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Table of Contents

• Happy Thanksgiving!
• Make your year-end planning appointment now
• Exercised ISOs during 2007? Consider the "escape hatch"!
• Consider refundable AMT credit for year-end planning
• Year-end withholding and estimated tax review
• 2007 alternative minimum tax is a fiasco
• Guidance for reporting deferred compensation on 2007 W-2s
• Transitional relief for non-qualified deferred compensation
• Ways and Means Chairman Rangel proposes repealing AMT
• Stock swap of ISO stock was a disqualifying disposition
• Secrets of Tax Planning for Employee Stock Option Advisors
• Questions and Answers
• Do I have to issue W-2s for disqualifying dispositions?
• 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 Thanksgiving!

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

We are thankful for our clients and the readers of this newsletter.

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Make your year-end planning appointment now!

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.

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If you exercised ISOs during 2007, should you use the "escape hatch"?

Remember if you exercised ISOs during 2007 and didn't sell the stock, your AMT adjustment will be based on the fair market value on the date of exercise. However, if you sell the stock before the end of the year of exercise, the AMT adjustment is eliminated. Ordinary income is reported for the excess of the selling price over the option price. I call this strategy "the escape hatch".

For example Jean Employee exercised an ISO for 1,000 shares of XYZ Software on March 1, 2007. The fair market value of the shares on March 1, 2007 was $55 per share and the option price was $5 per share. If Jean didn't sell the stock, she would report additional AMT income of $55 - $5 = $50 X 1,000 shares =$50,000. On November 30, 2007, Jean sells the stock for $15 per share. The AMT adjustment is eliminated, and Jean reports $15 - $5 = $10 X 1,000 shares = $10,000 of ordinary income for regular tax and AMT.

There is an important requirement to get this tax benefit. A loss would have to be "allowable" if the stock was sold at a loss. A common transaction that would disqualify the disposition for the escape hatch is a wash sale. A wash sale happens when replacement shares or an option to acquire replacement shares are acquired during the period 30 days before or 30 days after the sale.

For example, if Jean purchased 1,000 shares of XYZ Software for $16 per share on December 10, 2007, she would still have a disqualifying disposition of the ISO shares, but she would have $50,000 of ordinary income because the escape hatch wouldn't apply. Her loss of $15 - $55 = $40 X 1,000 shares would be disallowed as a current deduction. The disallowed loss would be added to the tax basis of the replacement shares. Therefore, the tax basis of the replacement shares would be $16 + $40 = $56 X 1,000 shares = $56,000.

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Consider refundable AMT credit for year-end planning

Remember that AMT credit can be refundable under legislation effective for 2007. Since the credit is phased out based on adjusted gross income thresholds, year end planning decisions such as deferring income or selling assets for capital gains could have an impact on whether you qualify for the refundable credit. I would expect that the refundable credit will apply mostly to retired persons, unemployed persons, or persons on sabbatical.

For more details, see our article, "Refundable AMT Credit Available for 2007".

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Year-end withholding and estimated tax review

Remember to review your withholding and estimated tax payments to be sure you avoid penalties for underpayment of estimated tax.

Withholding is considered made evenly during the year. Estimated tax payments are credited to a quarter according to when they are paid.

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2007 alternative minimum tax is a fiasco

Here we are at the end of the year, and we still don't know what the AMT exemption is. The House of Representatives passed H.R. 3996, which includes an AMT "patch". If the "patch" isn't enacted, millions more middle class taxpayers will be subject to the AMT. Tax increases are included in the bill to pay for the revenue loss. President Bush has indicated he would veto this legislation, if it is also passed by the Senate.

Under H.R. 3996, the AMT exemptions for 2007 would be $66,250 for joint filers, $33,125 for married, filing separately and $44,350 for singles.

Most tax planning software won't be updated for the AMT change until it is enacted.

We'll just have to make "best guess" estimates of tax liabilities based on the law as it stands, for now.

Another issue is the tax forms for next tax season. The IRS has indicated it won't include changes in the AMT exemption on the forms because they haven't been passed yet. There are many other expiring tax provisions involved. The late tax legislation will result in more errors on 2007 income tax returns.

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IRS issues guidance for reporting non-qualified deferred compensation on 2007 W-2s

The IRS has issued guidance to employers on reporting non- qualified deferred compensation on 2007 Forms W-2 and 1099-MISC.

The amounts deferred during the year under a non-qualified deferred compensation plan are not required to be reported for employees on box 12 of Form W-2, using code Y or for non-employees on Form 1099-MISC, box 15a.

The currently taxable income amounts are required to reported for employees at box 12 of Form W-2, using code Z and for non- employees in box 7 of Form 1099-MISC.

The Notice also includes information on how to determine the amount to be reported.

(Notice 2007-89, 2007-46 I.R.B.)

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IRS extends transitional relief for non-qualified deferred compensation plans

The IRS has provided additional relief to employers that need to get their non-qualified deferred compensation plans in compliance with the new rules under Internal Revenue Code Section 409A.

During 2008, taxpayers are not required to comply with the requirements of the final regulations. They are required to operate a non-qualified deferred compensation plan in compliance with the plan terms, consistent with Section 409A and applicable guidance, including Notice 2005-1, which would previously have been obsolete. If a provision of Notice 2005-1 is inconsistent with the final regulations, taxpayers may rely on either the final regulations or Notice 2005-1. If an issue isn't addressed in Notice 2005-1 or other guidance, taxpayers must apply a reasonable, good faith interpretation of the statute.

Taxpayers may not rely on the proposed regulations for periods after December 31, 2007, except for preamble Sections II.E and VI.E relating to applying Section 409A to partners and partnerships, sections XI.C for changes in payment elections or conditions, XI.H for substitutions of non-discounted stock options and stock appreciation rights for discounted stock options and stock appreciation rights, to the extent provided in Section 3 of Notice 2006-79, as modified in Notice 2007-86.

(Notice 2007-86, I.R.B. 2007-46.)

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Ways and Means Chairman Rangel proposes repealing AMT

House of Representatives Ways and Means Committee Chairman Charles Rangel has introduced a bill, H.R. 3970, which would repeal the alternative minimum tax on individuals, effective for tax years beginning after December 31, 2007. Since tax increases are included to make up for the lost revenue, it is highly unlikely the proposal will pass until President Bush's term of office is over. However, the proposal might be an indication of what might happen if a President is elected who is a Democrat.

The principal replacement for the AMT would be a surtax on "modified adjusted gross income". "Modified adjusted gross income" would be adjusted gross income minus the investment interest deduction. Other itemized deductions and personal exemptions would not be considered for computing the surtax.

A four percent surtax would apply to the excess of modified adjusted gross income over an initial threshold amount. The initial threshold amount for married filing joint or a surviving spouse would be the greater of $200,000 or an amount estimated by the IRS above which at least 90% of married persons filing a joint return would be affected by the alternative minimum tax for the first taxable year beginning in 2008 if it wasn't repealed. The thresholds for married, filing separately would be 1/2 the amount for married filing jointly, and the thresholds for singles and heads of households would be 3/4 the amount for married, filing jointly.

An additional .6% surtax would apply for modified adjusted gross income exceeding $250,000, $500,000 for married, filing jointly or surviving spouses.

The proposed legislation is 129 pages long, including a reduction in the maximum corporate tax rate from 35% to 30.5% and some severe cutbacks of business tax breaks.

This proposal is part of a continuing discussion about the AMT problem, which probably won't be resolved until the next President takes office.

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Stock swap of ISO stock was a disqualifying disposition

Kadayam Subash was an employee at Ecredit.com. He received incentive stock options relating to his employment. During February 2000, International Capital Group (ICG) acquired 30% of the stock of Ecredit in exchange for some of its own stock. The employees of Ecredit were invited to participate in the stock swap.

After the stock swap, in December 2000 and September 2001, ICG made additional cash investments in Ecredit, increasing its ownership interest to 99% at one point.

Subash exercised 28,123 of his stock options on June 7, 2000 and exchanged the shares to receive 14,170 shares of ICG stock. $534,295 was included in Subash's Form W-2 as ordinary income relating to the disqualifying disposition of his ISO shares.

Subash initially included the income on his 2000 income tax returns, but later amended the returns, claiming the swap was a non-taxable transaction.

In a summary judgment, a U.S. District Court in Massachusetts held against the taxpayer. In order to qualify for non-recognition, the "swap" would have to have qualified as a "B" reorganization - acquisition of at least an 80% interest in a corporation solely in exchange for stock. Since most of the Ecredit stock was acquired by ICG for cash, the transactions didn't qualify.

Therefore, Subash had a disqualifying disposition of his ISO shares, despite not receiving any cash in the transaction.

((Subash v. U.S.), U.S. District Court District of Massachusetts, July 12, 2007.)

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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). In order to qualify for a discounted fee, you must register by December 15, 2007. For details, contact Dawn Siemer at mgray@stockoptionadvisors.com or telephone 408-918-3162 weekday afternoons.

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Questions and Answers

Question

I am in the process of preparing W-2 forms for our employees, and have ISO and ESPP disqualifying dispositions for some employees who were not on our payroll for the 2007 calendar year. ADP, our payroll service, has purged them since there was no activity for the year.

Do we need to issue a W-2 for them? They will receive a Form 1099 from the stock brokerage companies for the sale of the stock.

Answer

Yes. You do need to issue a W-2 form for the disqualifying disposition.

The income to be reported is different from the gross receipts from the stock sales. The employees should make a basis adjustment for the ordinary income reported on Form W-2 when they report the stock sales.

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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.