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By Michael Gray

Table of Contents

• Have you made arrangements to have your tax returns prepared?
• Questions and answers
  • What happens if swapped shares are swapped for more stock?
  • Where can I get the number of stock options I have?
  • What are the pros, cons and alternatives to NQSOs?
  • What if the stock price is lower than my option price?
  • Are the details of company buy-outs public information?
  • After exercising NQSOs, will I owe money next April 15th?
  • How are ESPPs taxed?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

It's tax season! Have you made arrangements to have your tax returns prepared yet?

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Questions and Answers

Question

I've used stock swaps for exercises for the past few years. The company has a stock replacement program for stocks used for the swap.

I've read your articles pertaining to the basis for regular tax calculation, and understand that the basis of the tendered shares carries over to an equivalent number of new shares, with a zero basis for the incremental shares.

What happens to the basis if these shares are used for another swap?

Answer

The shares shouldn't be used for another swap until the holding period requirements are met.

Assuming that is the case, the regular tax basis will be zero for all of the shares. (The basis for the exchanged shares was zero and continues to be zero for an equivalent number of shares after the exchange. The basis for the additional shares received is also zero.)

For AMT reporting, the tax basis of the shares is based on the fair market value on the exercise dates. This is consistent with the rules for non-qualified stock options for regular tax reporting. For example, assume 10 additional shares were received when the fair market value of the shares was $10 each. These shares are then exchanged (with no additional cash investment) to exercise an ISO for 100 shares when the fair market value of the shares is $100 each. The AMT tax basis for 10 shares is $10 each and for 90 shares is $100 each.

Question

After our marriage, my ex-husband started to work at eBay. He was granted an NQO for 2,000 shares. The stock split, leaving an option for 4,000 shares. After the split, he sold 1,500 shares.

He should have options for 2,500 shares left, but his attorney is calculating the available shares to be 4,000 - 3,000 = 1,000 shares.

Shouldn't the total number of shares be based on the sale transaction and not doubled?

Answer

It sounds like you and your husband's attorney disagree about the facts of what happened. If the options weren't exercised, eBay should know how many are left. That would be an easy way to confirm the balance.

If the options were exercised, your ex-husband should be able to show with his brokerage statements what the sequence of transactions was.

Question

I live and work in California providing technical recruiting services for a California-based, pre-IPO company. I want to explore receiving part of my compensation as NQSOs instead of cash. I am an independent contractor, paid on an hourly basis. Can you explain the pros and cons, and what other alternatives I might have?

Answer

The advantage of receiving an option is you have no out-of-pocket risk until you exercise the option.

The disadvantage is you have little control over whether you will benefit from the arrangement. The company might never go public, and you might never be able to sell the shares.

With changes in the tax laws and financial reporting rules, issuing employee stock options is becoming more and more expensive, making them less attractive for start up companies.

I am favoring outright stock grants and stock sales to employees by start up companies over options in the current environment. Completed transfers reduce the uncertainty of the results of the transaction and the requirement for ongoing accounting recalculations. The employee has to be willing to accept more risk, but the income and cash exposure aren't too great.

Question

My husband works for Verizon. He has NSOs for 400 shares at $54 and 213 shares at $44. The price today for Verizon shares is $31 per share. Can he cash his options in at $31?

Answer

The description commonly used for your husband's options is "underwater". He can buy shares on the stock market for less than the option price. In this situation, the options will only become valuable if the market price of the stock increases to be more than the option price.

If you and your husband want to buy Verizon shares at $31 per share, simply place an order with your stock broker.

Question

I left a privately-held corporation where I had almost 5,000 vested options that expired 3 months after the end of my employment. Almost exactly 3 months after I left, the company announced that it was being purchased by a larger company of about $1 per share more than my option price. Employees with vested options were bought out at a price about $2 higher than my option price.

I have asked three times what the date of the sale was, and received no response. If the sale was before my expiration date, I'm guessing I would be entitled to the price of my options at that time.

Is the date of sale supposed to be public information? Where can I find it? If the sale was before my expiration date, do I have a legal basis for a claim, and would it be worth the cost?

Answer

First, I don't have enough information to answer your question about whether it would be worth the cost of filing a lawsuit, because I don't know how much you might be entitled to.

Private companies aren't subject to many public information requirements. You might try hiring a private investigator to find out the date of sale.

This is a legal matter that I'm not qualified to respond to, so I suggest that you consult with an attorney who understands stock options.

Question

I am exercising some non-qualified stock options with a strike price of 50¢ per share and a current fair market value of 70¢ per share. I will have income tax withholding for income of 20¢ per share.

Will I be liable for any additional tax between the exercise date and date of sale?

Will I be liable for more tax based on the value at the end of the year, even if I haven't sold the shares?

Answer

I am assuming your options were priced at the fair market value on the grant date, and so aren't subject to the new non-qualified deferred compensation rules. I'm also assuming the shares were fully vested or you made a Section 83(b) election for any unvested shares.

Sometimes an additional tax is due on April 15 after the year of exercise because the tax withholding rate (25%) is less than the actual tax on the income (up to 35%).

There shouldn't be any additional taxable income relating to the shares received until they are sold.

Question

Suppose I enroll in an ESPP. I purchase shares at $8.50 per share (85% of the lesser of the market price on the subscription date or the exercise date). The fair market value on the exercise date was $25.

I sell the shares within a year for $18 per share. Do I report ordinary income of $25 - $8.50 = $16.50 per share, and a capital loss of $18 - $25 = ($7) per share?

I would like to quickly sell ESPP shares for a $15 turnaround profit, but have older shares that must be sold first.

How does the situation change after I hold the shares after meeting the holding period requirements (more than two years after grant, more than one year after exercise)?

Answer

We have a report on our web site that explains this situation at stockoptionadvisors.com/espps-isos.shtml.

You are correct about the consequences when you sell ESPP shares before meeting the holding period requirements. There is no "escape hatch" in that situation like for ISOs.

There is an exception to the ordering rules for securities sales, called specific identification. It seems to me that if you make a simultaneous exercise and sale, the transaction should qualify because your intent is clear. It's even better to state your intention in writing when you are giving instructions for the transaction.

When you meet the holding period requirements for ESPP shares, you report ordinary income for the 15% discount based on the grant/subscription date value. The ordinary income is limited to the excess of the selling price over the option price. The fair market value on the exercise date is no longer a concern. Using your figures, the ordinary income would be $10 ($8.50/85%) - $8.50 = $1.50 per share. The long-term capital gain would be $18 - ($8.50 + $1.50) = $8 per share.

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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 newsletters?

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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