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Table of Contents

• Sorry, our internet connection was out of service
• Thank you Donna, and welcome back Dawn
• Second 2007 estimated tax payment is due June 15
• Now is a good time to finish extended 2006 income tax returns
• Michael Gray speaks on non-qualified compensation plans
• Exercise of disqualified ISO is currently taxable
• Questions and Answers
• What taxes are withheld for NQO exercises?
• Do buying companies pay employees for unexercised options?
• Do you know about our other newsletter?
• IRS Circular 230 Disclosure
• Consult with a tax advisor
• Subscribe to Michael Gray, CPA's Option Alert

Sorry, our internet connection was out of service

Everything seemed to be working fine with our DSL internet service until it suddenly switched off on May 18! The service was finally restored on June 4. Sorry for the inconvenience of not being able to receive emails for over two weeks. Donna Jeffries is wading through the backlog.

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Thank you Donna, and welcome back Dawn

Donna Jeffries is finishing her "tour of duty" as our temporary administrative assistant on June 8, and Dawn is returning from maternity leave on June 18. The plan is for Dawn to work afternoons while Grandma Janet babysits Kara. Dawn is looking forward to taking a break from being a 24/7 mom, and Janet is very excited about spending more time with her granddaughter.

We really appreciated Donna stepping in and stepping up for tax season and for helping us clear out old files from storage. This has also been a challenging period dealing with moving to our new location.

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Second 2007 estimated tax payment is due June 15

Remember the second estimated tax payments for calendar year taxpayers are due on June 15. If you have a change in your situation or your estimated taxes are based on your 2007 income and deductions, you should contact your tax advisor now.

If we can be of service with this, call Mike Gray at 408-918-3161.

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Now is a good time to finish those extended 2006 income tax returns

If you filed for an extension of time to file your 2006 individual income tax returns, the extended due date is October 15, 2007. It's easy to put this project "on the back burner" and wait until the due date to finish the returns.

There is a possibility that waiting until the extended due date could result in missing the deadline and filing late income tax returns. Sometimes an election is made on the return that must be made on a timely-filed return.

Also, penalties and interest may be charged for any unpaid tax finally determined.

Finally, your friendly neighborhood tax return preparer would appreciate having work for their team members to do and to avoid the stress of having a last-minute "crunch" of tax returns during October, requiring working overtime.

So do yourself and your tax return preparer a favor and finish your 2006 income tax returns during June this year.

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Michael Gray speaks on non-qualified deferred compensation plans

Michael Gray, CPA and attorney Michael Brayton will discuss the final regulations under Internal Revenue Code Section 409A, Non- Qualified Deferred Compensation Plans, at two presentations. One will be a breakfast meeting for the Silicon Valley San Jose Chapter, California Society of CPAs on July 18 from 8:30 a.m. to 11:30 a.m. at the Los Gatos Lodge. For details, call Stephanie Stewart at 408-983-1122. The second will be a lunch meeting for the Santa Clara County Bar Association on July 25 from noon to 2 p.m. at the Bar office 31 N 2nd Street, 4th floor in San Jose. For details, call Cindy Gartner at 408-975-2113.

These regulations have a surprisingly broad application, and the penalties for violating these rules are severe. Some items we'll be talking about include pricing employee stock options, waiver of salary for small business owners, split dollar life insurance and expense reimbursement arrangements, in addition to structuring traditional non-qualified deferred compensation arrangements.

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Exercise of disqualified ISO is currently taxable

Susan Moore was granted a series of incentive stock options while she was an employee of Cell Therapeutics, Inc. (CTI). She terminated her employment with CTI on January 12, 2001 and entered a consulting agreement, effective January 13, 2001. The company extended the term of her options and accelerated vesting.

Susan exercised her options on March 5, 2002, using funds from a margin account from CIBC Oppenheimer to pay the option price and taxes withheld by CTI. At the time she exercised the option, the shares were subject to a blackout window under the company's Insider Trading Policy, which lapsed on May 13, 2002.

CTI reported income relating to the exercise of the options on Susan's Form W-2. Susan reversed the income on her income tax return with a disclosure statement.

The IRS claimed Susan owed additional tax, and the case went to Tax Court.

The Tax Court found that the options did not meet the requirements to be incentive stock options, because Susan was not an employee during the 90-day period before exercising the options. There was considerable analysis as to her status as an independent contractor. One item of evidence was Susan's notification of the 401(k) administrator that her employment was terminated and directing the rollover of her 401(k) account to an IRA.

The Court also found the restriction on the shares didn't meet the requirements for postponing tax on the exercise of a nonqualified stock option. (Besides, the restriction lapsed two months after exercise during the same tax year.)

Finally, the Court rejected Susan's argument that the income should be postponed because she purchased the shares using non- recourse debt. Susan was personally liable to CIBC Oppenheimer for repayment of the margin loan.

Therefore, Susan was taxable on the income at the time of exercising her disqualified ISOs, which were therefore NQOs.

A saving grace, the Tax Court found that Susan was not liable for an Accuracy-Related Penalty, because she acted with reasonable cause and in good faith, depending on legal counsel and the issue at hand was novel at the time she filed her income tax return. (There was no history of court rulings on this issue in 2002. Thanks very much to attorneys Brian Isaacson and Duncan Turner, we have this history now and won't be able to escape these penalties in the future.)

(Moore v. Commissioner, T.C. Memo. 2007-123.)

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Questions and Answers

Question

An individual was employed by a company where he held nonqualified stock options. After terminating employment, the individual exercised some of the non-qualified options and sold them on the same day. What taxes are required to be withheld? The individual terminated during last year, 2006. How about 2007? (From a payroll coordinator in Texas.)

Answer

Since the options relate to being an employee, the income from exercising the options is subject to income tax withholding. The rate is 25% for the first $1,000,000 of supplemental compensation and 35% for supplemental compensation exceeding $1,000,000. The income is also subject to social security, Medicare, and federal unemployment taxes. Also check payroll taxes in your own state.

Shouldn't you be getting this information from your company's CPA firm?

Question

I have been reading information on your web site about non- qualified stock options. Does a buying company typically reimburse employees for options not yet exercised, given there is a market value to them?

Answer

I have seen many cases where employees are compensated for their options relating to a purchase. I have also seen employee options converted to options for purchasing company stock. If you are working on an acquisition, you should get legal advice about these issues.

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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.