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Table of Contents

• Tax season is here!
• Taxpayer had ordinary income from early ESPP disposition
• Income from exercising NQOs is ordinary compensation income
• NQO income at exercise, not when loan paid off
• Exercise of NQO effective on date notice delivered
• Correction relating to refundable AMT credit
• Baucus and Grassley propose AMT repeal
• Questions and Answers
• How do I report exercises I have no records of?
• When are my NQOs taxed if I have to hold them 5 years?
• Can a company let me keep options after I leave employment?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert!

Tax season is here! Make your appointment now

Time has a way of escaping us. There are only about two and one- half months left before the tax return due date. Time to get started now!

If we prepared your income tax returns last year, you should have already received instructions in the mail. If you haven't, please call Dawn Siemer at 408-918-3162.

To have us prepare your income tax returns, start with the online Tax Notebook organizer. Call Dawn Siemer at 408-918-3162 for instructions to get started. We also have a paper organizer, if you prefer that. We still need your documents (W-2s, 1099s, receipts for donations) to prepare your income tax returns.

We can prepare most income tax returns using information provided online and by mail. If you wish a personal meeting, please call Dawn Siemer at 408-918-3162 to schedule an appointment. Our calendar is filling up fast!

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Taxpayer had ordinary income from early ESPP disposition

Ms. Young J. Kim amended her 2002 federal income tax return to reclassify $4,234.94 of income from the early disposition of ESPP shares from wages to capital gains. Her employer included the income as wages on her Form W-2.

Ms. Kim had unused capital losses that she wished to apply to the income.

The ESPP shares were sold to get the cash to pay for purchasing ESPP shares.

The Tax Court held that the income was properly reported as wages on the original return and could not be reported as capital gains.

(Kim v. Commissioner, T.C. Memo 2007-14, January 18, 2007.)

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Income from exercising NQOs is ordinary compensation income

During 2000, Bidyut Bhattacharyya exercised Intel non-qualified stock options, for which $606,963 was included in his W-2 as wages.

Evidently, Mr. Bhattacharyya had significant capital losses that would have absorbed the income from the non-qualified stock options if it was taxable as a capital gain, so he claimed the income should be reported as capital gains on an amended income tax return.

The Tax Court held the income from the stock options should be included in wages as originally reported.

(Bhattacharyya v. Commissioner, TC Memo 2007-19, January 30, 2007.)

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NQO income at exercise, not when loan paid off

Ricardo Cidale exercised an option to purchase RealNetworks stock on January 31, 2000. He paid for the shares with a margin loan from Salomon Smith Barney. The loan was paid off when Mr. Cidale liquidated his RealNetworks stock at a substantially lower value during September, 2000.

Mr. Cidale filed an amended return, claiming that he should be taxed on the income from the options at the time the loan to Salomon Smith Barney was paid off, not on the exercise date. The Fifth Circuit Court of Appeals upheld a Texas District Court, ruling against Mr. Cidale.

(Cidale v. U.S., 2007-1 USTC 50,138, January 9, 2007.)

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Exercise of NQO effective on date notice delivered, not payment date

Edward Walter faxed a notice of exercise of his non-qualified stock options for Primus Knowledge Solutions, Inc. after the close of business on July 13, 2000. He had sufficient resources to pay for the shares and the withholding taxes. On July 14, he sent a correction to his original instructions, stating his desire to buy and hold the shares instead of making an exercise and sale of the shares.

On July 18, 2000, a check for $369,525.75 was written in payment of the option price.

In determining the income to be reported on Form W-2, Primus used the fair market value on July 14, $52.4375 per share. Mr. Walter made a -$366,795 adjustment on the "other income" line of Form 1040 to reduce the fair market value to $40.0625, the average price on July 19.

The Tax Court held that Mr. Walter had beneficial ownership of the shares when he exercised the option according to the terms of the plan by giving notice to Primus. Since he gave the notice after close of business on July 13, the value on July 14 should be used.

(I'll bet Mr. Walter is kicking himself for not selling the shares when he exercised the option.)

(Walter v. Commissioner, TC Memo 2007-2, January 3, 2007.)

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Correction relating to refundable AMT credit

My humanity is showing (again). Sometimes I get tired or in a hurry. It's just little old me pounding these keys.

In the December 28, 2006 newsletter, there is an example of computing the reduction of the refundable minimum tax credit for Jane, a single person. I forgot a step. The phaseout is 2% for each $2,500 over $156,400. Her allowable credit should be computed as follows: $200,000 AGI - $156,400 (exemption phaseout threshold) = $43,600 / $2,500 = 18 (rounded) X 2% = 36% phaseout. 100% - 36% = 64% X $20,000 (tentative refundable credit) = $12,800 refundable credit.

Also, the phaseout for a head of household for 2007 starts with an AGI of $195,500.

Sorry for the screw up and thanks to the reader who brought this to my attention.

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Baucus and Grassley propose AMT repeal

Senate Finance Committee Chairman Max Baucus (D-Montana) and member Charles Grassley (R-Iowa) have introduced legislation to repeal the individual alternative minimum tax, effective 2007.

Don't plan on this proposal passing. The estimated loss of revenue from the permanent repeal of the individual AMT over 10 years is estimated to be $60 billion per year. That's a big hole to plug. In order to accomplish the change, the regular tax could end up looking a lot more like the AMT.

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Questions and Answers

Question

I had a few thousand shares of stock from stock options, ESPPs and reinvested stock dividends. I sold all during 2006.

In assembling the basis information for reporting the sales, I have a few hundred shares for which I have no records.

How should I report them?

Answer

You might want to play detective a little longer and hunt down those records.

If you can establish that you had the shares more than one year (and the shares aren't disqualifying dispositions of ISO shares or ESPP shares), you can just report the total sale proceeds as long-term capital gains, with zero tax basis.

Question

I purchased 900 shares of stock by exercising a non-qualified stock option at work. The option price was $33.45 per share and the fair market value on the exercise date was $44.55 per share. I have to hold the stock for five years, and did not file a Section 83(b) election. How will the income be taxed?

Answer

You need to confirm with your employer that the shares will not be treated as vested until the five-year period has passed.

If that is the case, the excess of the fair market value over the option price on the vesting date will be taxable as ordinary compensation income.

Question

Can a public company allow me to hold my options after I leave the company and exercise them at a later date?

Answer

Yes. However, most companies only allow their employees to continue to have the right to exercise employee stock options for a limited time. Also, an option can only be treated as an ISO or ESPP if the individual was an employee from the time the option was granted until the date three months before the date of exercise. If the company allows you to extend ISOs or ESPPs, they will be converted to non-qualified stock options.

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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.