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By Michael Gray

Table of Contents

• New non-qualified deferred compensation rules create headaches
• Review your estimated tax and withholding status
• Should you prepay your state income tax?
• Should you use the "escape hatch" for your ISO shares?
• It's time for year-end planning
• Questions and answers
  • Is withholding required for non-employees with stock options?
  • Do you know any ISO tax advisors elsewhere?
  • Should I be compensated for lost options?
  • Is it better to exercise options or purchase stock at the same price?
  • Must employees be informed about changes in option status?
• Do you know about our other newsletter?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

New non-qualified deferred compensation rules create headaches for non-qualified stock options

The tax laws for non-qualified deferred compensation plans were radically changed by the American Jobs Creation Act of 2004, enacted on October 22, 2004. The IRS has issued preliminary guidance for the new rules in Notice 2005-1 and more comprehensive guidance in proposed regulations for Internal Revenue Code Section 409A (REG-158080-04.)

Under the new rules, non-qualified stock options (NQOs) issued with an option price below the fair market value of the stock on the date of grant (in the money) are deemed to be deferred compensation arrangements. The same concept applies to stock appreciation rights (SARs), which are beyond the scope of this discussion. Since most NQOs don't meet the requirements for non- qualified deferred compensation plans, NQOs that were "in the money" at grant will no longer qualify for tax deferral, resulting in income being taxable each year for the excess of the fair market value of the stock at the end of a taxable year in excess of the option price plus any previously taxed income (even though the option wasn't exercised). When the option is exercised, the taxable income will be the fair market value on the exercise date in excess of the option price plus any previously taxed income. The amount of taxable income each year under the deferred compensation rules is subject to an additional 20% penalty tax.

For example, assume a fully-vested non-qualified stock option was granted on February 1, 2005 to purchase 1,000 shares at $20 per share, and the fair market value of the shares on that date was $25 per share. Since the fair market value ($25) was more than the option price ($20), the options were "in the money" and the NQO is deemed to be a deferred compensation arrangement. Here are the amounts of taxable income and penalties for the following years and assumptions. (This is how we think the rules will work. The IRS hasn't issued a precise explanation yet.)

12/31/2005 - assumed fair market value per share is $30.
Taxable income is $30 - $20 = $10 X 1,000 shares = $10,000
Penalty tax = $10,000 X 20% = $2,000

12/31/2006 - assumed fair market value per share is $20
Since the fair market value is below the option price plus previously taxed income ($10 + $20 = $30 per share), there is no taxable income

12/31/2007 - assume option is exercised and fair market value is $35
Taxable income is $35 - $30 = $5 X 1,000 shares = $5,000
Penalty tax = $5,000 X 20% = $1,000

NQOs that were issued and vested before January 1, 2005 are grandfathered and not subject to the penalty tax. Under transitional rules, employers may "fix" old NQOs by December 31, 2006 so that employees can avoid the penalty tax. If employees exercise a NQO priced below fair market value on the date of grant that vests after December 31, 2004 before the employer "fixes" the option agreement to comply with the new rules, the penalty tax may apply.

NQOs issued by publicly-traded companies usually were issued at fair market value. The fair market value for non-public companies (like Google before its IPO) is harder to determine, so those plans might require modification.

See your plan administrator to find out whether it's safe to exercise your NQOs that vested after 2004 and whether your plan is being amended to comply with the new rules.

Generally, non-public companies will need to have an appraisal done within 12 months before a NQO is issued to determine the fair market value of the stock. Alternatively, a non-public company can use a valuation formula that would qualify for a non- lapse restriction that would be considered to be the fair market value of the stock under Treasury Regulations § 1.83-5 and the value is used for regulatory filings, repurchases from persons other than service providers and other requirements. (Consider getting a ruling for the formula.) Start-up corporations with illiquid stock may make a good-faith valuation of their stock with a written report substantiating how required factors were taken in consideration. (With the liability considerations involved, we're back to getting an appraisal.)

Incentive stock options and employee stock purchase plans are exempt from the new rules for non-qualified deferred compensation plans.

The proposed deferred compensation regulations are another nail in the coffin for non-qualified stock options for non-public companies.

Clearly, more relief is needed to avoid having employees "stub their toes" by exercising an option that was granted before 2005, "in the money" when granted, and not vested before 2005.

Companies, especially non-public companies, should have their stock option, stock appreciation rights and non-qualified deferred compensation plans reviewed immediately and suggest that employees who might have received "in the money" options postpone exercising them until the plans are cleaned up.

Employees should proceed with caution - get tax advice.

Everyone should write to their representatives in Congress to suggest that non-qualified stock options of non-public companies (when granted) should be excluded from the penalty tax for non- qualified deferred compensation plans. The requirements for valuation are make issuing NQOs too expensive for small companies, and so are discriminatory. Alternatively, a safe- harbor valuation formula for non-publicly traded stock should be included in the regulations that is practical and doesn't require exotic economic modeling. Tax practitioners should send comments to the IRS by January 3, 2006. The address for submissions is: CC:PA:LPD:PR (REG-158080-04), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. A public hearing is scheduled on January 25, 2006.

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Review your estimated tax and withholding status

Remember to review your estimated and withholding status for 2005. For ISOs and ESPPs, there is no withholding when the options are exercised or when the shares are sold. There could be a tax due that results in a penalty for underpayment of estimated tax.

In addition, the federal withholding rate for most exercises of non-qualified stock options is 25%, while the maximum income tax rate is 35%. Many taxpayers are surprised to learn they have a balance due on April 15 because not enough tax was withheld to cover the tax.

There is an exception from the penalty for underpayment of estimated tax when you pay the tax (including the AMT) on last year's income tax returns. When your adjusted gross income for last year exceeded $150,000, the required minimum amount is 110% of the tax on last year's income tax returns.

Consider consulting with a tax advisor to review your estimated tax and withholding status, and to estimate the amount that will be due with your 2005 income tax returns.

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Should you prepay your state income tax?

More and more taxpayers are finding they are subject to the alternative minimum tax. State income taxes are not deductible for the alternative minimum tax, so you might not receive a federal tax benefit from prepaying the tax by the end of the year.

In order to find out the answer, the computations have to be made for your particular facts.

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Should you use the "escape hatch" for your ISO shares?
(a reminder)

Employees who exercise incentive stock options and hold the stock are sometimes unpleasantly surprised to learn they are subject to an alternative minimum tax based on an adjustment for the excess of the fair market value on the date of exercise (or later vesting date) over the option price. If the stock has dropped in value, the employee may find he or she owes a tax that exceeds the value of the stock!

There is an "escape hatch" built into the Internal Revenue Code. If the stock is sold before the end of the year of exercise and the transaction would qualify to report a loss if one was realized, ordinary income is reported for the lesser of the selling price of the stock or the fair market value on the date of exercise (or later vesting date) over the option price.

For example, Jane exercised an ISO on February 1, 2005. The stock received was fully vested. The fair market value of the stock received was $110,000 and the option price was $10,000. As of December 31, 2005, the fair market value of the stock is $10,000. If Jane held the stock after December 31, 2005, she would have an AMT adjustment for the ISO exercise of $100,000.

If Jane sold the stock for $10,000 on December 31, 2005, the ordinary income would be limited to the excess of the selling price over the option price, or zero.

The escape hatch isn't available if a loss would be disallowed for the transfer, such as a gift instead of a sale or a wash sale. The wash sale rule applies if identical stock is purchased during the period 30 days before or 30 days after the sale. It can also apply when you purchase an option to buy the stock during that period. You need to be especially careful during that period not to buy additional shares by exercising another employee stock option, including exercising another ISO or NQO, or purchasing ESPP shares.

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It's time for year-end planning

Less than one month left in the year. Considering the holidays, the times available for year-end planning consultations will be limited. Why not call for your appointment now? Michael Gray's telephone number is 408-918-3161.

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Questions and Answers

The answers to many of your questions can be found in our reports, Executive Tax Planning For Incentive Stock Options and Executive Tax Planning For Non-Qualified Stock Options, which are available at no charge at our web site, www.stockoptionadvisors.com.

Question

What taxes are required to be withheld for an individual who exercises a non-qualified stock option who is not a company employee? This individual is a member of our board of directors and is not a resident of California.

Answer

Since the individual is not an employee, his or her income is not subject to withholding taxes or employment taxes that apply to employees.

California requires 7% income tax withholding for non-employee earned compensation paid to an individual who is not a resident of California. See FTB Publication 1023 and FTB Forms 587, 590, 592, 592-A, and 592-B. The web site for the Franchise Tax Board is www.ftb.ca.gov. Shouldn't you be talking to your tax return preparer about this?

Question

Do you know any ISO tax advisors in the Orange County, CA area to refer?

Answer

We tried to assemble a directory of tax advisors (for a fee), but not enough people would sign up to make it worthwhile. Sorry. We have clients located in other parts of California and in other states. Maybe we can help?

Question

A company I was working for sold all of its manufacturing assets to another firm. A number of upper-middle managers were "offered" jobs with the new firm, but there was really no choice. If you didn't go with the new firm, you had no job. The unvested stock options of this group of managers were terminated. Under the circumstances, this hardly seems fair, and we have been told by each firm that the "other" firm should make us whole. Do we have any other recourse?

Answer

I'm sorry, but I'm not qualified to answer this question. You need a lawyer. Here are a few thoughts: There are no guarantees built into stock options. If a company terminates you, you can lose unvested options. Although I am not in your position, it seems to me you always have a choice to seek employment elsewhere. If you decide to make a stink about this situation, you might not be viewed kindly for promotions or when choices are being made for layoffs. Now, if you want to go ahead, find a lawyer who doesn't share these opinions to represent you.

Question

I have 1,000 shares of non-qualified stock options at an option price of $18 and the fair market value of the shares is also $18. I expect the stock to increase in value to $30. My advisor is telling me that it's better to exercise the options in this case rather than buying the shares on the open market. What's the difference?

Answer

If you have a choice, it's better to buy the shares on the open market and not exercise the options. The value of the options is having a right to exercise them at a constant price when the market value increases, without having to risk a cash outlay. Of course you will have ordinary income if the stock value increases. Why lose a valuable right when you can get the same benefit while keeping the right?

An exception is when you don't have a choice or you are in front of a hyper-increase. For example, Google employees were able to get most of their shares before the company went public by exercising employee stock options. If that's the only way you can get the shares and you expect a huge increase in value like that, it's best to exercise the options earlier. Just remember that Google was an exception and the value of most new issues goes down after the employee lock-out period expires.

Question

I retired about six months ago. Just yesterday, I was told that my ISOs may now be NQSOs because I no longer work for my former employer.

How can I be sure this is correct? If so, is my employer liable for the change in the taxability if they did not inform me of this within 90 days of my retirement?

I have options for about 5,000 shares and was told I had three years to exercise after I retired. I made a cash exercise of 1,200 shares during April, 2005 and had planned to sell some of those shares during 2006, after meeting the holding period requirements. Then I would use the proceeds to exercise more shares.

Answer

Again I'm sorry, but you need a lawyer to determine whether you have a cause of action against your employer. You should have received documents explaining the plan when the options were granted, including a recommendation that you seek tax counsel. I think you are fortunate, because in many cases stock options lapse a much shorter time after leaving an employer, often after 90 days after termination.

According to Internal Revenue Code Section 422(a)(2), in order for an option to qualify as an Incentive Stock Option, the holder must have been an employee during the period beginning on the grant date and ending on the day 3 months before the date of exercise. There is the "proof" that the "90-day rule" (actually three months) applies.

It's a shame you didn't consult with a tax advisor when you retired. I think you should still consider seeking advice for your future decisions.

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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.)

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P.S.

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