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Table of Contents

• Time to review withholding and estimated tax payments
• Relief for non-qualified deferred compensation rules
• IRS studies supplemental wage withholding
• IRS to look more carefully at executive compensation
• Questions and answers
  • How many of my CEO's options can be ISOs?
  • Are private company stock options exercisable?
  • Will I be taxed on ISOs I exercise if I don't sell them?
  • What is the difference between exercising now and later?
  • How do I send my 83(b) election to the IRS when e-filing?
  • Can we deduct our loss on options in a bankrupt company?
  • Why was Medicare deducted from my ISO exercise?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor

Time to review withholding and estimated tax payments

Remember to review your withholding and estimated tax situation for 2006.

There is no estimated tax penalty provided the taxpayer pays at least 90% of the tax (including AMT) on the current year's tax return through withholding and/or equal quarterly estimated tax payments.

For taxpayers who have no more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding. For taxpayers who have more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year's income tax return, there is no penalty for underpayment of estimated tax provided at least, for 2006, 110% of the income tax on the previous year's income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.

Taxpayers who have uneven income and deductions may also compute their estimated tax on an "annualized" basis. You multiply the year to date income and deductions to arrive at amounts for a year, compute the tax for that amount, then pay amounts to cumulatively pay in 1/4, 1/2, 3/4 and 100% of those amounts. You should probably get help from a professional tax return preparer to do this.

In addition to estimated tax payments, review your withholding level. Adjusting withholding has the advantage that, when computing the penalty for underpayment of estimated tax, withholding is assumed to have been paid in evenly throughout the year. This makes withholding the best place to catch up on underpayments early in the year.

If we can be of service in helping with your estimated tax and withholding, please call Michael Gray at 408-918-3161.

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IRS announces transitional relief for new non-qualified deferred compensation rules

The IRS doesn't expect to issue final regulations for the new deferred compensation rules (Section 409A) until at least July, 2006.

Meanwhile, the IRS has announced additional transitional relief for corrections to deferred compensation plans relating to assets located offshore and when assets become restricted upon a change in the employer's financial health. Under the transitional rules, these provisions may be modified by plans up to December 31, 2007.

The extension only applies to "grace period assets" which have a March 21, 2006 cut-off date. Transfers to off-shore trusts after that date won't qualify for the relief.

Companies and their tax advisors that have non-qualified deferred compensation plans should study these transitional rules.

(Notice 2006-33.)

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IRS studies supplemental wage withholding

Marie Cashman from the IRS Office of Chief Counsel made a presentation at the Second Annual American Payroll Association about supplemental wage withholding.

The IRS is working on final regulations implementing changes in the American Jobs Creation Act of 2004. The final regulations are expected to be issued by June 30, 2006. Under those changes, supplemental wages over $1 million are subject to a flat 35% withholding rate. Supplemental wages up to $1 million are subject to a flat 25% withholding rate.

Members of the Association are asking for time to modify their software to comply with the new rules.

Ms. Cashman pointed out that, when the flat withholding rates are used, there is no modification for the employee's personal circumstances, such as making alimony payments deductible on the personal income tax return. In addition, if the employee doesn't have regular wages (my example -- such as when an employee exercises a non-qualified stock option after leaving the employer), amounts that would normally be treated as supplemental wages are treated as regular wages. (See proposed amendments to supplemental regulations §31.3402(g)-1(a)(ii).)

Some commenters have asked for some transitional relief until 2007, after the final regulations are issued, but the statutory effective date for the new rules is January 1, 2005.

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IRS to look more carefully at executive compensation

According to Walter L. Harris from the IRS Large and Mid-Sized Business Division, IRS agents will be looking more carefully at executive compensation packages. Mr. Harris made the announcement at the Second Annual American Payroll Association's 2006 Capitol Summit on March 24 in Washington, D.C. The procedures will be specified in the new Corporate Executive Compliance Strategy.

Issues were discovered during the Compliance Initiative Project.

As a result, tax returns of the executives will be reviewed to assure they are reporting income items from companies under examination. Agents will determine that the executive filed an income tax return and that income from the corporation was properly reported.

One of the focus areas is employee stock options and phantom stock.

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Questions and Answers

Question

I have a question regarding an ISO limitation.

My CEO got two huge grants - one last year and one the previous year, and we don't understand which portion is an ISO and how much is an NQ stock option.

Answer

I recommend that you consult with your company's CPA firm about this.

The maximum grant for an ISO is for $100,000 to be exercisable during a calendar year, based on the fair market values on the grant dates (usually the same as the option price). This means you have to schedule when the shares will vest.

Since an option grant can vest over many years, a "large" grant can still qualify as an ISO.

The options also have to be designated as incentive stock options in the option agreement.

If an employee stock option is not an ISO or under an employee stock purchase plan, it's a non-qualified stock option.

Question

I have stock options from a private company. Are these exercisable?

Answer

Such options shouldn't have been granted unless they are exercisable. A bigger issue is, "Can you sell the shares?" There are usually severe limitations for selling private company stock. That's one reason you have to be very careful when exercising options in a private company. You can be required to pay a tax without having the cash to pay it.

Question

I left a company in California two months ago and returned to New Jersey to work for another company. I am considering exercising vested incentive stock options from the previous company. Will I be taxed on the exercise even if I don't sell the shares that year? The company will be going public in a few months.

Answer

The excess of the fair market value of the stock over the option price on the date of exercise will be taxable on the alternative minimum tax schedules on your federal and California income tax returns. (That's right! It's AMT taxable income in California!)

That doesn't mean you shouldn't go ahead, but someone should be helping develop the cash you will need and advising you about whether it makes sense. You don't have much time because you must have been an employee of the company within three months before the date of exercise. Some options lapse sooner after separation from service.

This is a service that we offer.

Question

I need clarification on these facts:

Non-qualified Option for 1,000 shares @ $20
Current fair market value $35
Expected price in 2007 $50

If I make a same day sale in 2007, my ordinary income would be ($50-$20)x1,000 = $30,000. If I exercise the options today and keep them for more than one year, I would report ($35-$20)x1,0000 = $15,000 ordinary income for the current year and ($50- $35)x1,000 = $15,000 long-term capital gains next year.

Is this right?

Answer

Yes.

Question

I filed a Section 83(b) election for restricted stock that I received during 2005. I have filed my 2005 income tax return electronically. Should I send a hard copy of the original 83(b) election, identified by the DCN number, to the IRS?

Answer

I suggest that you send the election with an "informational" Form 1040X to be associated with your file. I don't think it's a good idea to electronically file income tax returns when elections like this one are required. The IRS is supposed to be upgrading the electronic filing system to enable attachments of PDF files that will eliminate this problem.

Question

My husband has Delta Air Lines employee stock options which were given to him as an employee. The company is now bankrupt. Can we claim a deductible loss for these options on our income tax returns?

Answer

No. Since there is no taxable income when the options are granted, you have no tax basis (investment) in the options to deduct.

Question

On the exercise of ISOs that resulted in W-2 income of $150,000, the Medicare income was over $1 million and Medicare tax was paid on that amount. Why is that?

Answer

Because someone made a mistake. There is no Medicare income from the exercise of an ISO. Go tell your payroll department to fix it, issue a corrected W-2 and refund the excess Medicare tax.

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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.

We are starting a newsletter devoted to real estate tax issues - Michael Gray, CPA's Real Estate Tax Letter. Like this newsletter, we will talk about new developments, have reports on special tax concerns, and answer questions and answers. The subscription rate is $19.95 per month. For a sample issue, visit realestatetaxletter.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.

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