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Table of Contents

• Trick! The year is almost over already!
• Last chance for 2005 income tax returns for most taxpayers
• Governor Schwarzenegger approves tax legislation
• SEC chief accountant weighs in on backdating of stock options
• SEC issues disclosure guidelines for executive compensation
• Congressional Research Service updates report on stock options
• IRS Commissioner proposes information sharing with other government agencies
• Another taxpayer with ISOs loses before the Tax Court
• Questions and answers
• Is there a tax consequence for swapping ISO shares?
• When do I issue a 1099-MISC vs a W-2 for NQSO exercises?
• Is the exercise price of stock options adjusted for stock splits?
• How do I sell private company stock?
• What are the tax consequences of making option stock gifts?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Trick! The year is almost over already!

Halloween will be here soon, which also means it will soon be the holiday season! The stores are setting up their displays of decorations and gift ideas.

There are only three months left to prepare for the end of the year. What needs to be done for your tax situation? Now is the time to set up your year-end planning appointment. Call Dawn Siemer at 408-918-3162 today.

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Last chance for 2005 income tax return for non-corporate taxpayers

The extended due date for calendar year noncorporate taxpayers, including most individuals, partnerships, estates, and trusts is October 15. That is also the extended due date for making deductible employer payments to qualified retirement plans of these entities, including Keoghs, SEPs, defined benefit plans, profit sharing plans, ESOPS and 401(k) plans. The extended due date for 2005 gift tax returns is also October 15. This is a critically important due date, so please be sure your income tax returns are filed on time. In some situations, penalties can even be imposed when there is a tax overpayment. If we can be of service to you in this area, call Dawn Siemer at 408-918-3162 for an appointment.

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Governor Schwarzenegger approves tax and business legislation

Here are some of the items of 2006 legislation just approved:

• AB2341 changes and simplifies termination procedures for corporations, LLC, LPs and LLPs. The legislation should allow an entity to avoid having to file an income tax return and pay minimum franchise taxes when the entity has stopped doing business and paperwork is being processed in the Secretary of State's office. The above business entities will have one year from the filing of a timely, final tax return to file dissolution/cancellation paperwork with the Secretary of State. The requirement that corporations and LLCs get a Tax Clearance Certificate before dissolving has been eliminated.



• Effective for 2007, California registered domestic partners will file California income tax returns as married persons. This will be a major item of non-conformity with federal tax law, probably requiring that the income tax returns be processed on two sets of forms. All California registered domestic partners should have their income tax returns prepared by a professional tax return preparer for their 2007 income tax returns. (SB 1827.)



• The governor vetoed AB 1614, which would have required LLCs to apportion income to determine the LLC total income fee. The question of whether California's current fee structure is constitutional remains to be determined by higher courts of appeal.



• Beginning January 1, 2007, California will allow real estate withholding based on an estimate of the tax due from the gain. The seller will have a choice to withhold tax at the maximum California rate (9.3% for individuals and 8.84% for corporations) on the estimated gain from the sale or 3.33% of the total sales price. (Stand by for new forms to be issued by the Franchise Tax Board.) (AB2962.)

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SEC chief accountant weighs in on backdating of employee stock options

On September 19, Conrad Hewitt, chief accountant of the SEC issued a letter to Financial Executives International and the American Institute of Certified Public Accountants.

In the letter, Mr. Hewitt reiterated the position of the SEC (actually as stated by the Financial Accounting Standards Board Interpretation No. 44) that the measurement date for an employee stock option usually cannot occur before shareholder approval, except in the very limited circumstance that management and the board of directors control sufficient shareholder votes to approve the plan. The basis for this position is the principle that the terms of a stock option cannot be considered known and no longer subject to change until the persons empowered to make grants have determined, with finality, the terms and recipients of those awards.

Mr. Hewitt revisited some of the associated issues, including whether prior grants were valid and the misstatement of tax provisions, associated with erroneously reporting the dates of employee stock options.

You can find the entire letter at www.sec.gov/info/accountants/staffletters/fei_aicpa091906. htm.

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SEC issues disclosure guidelines for executive compensation

The SEC released final amendments to its rules relating to the disclosure of executive compensation during August, 2006. (SEC Release No. 34-54302.) These new disclosure rules dovetail with the disclosure guidelines issued by the Financial Accounting Standards Board in FAS 123R. The SEC has specified that the company's policies and procedures for making grants of stock options should be disclosed. Some of the dates and amounts specified in FAS 123R should be presented in tabular format.

The internal accountants for public companies should be discussing these guidelines with their outside auditors.

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Congressional Research Service updates report on Employee Stock Options

The Congressional Research Service (CRS) studies issues of concern to Congress for reference for proposed legislation.

The CRS issued an updated report on employee stock options on September 7.

The report includes updated material on the Financial Accounting Standards Board's SFAS 123R, requiring expensing employee stock options, and on the scandal about backdating stock options.

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IRS Commissioner proposes information sharing with other government agencies

IRS Commissioner Mark W. Everson testified before the Senate Finance Committee on September 6. Commissioner Everson said that Congress should consider allowing the IRS to disclose tax return information to the SEC and the Department of Justice. He said the SEC's sharing of information on backdating has helped the IRS identify potential returns to audit for the backdating issue, but the IRS currently can't share the results of its investigations.

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Another taxpayer with ISOs crashes and burns before the Tax Court

Nield Montgomery was formerly the president and CEO of MGC Communications. The stock of MGC Communications was traded on NASDAQ. He was granted MGC ISOs between April, 1996 and March, 1999.

Mr. Montgomery resigned as president of MGC during November, 1999. He made a new employment agreement with MGC, under which the vesting of his ISOs was accelerated. He then exercised many of his ISOs during 2000 and sold and made gifts of shares during 2000 and 2001.

Initially, Mr. Montgomery reported an alternative minimum tax for 2000, but failed to pay the balance due reported on his income tax return. When the IRS pursued collection, he amended the income tax return to eliminate the alternative minimum tax.

The IRS redetermined Mr. Montgomery's tax liability and found that he had unreported income because some of his ISOs were disqualified (more than $100,000 were exercisable for certain years) and he was subject to the alternative minimum tax.

Mr. Montgomery claimed he was not subject to the alternative minimum tax because the stock received on exercise of the ISOs was subject to a substantial risk of forfeiture under SEC Rule 16(b). He said that, since he issued the options to himself, an exception to the six-months from grant rule applied for discretionary transfers under an employee benefit plan. The Tax Court ruled the exception didn't apply in this case, and that, since the options were exercised more than six months after the grant date, there was no substantial risk of forfeiture, citing Tanner v. Commissioner, 117 T.C. 237, 239 (affd. 65 Fed. Appx. 508 (5th Cir. 2003). Therefore, the AMT adjustment applied for 2000.

Mr. Montgomery said that he met the $100,000 per year requirement for the ISO limitation when the options were granted, and the acceleration should be disregarded. The Tax Court found the acceleration should be considered, resulting in some of the ISOs being converted to NQOs and ordinary income being taxable when the options were exercised during 2000.

Mr. Montgomery claimed that he should be able to carry back AMT capital losses when the stock was sold to reduce the AMT income for the year of exercise. The Tax Court relied on its ruling in Merlo v. Commissioner, 126 T.C. 205, 211-212 (2006) to find the rules that disallow carrying back capital losses that apply for regular tax reporting also apply for AMT reporting.

Mr. Montgomery claimed the $3,000 capital loss limit doesn't apply for AMT reporting, resulting in an AMT net operating loss to carry back to the year of exercise of the ISOs. The Tax Court also cited its Merlo decision in finding the regular tax limitations also apply for AMT reporting, thus making a net operating loss carryback unavailable.

The Tax Court gave Mr. Montgomery a "bone" by not assessing the accuracy penalty because the rulings in this area are fairly new.

(Montgomery v. Commissioner, 127 T.C. No. 3 (August 28, 2006).)

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Questions and Answers

Question

I had previously understood that there was no regular or AMT tax consequence from exercising ISOs by surrendering shares of the employer company (a swap).

Please confirm that this understanding was in error.

Answer

Yes. Although there is no regular taxable income from exercising the ISO, you will have the same additional AMT income as if you paid the option price in cash.

Question

Does a company need to issue a 1099-MISC to a consultant when the spread for the exercise of a NQSO is less than $600?

If the stock option agreement is written so the service may be provided as a consultant or an employee, do you determine whether to issue a 1099 or W-2 based on the status of the grantee on the date the option is granted, exercised or vested?

Answer

To determine whether a 1099-MISC is issued, you need to determine the total compensation paid. It seems likely there will be some payments in addition to the NQO spread to "kick over" the limit.

How do you have vesting for a non-employee?

I'm not quite sure how to answer your question about the "dual option" without a lot of research. I would say it depends on how the services were provided - as an employee or as a consultant. If it's both, you might have to segregate the amounts.

Life is complex enough with so many issues coming out on options like backdating, etc. I suggest that this type of agreement should be avoided.

Question

When a company splits its stock, is the exercise price in the (pre-split) stock option plan automatically reduced to reflect the split?

Answer

Yes.

Question

I recently terminated employment from a company where I worked for more than five years. I received stock options which are fully vested. The stock is not publicly traded.

Can I sell the stock back to the company or to another employee?

The options will lapse mid-October.

Answer

Since the stock isn't publicly traded, your only choices are to sell the shares to the company or in a private sale, probably to an employee.

You can't "force" such a transaction.

Many people find they can't sell the stock and have to let the options lapse.

If you find a buyer other than the company, you will need legal help to set up the transaction. You will also need to know how the company will report the transaction to determine the tax consequences.

Question

What are the tax consequences for making a gift of ISO shares more than two years after the grant date and more than one year after the exercise date?

Answer

Since the holding period requirements have been met, there is no income tax consequence for the transfer.

If the value of the stock (during 2006) exceeds $12,000 on the date of the gift, it should be reported on a gift tax return.

The donee will receive the holding period, regular tax basis and AMT tax basis of the stock from the person who exercised the option, and so can sell the stock for a long-term capital gain.

The employee probably won't be able to recover any AMT credit relating to the exercise of the ISO. The donee does not receive the AMT credit from the donor.

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Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter.

We do not provide free technical support for TurboTax!

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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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