Print This Page

Table of Contents

• Trick! The year is 3/4 over!
• Private Letter Ruling explains handling ISOs for divorce
• Secrets of Tax Planning for Employee Stock Option Advisors
• Questions and Answers
• Should I sell my incentive stock before the year end?
• How should I value my privately held stock?
• Is it best to exercise options before or after death?
• 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 3/4 over!

Hope you and your family have a happy and safe Halloween!

Janet and I will be out of town on our vacation for a Polar Bear expedition! (I'll be out of the office from October 25, returning November 12.)

The end of the year will soon be here, so make your year-end planning appointments now! Call Dawn Siemer at 408-918-3162 on weekday afternoons.

Return to Table of Contents

Private Letter Ruling explains handling ISOs for divorce

The IRS has issued a private letter ruling affirming divorcing taxpayers' plan for dividing ISOs.

The divorcing taxpayers are residents of a community property state.

The incentive stock options were to remain in the name of the employee spouse, who would hold them as trustee for the non- employee spouse. The non-employee spouse would direct the employee spouse when to exercise the option. After the exercise, the stock would be transferred to the non-employee spouse.

The IRS affirmed that the arrangement would not violate the requirement that incentive stock options may only be held by employees. The non-employee spouse should report the alternative minimum tax income relating to the exercise of the ISO. The transfer of the shares from the employee spouse to the non- employee spouse would not be a disqualifying disposition. The non-employee spouse would report the future consequences of disposing of the ISO shares, including the AMT basis adjustment and the availability of AMT credits.

(LTR 200737009, June 15, 2007.)

Return to Table of Contents

Secrets of Tax Planning For Employee Stock Option Seminar for Advisors

Michael Gray, CPA will lead a two-day, 16-hour seminar using Secrets of Tax Planning For Employee Stock Options, Stock Grants and ESOPs, 2nd Edition as the textbook. The seminar will take place on Friday and Saturday, January 25 and 26, 2008 at the Pruneyard Inn in Campbell, California (about 20 minutes from the San Jose International Airport.) For details, contact Dawn Siemer at mgray@stockoptionadvisors.com or telephone 408-918-3162 weekday afternoons.

Return to Table of Contents

---

Questions and Answers

Question

During the first quarter of 2007, we exercised ISOs and NQSOs. The Option price was between $4 and $9 and the fair market value of the stock on the date of exercise was about $23. We sold the NQSO shares and kept the ISO shares, planning to hold them to qualify for long-term capital gain treatment just before our income tax returns for 2007 are due.

Currently the stock price is hovering around $13. Are there any tax advantages of selling all of the shares, and then buying them back at the current market price?

Answer

This is a good year-end planning reminder. This situation needs to be handled very carefully.

There is an "escape hatch" to avoid the alternative minimum tax when the value of stock falls after exercise. If the stock is sold during the year of exercise, ordinary income is reported for the excess of the selling price over the option price. (Internal Revenue Code Section 422(c)(2).) But be very careful. In order to qualify, the disposition must be a sale or exchange with respect to which a loss (if sustained) would be recognized to the individual. A loss would be disallowed under the wash sale rules if similar stock or an option (including having another employee stock option granted) was acquired during the period starting 30 days before the sale and 30 days after the sale.

This means you can't sell the stock and immediately repurchase it and receive this tax benefit.

Everyone who exercised an ISO early in the year should be reviewing their positions as we get close to the end of the year to determine whether to use the "escape hatch".

Question

I am a consultant to a privately-held company. For the past four years, I have been receiving non-qualified stock options as part of my compensation. The stock is restricted. Over the last four years, there have been two private offerings, in which the stock was sold at a price higher than my option price.

I would like to exercise the options on October 1.

Can I value the stock at $0 since the stock is restricted, or can I value it at the option price, or must I use today's value, which I have no way of valuing?

Answer

Most restrictions are disregarded in determining the taxability of the shares received, unless those restrictions will never lapse. However, the value of shares is adjusted to reflect the lack of liquidity of stock that isn't publicly traded and for the lack of control of a minority interest.

Considering the guidelines that have been issued under Internal Revenue Code Section 409A and the final regulations for that section, the company should provide you with the fair market value of the shares. This is also a critical issue for the company, because it gets a tax deduction for the amount you are required to report as taxable income.

Question

I have a client who is terminally ill (life expectancy less than 6 months). My client has about $1.5 million in ISOs, with an option price of about $300,000 and an unrealized gain of $1.2 million.

What are the tax implications of exercising the ISOs before death and selling the resulting shares after death, assuming all of this is accomplished during 2007? My client lives in Texas, a community property state.

Would it be better to exercise the ISOs after death?

Answer

For ISOs that are unexercised at death, the holding period requirements and the requirement that the holder be an employee within three months after leaving employment are eliminated. (Internal Revenue Code Section 421(c)(1)(A).) The employee must have met the employment requirement as of the date of death. (Treasury Regulations Section 1.421-2(c)(1).)

Therefore, for regular tax reporting, any gain with respect to any stock received from exercising an ISO after death will be a capital gain. Whether the capital gain is short-term or long-term will depend on the holding period of the stock after exercising the option.

The basis of shares acquired from exercising an ISO after death equals the estate tax value of the option plus the option price.

For AMT reporting, ISOs are taxed like NQOs. When an ISO is exercised, there will still be an AMT adjustment for ordinary income, resulting in an item of income with respect of a decedent. The AMT basis of the ISO stock will be the option price plus the ordinary income reported for AMT.

When the ISO is exercised before death, a transfer of the stock by bequest or inheritance is not a disqualifying disposition. (Internal Revenue Code Section 424(c)(1)(A).)

Exercising the option before death will result in an AMT, and the AMT credit will disappear at the death of the employee.

The holding period requirement is waived with respect to stock sold after the death of the employee. (Treasury Regulations Section 1.421-2(d).) Therefore, a sale of the stock will not result in a disqualifying disposition.

Under the rules relating to inherited property, the tax basis for the stock will be the fair market value as of the date of death or the alternate valuation date (Internal Revenue Code Section 1014(a), and the gain with respect to the sale of the stock will be a long-term capital gain (Internal Revenue Code Section 1223(11).) For stock held as community property, the basis adjustment and new holding period applies to 100% of the stock, regardless of which spouse is first deceased (Internal Revenue Code Section 1014(b)(7).) (These basis adjustment rules could change if the repeal of the estate tax becomes effective in 2010.)

Determining the "correct" answer to your question involves unknowns, including changes in the price of the stock on the date of exercise, the date of death and the date of sale. A "rule of thumb" answer is it's probably better to exercise before death, because the AMT will be deductible when computing the estate tax and getting a "fresh start" basis adjustment and long-term holding period after death. This decision could also have an impact on the amount to be allocated to trusts after death.

I recommend that your client consult with a tax advisor and an attorney about this matter before making a final decision.

---

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!

Return to Table of Contents

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.

Return to Table of Contents

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.

Return to Table of Contents

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.

Return to Table of Contents

(Michael Gray is the author of Secrets of Tax Planning For Employee Stock Options, Stock Grants and ESOPs.)

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.