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Michael Gray, CPA's Option Alert #36
An irregular alert for issues relating to employee stock options
December 29, 2006
© 2006 by Michael Gray, CPA
ISSN 1931-2768
(If you find this information valuable, please pass it on to a colleague!)
Table of Contents
- Happy New Year
- Secrets of Tax Planning for Employee Stock Options, Stock Grants and ESOPs is complete
- 'Tis the season to exercise ISOs?
- Final 2006 estimated tax payment is due January 15
- Tax organizers and tax notebook instructions are in the mail
- Yes, we do prepare income tax returns!
- Tax Relief and Health Care Act includes some AMT relief
- Tax Relief Act adds information requirement for exercises of ISOs and ESPPs
- Google plants to set up market for employee stock options
- Non-employee spouse taxed on income from NQO exercise
- 9th Circuit says on exercise of NQO using margin loan
- Tax Court finds taxpayer didn't meet employment requirement for ISO - option exercise treated as NQO
- Tax Court finds Section 83(b) election was valid
- Income from exercise of stock options is not capital gain
- Notice issued on information reporting for non-qualified deferred compensation
- Questions and Answers
- Do you know about our other newsletters?
- IRS Circular 230 Disclosure
- Consult with a tax advisor
- Subscribe to Michael Gray, CPA's Option Alert
Happy New Year
We wish you a healthy and prosperous 2007! We'll do our best to help you keep as much as possible of your hard-earned gains.
Secrets of Tax Planning For Employee Stock Options, Stock Grants and ESOPs is complete
During the past year, I have written a new edition of Secrets of Tax Planning For Employee Stock Options, Stock Grants and ESOPs. The book principally focuses on tax planning for participants in the plans. Details will be released next month.
'Tis the season to exercise ISOs?
Although we think the risk of holding ISO shares after an exercise often isn't justified by the tax savings when the holding requirements are met, some people decide to go for the "brass ring". It's difficult to recoup the AMT credit when the stock is sold after the holding period requirements are met, so the federal tax rate for the spread at the exercise date ends up being 28% (the AMT tax rate, compared to about 32% regular tax after the tax benefit of the state tax deduction in a state like California).
Recent tax legislation may help you eventually recover some of the AMT credit. See the explanation below.
If you decide to hold the stock, it usually is best to exercise the option early in the year. Assuming the exercise is made more than one year after the grant date, only the second requirement of holding the stock more than one year after the exercise date must be met to realize the tax savings.
There are two advantages of exercising early in the year. These advantages only apply if the stock is publicly traded or the stock can otherwise be sold at the end of the year and during the next year.
- If you have a lower income tax for the tax year before the year of exercise, you can make estimated tax payments or have withholding based on the previous year's tax (110% of last year's tax if your adjusted gross income for last tax year was more than $150,000), so most of the tax due relating to the option exercise may not be due until April 15 after the year of exercise. By that date, you should have met the holding period requirements so the stock can be sold to generate the cash to pay the tax.
- If the market price for the stock has fallen at the end of the year, you can sell the stock before the end of the year of exercise. You pay tax on ordinary income, being the excess of the sales price of the stock over the option price. The alternative minimum tax adjustment for the exercise date is eliminated. I call this the "escape hatch". In order to qualify, the transaction has to qualify for reporting a loss (if a loss was realized). This means you can't sell or gift the stock to a related party and that you have to avoid the wash sale rules. You can't purchase the same type of stock within 30 days before or 30 days after the sale (including other ISO, ESPP or NQO exercises).
Final 2006 estimated tax payment is due January 15
Remember the final 2006 estimated tax payment for individuals, estates and trusts is due on January 15. If you need help to determine the appropriate payment to avoid underpayment penalties or avoid a big overpayment, consult with your tax advisor.
Tax organizers and tax notebook instructions are in the mail
If we prepared your 2005 income tax returns, we have mailed paper tax organizers or electronic tax notebook instructions to you. If you haven't received them by January 7, please call Dawn at 408-918-3162. Also, please call Dawn if you would like us to prepare your 2006 income tax returns and would like tax notebook instructions or a paper organizer.
Yes, we do prepare income tax returns!
With our free newsletters and the information we make available at no charge on the web, some people wonder how we make a living. We prepare income tax returns and provide tax and business consulting services. We are accepting selected new clients and are thrilled when our clients and friends refer their friends, associates and family members to us. To inquire about becoming a client of our firm, please call Dawn Siemer at 408-918-3162 or send an email to her at eso-advisors@stockoptionadvisors.com. We must receive your tax information by March 1 to guarantee delivery by April 15.
Tax Relief and Health Care Act includes some AMT relief
The Tax Relief and Health Care Act of 2006 was enacted on December 20, 2006. Section 402 of the Act adds Internal Revenue Code Section 53(e) to the rules for the tax credit for prior year minimum tax to permit a refundable credit for certain old unused minimum tax credits.
The minimum tax credit eligible for the AMT refundable credit is the portion of the credit carryover attributable to taxable years before the third taxable year immediately preceding the taxable year. For 2007, minimum tax credit carryovers attributable to tax years before 2004 would be eligible.
The determination of the allowable credit is strange. Here is the wording in the Internal Revenue Code:
"The term 'AMT refundable credit' amount means, with respect to any taxable year, the amount equal to the GREATER of --
- the LESSER of
- I. $5,000, or
- II. the amount of long-term unused minimum tax credit for such taxable year, OR
- 20 percent of the amount of such credit."
For example, assume John has unused AMT credit carryover from 2003 to 2007 of $3,000, and doesn't have enough AMTI for a phaseout. John would be refunded $3,000 under (i) above.
Another example, assume Jane has unused AMT credit carryover from 2003 to 2007 of $100,000, and doesn't have enough AMTI for a phaseout. Jane would be refunded $20,000 under (ii) above.
If the minimum tax credit determined under the "old law" for a taxable year is greater than the refundable credit, no additional refundable credit is allowed.
The refundable credit is phased out for higher-income taxpayers based on the same ratio as applies to phase out personal exemptions. The phase out is two percentage points for each $2,500, or $1,250 for married persons filing a separate return, (or fraction thereof) by which the taxpayer's adjusted gross income1 exceeds certain threshold amounts, to a maximum of 100%.2 For 2007, the threshold amounts are $234,600 for joint filers or a surviving spouse, $195,500 for a head of household, $156,400 for single taxpayers, and $117,300 for married persons, filing separately.3
For example, Jane, a single person who is not a head of household, would otherwise qualify for a refundable credit of $20,000 for 2007. Her adjusted gross income is $200,000. Her phaseout is $200,000 - $156,400 = $43,600 / $2,500 = 18% (rounded) X 2% = 36%. Her allowable credit is 100% - 36% = 64% X $20,000 = $12,800.
The refundable credit is treated similarly to an estimated tax payment or withholding, and is, therefore, refundable even if there is no tax to offset.
This special provision is effective for "taxable years beginning after December 20, 2006" (2007) for any taxable year beginning before January 1, 2013, or 2007 through 2012 for most individual taxpayers.
Tax Relief Act adds information requirement for exercises of ISOs and ESPPs
The Tax Relief And Health Care Act Of 2006, enacted December 20, 2006, has modified the information reporting requirements for employers, effective 2007 and thereafter. Employers will also be required to provide information as prescribed by the IRS in regulations first to the employee by January 31 of the year following the transfer of shares relating to the exercise of an incentive stock option. A copy of the information return will also be filed with the IRS, presumably by February 28 like other information returns.4 (The first information returns are required to be issued to employees by January 31, 2008 for 2007 exercises.)
Google plans to set up market for employee stock options
Google announced on December 12, 2006 that it is creating a marketplace for its employees' employee stock options. "We are doing this to make the value of options more tangible to employees," said Dave Rolefson, Googles equity and executive compensations manager.5
I don't have the details for Google's plan, but establishing a marketplace for non-qualified stock options could have some interesting results.
If the options are immediately tradable when granted or when they become vested, they would have an ascertainable value. This would make the options taxable when granted or vested, not when they are exercised. Employees who receive non-vested options could make a Section 83(b) election to have the options treated as if they were vested. (See the section below on vesting and the Section 83(b) election.)6 The options would be valued based on the market trading values when granted or traded, like we do for stock now.
Another result would be the company could use the trading value of the options to establish their fair market value for accounting purposes, instead of using the estimates computed based on complex formulas. This would create an objective basis of value that would be more certain. An accountant can compute different values with the same facts when the options aren't traded in an established market.
Non-employee spouse taxed on income from NQO exercise
The IRS has privately ruled that when an employee retained ownership of NQOs allocated to the employee's former spouse in a property settlement for a divorce and later exercised the options and distributed the shares to the former spouse, the income from the exercise of the option is taxable on the former spouse's income tax return and the former spouse is entitled to claim the tax withheld when the option was exercised, despite these items being reported on the employee's Form W-2. The employee receives the credits for social security taxes withholding.
This ruling provides a road map for divorcing couples in a similar situation, but may not be cited as precedent by other taxpayers. (Letter Ruling 200646003.)
9th Circuit says no deferral for exercise of NQO using margin loan
The 9th Circuit Court of Appeals affirmed the summary judgment of a U.S. District Court finding an employee must report taxable income from the exercise of non-qualified stock options when the employee exercised the options using funds from a margin account. Since the funds were borrowed from a third party and not from the employer, the loan should not be treated as the grant of another option. (United States v. Tuff, No. 05-35195 (9th Circuit, 12/4/2006.)
Tax Court finds taxpayer didn't meet employment requirement for ISO - option exercise treated as NQO
Robert Humphrey resigned as vice president of i2 Technologies, Inc. effective December 31, 1999. He later exercised employee stock options, including ISOs, on November 13, 2000.
In an amended return, Humphrey claimed he was still employed by i2 Technologies through October, 2000, so he shouldn't be subject to regular tax on the exercise of the ISOs.
The Tax Court reviewed the facts, concluding that Humphrey received no compensation relating to any work that he performed after December 31, 1999 and found that Humphreys was not an employee through October, 2000 and had terminated his employment on December 31, 1999. Therefore the former ISOs were disqualified and the exercise was currently taxable as the exercise of NQOs.
(Robert C. and Patricia C. Humphrey v. Commissioner, T.C. Memo. 2006-242, 11/9/2006.)
Tax Court finds Section 83(b) election was valid
Anthony Kadillac exercised non-vested ISOs received as an employee of Ariba Technology on April 5, 2000 and made a timely Section 83(b) election.
On April 4, 2001, Anthony's employment at Ariba was terminated and he was required to resell his non-vested shares to the company for the option price.
Anthony filed amended returns, claiming the Section 83(b) election was invalid because the shares weren't "transferred" to him, since they weren't vested. He also claimed he should be entitled to claim losses from his forfeiture because his termination was a foregone conclusion at the time the options were granted, and that AMT capital losses aren't subject to the regular tax limitations of capital gains plus $3,000, so he should be entitled to an AMT net operating loss carryback.
The Tax Court found the Section 83(b) was valid, and his termination wasn't a foregone conclusion when the options were granted. No deduction is allowed for the income reported from a Section 83(b) election when the stock is forfeited. The regular tax limitations for capital losses apply for AMT reporting, so no AMT net operating loss results from an AMT capital loss.
(Anthony J. Kadillak v. Commissioner, 127 T.C. No. 13, 11/7/2004.)
Income from exercise of employee stock options is not capital gain
Jorge Svoboda reclassified income on his W-2 representing the gain from exercising his employee stock options as long-term capital gains. He claimed the date of grant as the acquisition date and the date of exercise and sale of the stock as the sale date.
Jorge also claimed the options that he received were incentive stock options.
The Tax Court found that the company documents issued at the time the options were exercised indicated they were non-qualified stock options. The income was additional compensation and correctly reported on Form W-2. Even if the options were ISOs, the holding period requirements were not met, so ordinary income would result.
It was apparent that Jorge was completely confused about the tax laws that apply to these transactions, so the Court waived penalties.
(Svoboda v. Commissioner, T.C. Memo. 2006-235, 11/2/2006.)
Notice issued on information reporting for non-qualified deferred compensation
The IRS has issued a notice explaining information reporting requirements for non-qualified deferred compensation plans for 2005 and 2006.
The notice is lengthy, so there isn't space for a detailed explanation.
In short, an employer is not required to report deferred compensation that isn't currently taxable in box 12 of Form W-2 using code Y, and a payer isn't required to report deferred compensation for non-employees that isn't currently taxable in box 15a for Form 1099-MISC.
An employer is required to include deferred compensation amounts that are currently taxable as additional wages in Box 1 of Form W-2, and also report the amount of Section 409A income in box 12 of Form W-2, using code Z. The taxable income amounts are supplemental wages, eligible for alternative withholding amounts (generally 25% federal income tax withholding), and are also to be reported on line 2 of Form 941.
A payer of taxable deferred compensation to a non-employee reports those amounts as non-employee compensation in box 7 of Form 1099-MISC and as Section 409A income in box 15b of Form 1099-MISC. (Notice 2006-100, 2006-51 IRB.)
Questions and Answers
Question
I'm confused about the AMT credit. I believe I should have an AMT credit carryforward from 2005 based on some ISOs we exercised in 2005. But the return shows no credit. Perhaps I should amend last year's return? Are there situations where it would be possible to pay a lot of AMT due to ISO exercise, but still not have the credit available for later years?
Answer
The credit will be determined on Form 8801, Credit for Prior Year Minimum Tax, with your 2006 income tax return. You can get a copy of the form at the IRS web site, www.irs.gov.
Question
I am interested in the viability of buying puts in the open market to hedge unexercised ISOs. Consequences?
Answer
When you buy a put as an offsetting position to stock, short sale rules apply that erase the holding period when the stock hasn't met the holding period requirements for long-term capital gains. (Internal Revenue Code Section 1233(b), Revenue Ruling 78-182.) Therefore, offsetting puts should be used carefully, with the awareness that the holding period "clock" for the stock doesn't start until the put is eliminated.
An alternative approach is to buy a put for a stock that has a similar stock price movement to the ISO stock. An example might be to buy a put for AMD stock as a hedge for Intel ISO stock.
Employees should also check for "insider" restrictions prohibiting them from getting hedge positions against company stock.
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!
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.
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.
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.
(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.
1 Determined without regard to the exclusion under Section 911 for citizens or residents of the U.S. living abroad, the exclusion under Section 931 for income from sources within Guam, American Samoa, or the Northern Mariana Islands, and the exclusion under Section 933 for income from sources within Puerto Rico. (Internal Revenue Code § 53(e)(2)(B)(ii).)
return2 Internal Revenue Code § 151(d)(3)(B)
return3 Internal Revenue Code § 151(d)(3)(C), Revenue Procedure 2006-53.
return4 Internal Revenue Code § 6039(b), Technical Explanatio of H.R. 6408, The "Tax Relief and Health Care Act of 2006," As Introduced In The House On December 7, 2006, Joint Committee On Taxation, Title IV, Item 2.
return5 "Google sets up options market", San Jose Mercury News, December 13, 2006, page 1A
return
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