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Table of Contents

• We have moved!
• Welcome baby Kara Siemer!
• IRS issues final Section 409A regulations
• Questions and Answers
• How do I avoid California taxes on my Washington options?
• When does my company have to pay withheld taxes to the IRS?
• Do you know about our other newsletters?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

We have moved!

Please make a note that we have moved. Our new address is 2190 Stokes St., Suite 102, San Jose, CA 95128, which is about a three-minute walk from our old address. Our telephone numbers, fax number and email addresses remain the same.

Moving has been an adventure. Our telephone system was out of service from Friday, April 27 to Friday, May 4.

We didn't have internet access from April 27 to May 9. Donna Jeffries says she has over 3,800 emails to wade through!

A big THANK YOU to my brother-in-law, Lane Johnston, who helped me move our filing cabinets and over 100 boxes to our new office.

Things are finally getting settled, but we still have many boxes to unpack. Whew!

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Welcome baby Kara Siemer!

Kara Norrine Siemer was born on April 25. She was five pounds, ten ounces. She is my first granddaughter and second grandchild.

Mother Dawn (Gray) and father John Siemer are thrilled and doing well.

Here is Kara

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IRS issues final Section 409A (non-qualified deferred compensation) regulations

On April 7, the IRS issued final regulations for Internal Revenue Code Section 409A, which gives the rules that apply to non- qualified deferred compensation plans.

Sometimes non-qualified stock options and other equity-based compensation plans can be subject to Section 409A. Since compensation will have to be reported each year for plans subject to the rules and penalties apply to the compensation amounts, you want to avoid it if at all possible.

The new regulations are effective April 17, 2007, but Notice 2005-1 and the proposed regulations can be relied on for taxable years beginning before January 1, 2008.

Most of the provisions relating to equity-based compensation are similar to those of the proposed regulations. "Statutory" stock options - including incentive stock options and employee stock purchase plans, aren't subject to Section 409A because the options are required to be valued based on the fair market value on the grant date (with the exception of the 15% discount for ESPPs and the ability to use the lesser of the fair market value of the stock on the grant date or the exercise date to price an ESPP.)

Non-qualified stock options aren't subject to Section 409A if the option price isn't less than the fair market value of the stock on the grant date.

Companies can replace improperly priced options with properly priced ones. For top officers, replacement options had to be issued by December 31, 2006. For other employees, replacement options can be issued up to December 31, 2007.

The valuation rules in the proposed regulations generally continue to apply under the final regulations. For publicly- traded stock, the fair market value may be determined based on the last sale before or the first sale after the grant, the closing price on the trading day before or the trading day of the grant, the arithmetic mean of the high and low prices on the trading day before or the trading day of the grant, or another reasonable method based on actual transactions of the stock. An average selling price within a specified period within 30 days before or 30 days after the valuation date can be used. The same method should be consistently used for all non-qualified options granted by the company.

If the stock isn't publicly traded on an established securities market, a the stock must be valued by a "reasonable method." The method could be a formula or could be an independent appraisal using a valuation date no more than 12 months before the grant of the option.

If the company is a start up company that has been in business less than 10 years and has no publicly-traded stock, the stock valuation should be evidenced by a written report by a person the company believes is qualified to issue such a report. (Back to an appraisal.)

The valuation requirements for a start-up are supposed to be more relaxed, unless the company expects a change of ownership within 90 days after grant or that a public offering will be made within 180 days after the grant.

Although alternative valuation methods can be used, determining value based on an appraisal shifts the burden of proof the to IRS.

The final regulations eliminate the requirement that the same consistent valuation be used for determining the option price, establishing the payment amount for a stock appreciation right, or a buyback amount. Once an exercise price has been established, the exercise price may not be changed retroactively to the use of another valuation method.

The stock for which options may be issued has been liberalized in the final regulations. The stock must be common stock, and must not have any preferences as to distributions. Service recipient stock includes stock of the corporation for which the service provider was providing services at the date of grant, or any corporation in a chain of organizations all of which have a controlling interest in another organization, beginning with the parent organization and ending with the organization for which the service provider was providing services. (Parent stock can be used, but not stock of a "sibling" or "child" entity.)

A controlling interest only requires a 50% interest (it was 80% in the proposed regulations), and a 20% interest can qualify when the stock right is based on a legitimate business criteria.

If the option is modified, the modification could be considered to be a new grant of an option, which could make the option subject to Section 409A. This particularly applies if the term of the option at the old price is extended. However, extensions of time to exercise options before April 10, 2007 are grandfathered.

Although the acceleration of the date when an option is exercisable isn't considered to be a "modification," for a stock right otherwise subject to Section 409A, it might be an impermissible acceleration of a payment date.

My printout of the preamble and the regulations are 232 pages. There are many common transactions that the regulations can apply to besides stock options. I can't cover all of the details here. If you are a tax advisor, I recommend that you study them. If you are a taxpayer, I recommend that you ask your tax advisor to review how these new regulations apply to you.

(TD 9321, 72 FR 19233, April 17, 2007.)

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Questions and Answers

Question

I recently received a job offer in California and am considering relocating. I have some ISO shares received in Washington state that are "locked up" and I hoped to sell the shares later this year. I've held them for more than one year, and expect to pay Federal capital gains tax and AMT. I'm concerned I will have an additional California tax liability.

Any pointers?

Answer

Don't move to California until you sell the shares. A California resident is subject to tax on his or her worldwide income, with a potential state tax credit if another state taxes the income. Washington state has no state income tax, so no state tax credit will be available. Since you weren't a resident of California when you exercised the options, there was no California AMT and no California AMT credit.

California gives no tax break for long-term capital gains. They are subject to the regular tax rates - generally up to 9.3%, 10.3% if you have over $1 million of California taxable income.

Question

I recently exercised some stock options and my employer withheld about $40,000 in taxes. Is there a time requirement for them to report and pay these taxes to the IRS and state?

Answer

Yes. The time frame is pretty short. See IRS publication 15, Circular E at the IRS web site, www.irs.gov, page 19.

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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 now offering our real estate tax newsletter, Michael Gray, CPA's Real Estate Tax Letter, free of charge. Like this newsletter, we will talk about new developments, have reports on special tax concerns, and answer questions and answers. To subscribe and read 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.