercise, provided there is no "wash sale" (purchase of similar securities within 30 days before or after the sale).

Question

I used to work for a company in San Diego, California and I received stock options from them. I resigned from that company and moved to Washington state, where I now live and work.

I have to exercise the options now. Since I am not a resident of California anymore, is the income from the exercise of the options subject to California tax?

Answer

Yes. Since all of the services for which the options were issued were performed in California, all of the income is taxable in California. See FTB Publication 1004. (You can get a copy at 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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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.

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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.