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By Michael Gray

Table of Contents

• Goodbye to ESOAA – A Heart to Heart Talk
• Last chance to buy educational materials online
• Recording available of November 12 telephone conference
• Should you use the "escape hatch" for your ISO shares?
• FASB says options must be expensed in 2005
• Senators propose accounting compromise for employee options
• Grassley proposal would accelerate income from option exercises
• Questions and Answers
  • Must I accept my employer's valuation of their stock?
  • Can I eliminate AMT by exchanging shares?
  • Would an 83(b) election make our income taxable in the US?
  • Can I delay my income from NQSOs by holding the stock?
  • How do I find someone to purchase my stock?
  • Can I avoid taxes by giving my options to charity?
• Consult with a tax advisor

Goodbye to ESOAA -- A Heart to Heart Talk

This is the final issue of the ESOAA Option Alert. It will be replaced by Michael Gray, CPA's Option Alert. Only the name will change; the content will be the same.

There hasn't been enough interest in our resource products and services to support a separate entity, so the purpose of the web site, www.stockoptionadvisors.com, and the newsletter will be to market services for my CPA firm, Michael Gray, CPA.

The Employee Stock Option Advisors Association, LLC has been a great learning experience. We originally set up the company on September 25, 2000 -- just in time for the market crash. I guess the timing just wasn't right. We were never successful in assembling a list of professionals willing to pay for participating in the association to market their services to employee option holders.

This also means an updated version of the Secrets of Tax Planning For Employee Stock Options reference manual will not be issued.

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Last chance to buy educational materials at our Web Site

We have some excellent educational materials at our web site that will be discontinued, including video tapes, audio tapes and CDs of our two-day seminar during November, 2001, recordings of other seminars and teleconferences, and the Secrets of Tax Planning For Employee Stock Options reference manual with optional recordings.

We will discontinue offering them on the web site because we are closing our online merchant account relating to terminating ESOAA.

Michael Gray, CPA will stand behind your satisfaction guarantee.

Please go to our web site, www.stockoptionadvisors.com, click on "Educational Materials" and make your order before December 15, 2003.

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Recording available of November 12 telephone conference

Michael Gray, CPA made an excellent telephone seminar presentation on November 12, "Secrets of Tax Planning For Employee Stock Options Under The New Tax Laws."

The presentation, covering non-qualified options, incentive stock options, and employee stock purchase plans, lasted about an hour.

You can get a recording of the conference for $129 plus $1.50 shipping. California residents are subject to sales tax of $10.64.

To order a copy, visit our web site, www.stockoptionadvisors.com/newtaxlaw.shtml or call Dawn Siemer at 408-918-3162 by December 15, 2003. Michael Gray, CPA will honor your satisfaction guarantee.

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Should you use the "escape hatch" for your ISO shares?

Employees who exercise incentive stock options and hold the stock are sometimes unpleasantly surprised to learn they are subject to an alternative minimum tax based on an adjustment for the excess of the fair market value on the date of exercise (or later vesting date) over the option price. If the stock has dropped in value, the employee may find he or she owes a tax that exceeds the value of the stock!

There is an "escape hatch" built into the Internal Revenue Code. If the stock is sold before the end of the year of exercise and the transaction would qualify to report a loss if one was realized, ordinary income is reported for the lesser of the selling price of the stock or the fair market value on the date of exercise (or later vesting date) over the option price.

For example, Jane exercised an ISO on February 1, 2003. The stock received was fully vested. The fair market value of the stock received was $110,000 and the option price was $10,000. As of December 31, 2003, the fair market value of the stock is $10,000. If Jane held the stock after December 31, 2003, she would have an AMT adjustment for the ISO exercise of $100,000.

If Jane sold the stock for $10,000 on December 31, 2003, the ordinary income would be limited to the excess of the selling price over the option price, or zero.

The escape hatch isn't available if a loss would be disallowed for the transfer, such as a gift instead of a sale or a wash sale. The wash sale rule applies if identical stock is purchased during the period 30 days before or 30 days after the sale. It can also apply when you purchase an option to buy the stock during that period. You need to be especially careful during that period not to buy additional shares by exercising another employee stock option, including exercising another ISO or NQO, or purchasing ESPP shares.

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FASB says options must be expensed in 2005

The Financial Accounting Standards Board has indicated that it intends to require employers to report an expense on their income statements, effective in 2005.

In response to arguments about the difficulty of valuing the options, the FASB says it will allow employers to use any reasonable method, so long as they can justify it as most appropriate under the circumstances. The values computed under most of the accepted methods in the field will usually be close to the same.

The final rules on reporting for grants of stock options to employees are scheduled for release in the second half of 2004.

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Senators propose accounting compromise for employee options

A bipartisan group of senators are submitting proposed legislation to resolve the issue of whether an expense should be reported on a company's income statement for stock options granted to employees. Under the proposed legislation, an expense would only be reported for the five highest-paid executives.

The Financial Accounting Standards Board will oppose this proposal because it is not based on an accounting principle, but on expediency.

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Grassley proposal could accelerate income from option exercises

Senate Finance Committee Chairman Charles Grassley released his mark for a pension reform bill, the "National Employee Savings and Trust Equity Guarantee Act", on September 15.

There are three provisions relating to employee stock options in the proposed legislation.

One proposal would deny deferral of income tax beyond the exercise date of stock options. As I understand it, the postponement of tax until the stock received was vested or was not subject to restrictions under SEC Rule 16b would be lost. This would be like a "forced" Section 83(b) election and could create a hardship for some employees who would owe a tax but would not be able to sell their stock to generate the cash to pay it. (Many tax advisors favor changing the current rule so that the default would be to tax the gain at exercise and the employee could elect to postpone reporting the income until the stock vests.)

Another proposal would increase the withholding rate to the highest marginal tax rate on supplemental pay over $1 million. Right now, the highest marginal tax rate is 35% and the withholding rate for supplemental pay is 25%. Taxpayers often find they owe additional tax on April 15 after the year of exercise of a non-qualified stock option. Under the proposal, an employee would probably have an overpayment of tax when there is an offsetting deduction for state income taxes.

The final proposal would provide that employment taxes don't apply for the exercise of qualified stock options (ISOs and ESPPs). This codifies the current situation. The IRS has indefinitely suspended imposing employment taxes for exercising qualified stock options.

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Questions and Answers

Question

I hold vested NSOs in a private company and would like to exercise but the owners of the company are putting an unreasonable valuation on the company and making it impossible to consider given the tax consequences. I think this is because these options expire in 2 years and they represent about 8% of the company.

They say the FMV for the company is $5 per share and I say it is $2 based on industry conditions and comps. Even if we do agree on the FMV for the company, how do you come to an appropriate price for the minority stock that is severely restricted by a shareholder agreement?

Do I have any alternative paths to pursue? Can you refer me to similar precedent or law?

Answer

The fair market value of stock that is not publicly traded is a difficult one. If the issue is litigated, it is a question of fact to be established by the taxpayer.

The employer is given considerable leeway in its representation of value, but the employee can dispute the value asserted by the employer. The best way to do this is to get an independent appraisal by a qualified appraiser. This is an expensive process and usually requires the cooperation of the employer's accounting department. Employees in this position are entitled to valuation reductions for lack of control and lack of marketability.

There is clearly a conflict of interest in the value determined. The employer gets a tax benefit in the form of a higher deduction for a high value. The employee prefers to minimize income, favoring a low value.

Find out if there are other employees in the same position as you. Maybe you can split the cost of an appraisal. You will want to work with a tax return preparer who is an attorney, CPA or enrolled agent on this issue.

Question

Does an exchange of company shares when exercising an ISO change the AMT result? What authority can be cited to support your response?

Answer

The AMT adjustment reported when the option price is paid by a swap of previously-owned shares of the same stock is the same as when the option price is paid using cash.

The explanation/authority is the AMT adjustment is determined under the same rules that usually apply to non-qualified stock options. (IRC § 56(b)(3)). The rules that apply to non- qualified options are explained at Revenue Ruling 80-244.

Question

We are two Dutch nationals about to form a Delaware corporation.

We are considering filing an 83(b) election because we want to attract investors.

We are also considering moving to the States, in which case we would become US taxable, but this is not certain.

Does filing an 83(b) election mean that we will be taxable in the States when selling our stock, even if we are not taxable in the States?

Answer

The § 83(b) election relates to property received in connection with employment. It doesn't have anything to do with attracting investors.

Whether you will be subject to US tax relates to whether you are a US resident or are compensated for services rendered in the US.

You really should find a tax advisor who knows US tax law to work with. Since you are Dutch nationals, you have special problems that favor retaining an international accounting firm.

Good luck!

Question

I plan to retire at the end of this year and I have some non- qualified stock options that I have not exercised yet. Since I must exercise them before I retire or lose them, I obviously need to exercise them soon. Is there any advantage to exercising and holding the stock versus exercising and selling it? My wife's income has been very good this year, and I didn't want to increase our joint income any higher because of the tax consequences. Is there anything I can do to limit the tax impact of exercising these NQSOs?

Answer

Assuming your employer is a publicly-traded company, there is no tax advantage in not selling the stock after exercise. Is there any possibility you can postpone your retirement until early next year? Since you income will presumably go down, you should be subject to tax in a lower tax bracket by waiting until next January to exercise your options.

Question

I recently had to go on medical disability and need to sell shares from exercising options from my previous employer, an SSF- based pharma. I have 6,200 fully-vested shares. I checked with the company's general counsel and he said that I was free to sell the shares to a third party. I'd then have to complete some paperwork with their outside counsel to complete the transaction. How do I go about finding someone to purchase these shares?

Answer

If the company is publicly traded, you should be able to sell them through a stock broker.

If the company is not publicly traded, your best bet is to either have your shares redeemed by the company or to find another shareholder who wants to own more of the corporate stock. Either choice is going to require some legwork to make the connection you need. Unless you can find someone who is just short of owning the majority of the corporate stock, you will not be in a strong bargaining position to get a good price for your stock.

Good luck!

Question

I currently have 200 NQSOs, and was wondering if it is possible to gift the shares without exercising them. I understand that if I exercise the shares, they are taxed as ordinary income. I don't need the shares or the money that would come from it. I wanted to make a gift to a local charity because I am fortunate enough to be in a position to do so, and they do a wonderful job in my community.

If that cannot be done, can I do a swap with shares I currently own to reduce my taxes?

Answer

You might be able to make a gift of the options to a charity. Find out your company's policy.

Making the gift will not eliminate your income. This would be an assignment of income, which isn't allowed during your lifetime. When the charity exercises the options, you will have ordinary income reported on Form W-2. You should have an offsetting tax deduction for the charitable contribution, possibly limited to 50% of your adjusted gross income.

Paying for exercising a non-qualified option with previously- owned shares would permit you to avoid paying tax relating to the transfer of the surrendered shares. Your ordinary income would be the same as if you paid for the shares with cash.

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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. We intend to eventually publish a directory of ESOAA members who are committed to helping clients with employee stock option issues.

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 http://www.amazon.com or http://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.