Michael Gray, CPA’s Option Alert #52

An irregular alert for issues relating to employee stock options

April 10, 2008
© 2008 by Michael Gray, CPA
ISSN 1931-2768

(If you find this information valuable, please pass it on to a colleague!)

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Michael Gray quoted in the Wall Street Journal

Michael Gray was interviewed and quoted in the Wall Street Journal article, “When to Exercise Options” on page D4, Thursday, March 27, 2008.

The article focused on upcoming changes in the tax laws to be considered in deciding whether to exercise employee stock options sooner instead of later. The reductions in the maximum tax rate to 35% from 39.6% and the reduction in the long-term capital gains rate to 15% from 20% are due to expire after 2010.

We have reminded clients and prospective clients to keep these changes in mind as a consideration in the decision-making process.

Michael Gray was also consulted for an upcoming article in the Wall Street Journal that should be appearing this week about common errors made on income tax returns for reporting employee stock option transactions.

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Only 4 days left in tax season! Time to think about extensions

There isn’t enough time left to give preparing tax returns the attention they deserve, but we can help a few more new clients with extensions and finish their returns later. To make an appointment, please call Dawn Siemer weekday afternoons at 408- 918-3162.

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Extensions – and when you don’t have the money to pay the tax

(This is a reprint from past newsletters.)

What do you do when you don’t have the money to pay the tax?

My first recommendation is to file your income tax returns, certified mail, by the initial filing date. One of the nastiest penalties in the IRS’s arsenal is for late filing – 5% per month to a maximum of 25%. Some people who owe money don’t file their returns because they are afraid. THIS IS A HUGE MISTAKE! The best approach is to be honest about your situation and work with the tax authorities to resolve it.

When you file an extension, any balance of tax due when the tax return is filed represents an exposure for the late filing penalty.

Please don’t misunderstand me. I regularly use extensions for my clients and myself as a workload “safety valve”. We often don’t have the information to complete a return by the due date. They just aren’t appropriate when there will be a significant balance due that won’t be paid by the original filing due date.

Remember the automatic extension of time to file for 2007 income tax returns is for six months to October 15, 2008.

Remember to state a good (high side) estimate of total tax liability for 2007 on line 4 of federal Form 4868 or the extension will be invalid. According to the Treasury regulations for the requirements to file a valid automatic extension request, “an application for extension must show the full amount properly estimated as tax for the taxable year.” (Reg. § 1.6081-4(a)(4).) The regulations relating to reasonable cause for failure to file a tax return state that if a taxpayer satisfies the requirement of showing the full amount estimated as tax, the taxpayer has a reasonable cause for failure to file during the extension period provided (1) the excess of the amount of tax shown on the return over the amount of tax paid by the original filing date (including the amount paid with the extension form) is no greater than 10 percent of the amount shown on the return (restated, 90% of the tax is paid by the due date), and (2) any balance due shown on the return is paid with the return. (Reg. § 301.6651-1(c)(3).)

(For California taxpayers, the extension is paperless so the amount of the tax need not be stated. You are still required to pay at least 90% of the tax by the original due date with Form FTB 3519 to avoid the late filing penalty.)

If you have filed an income tax return for 2006, you can process your federal extension electronically (using tax return preparation software or through a tax return preparer). If you make a tax payment using a credit card, you can extend your income tax return by calling 888-729-1040 or 800-272-9829 by April 15. (For California extension payments, the extension is 1555.) Better call early to beat the rush! Mailing a paper form is still acceptable and is the only way a person who didn’t file a 2006 income tax return can request an automatic extension.

You can also make a credit card payment online at www.pay1040.com or www.officialpayments.com. California also has a web payment option at www.ftb.ca.gov.

A taxpayer can still avoid the late filing penalty by demonstrating a “reasonable cause,” but this can be a hassle and the taxpayer is at the mercy of the subjective judgment of a representative of the tax authority.

Should you borrow using a margin account? In most cases, this is not a good choice because of the exposure to margin calls if the market declines.

Should you use an equity advance loan, secured by your principal residence? In some cases it might be to your advantage, if you can get a favorable interest rate. Remember that interest for an equity loan not used for home improvement is only deductible on a loan amount up to $100,000. This interest is not deductible when computing the alternative minimum tax.

Remember that IRA accounts and even other retirement accounts can be temporary sources of funds. Distributions from IRAs that aren’t minimum required distributions can be rolled over to another IRA or returned to the same IRA within 60 days after a withdrawal. This exception only applies to one rollover per year. (You must wait more than one year after a rollover is completed before making another one.)1

Certain distributions from other qualified plans can also be rolled over within a 60-day period to an IRA or another qualified plan.2 Using IRAs or qualified plans as a temporary source of funds to pay taxes can be useful if the funds to complete the rollover will soon be available, such as when there is a lockout “window” that will soon be open. The cost of an error can be high, because if the rollover isn’t completed before 60 days have expired, the distribution may be subject to tax as ordinary income plus a 10% early distribution penalty.3

The IRS has a form for installment agreements, Form 9465. They would prefer that you submit the form with your income tax return. You can take up to five years to pay off your tax liability. An advantage of arranging an installment agreement is the penalty for late payment of tax is reduced from 1/2% per month to 1/4% per month. In addition to penalties, interest is charged for late tax payments. The interest rate is adjusted quarterly. Recently, the rate has been eight percent.

Another alternative is to make an Offer in Compromise, Form 656. With this procedure, the IRS actually can reduce your tax based on your ability to pay. You don’t have to wait until you have owed the tax a long time to use this procedure. I think it’s best to work with an attorney, CPA or enrolled agent when making an Offer in Compromise. If the amount is large, an attorney is probably the best choice.

Although it may provide relief from your other creditors, bankruptcy doesn’t offer much help for recent debts for income taxes. When you make payments on your tax bill, be sure to specify to apply the payments to taxes due. Penalties and interest are dischargeable in bankruptcy, but income taxes aren’t.

It may be to your advantage to plan how to use regular tax or alternative minimum tax capital loss carryovers or minimum tax credit carryovers. You might need to generate capital gains, which can be difficult when you’re in financial distress.

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First individual estimated tax payment is due April 15

(This is a reprint from past newsletters.)

Remember to review your estimated tax situation for 2008.

There is no estimated tax penalty provided the taxpayer pays at least 90% of the tax (including AMT) on the current year’s tax return through withholding and/or equal quarterly estimated tax payments.

For taxpayers who have no more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year’s income tax return, there is no penalty for underpayment of estimated tax provided at least the income tax on the previous year’s income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.4 For taxpayers who have more than $150,000 of adjusted gross income ($75,000 for married persons, filing separately) on the previous year’s income tax return, there is no penalty for underpayment of estimated tax provided at least, for 2008, 110% of the income tax on the previous year’s income tax return (including AMT) is paid in equal quarterly estimated tax payments plus withholding.5

Taxpayers who have uneven income and deductions may also compute their estimated tax on an “annualized” basis. You multiply the year to date income and deductions to arrive at amounts for a year, compute the tax for that amount, then pay amounts to cumulatively pay in 1/4, 1/2, 3/4 and 100% of those amounts. You should probably get help from a professional tax return preparer to do this.

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IRS says include stock compensation for offshore income allocation

The IRS has issued a coordinated issue paper reiterating its position that stock-based compensation, including non-qualified stock options, non-deductible expenses from ISOs and ESPPs, and stock grants must be included in costs for allocating income between US and offshore entities and activities in a qualified cost sharing arrangement under Treasury Regulations Section 1.482- 7.

The IRS disagrees with a Tax Court ruling in Xilinx Inc. v. Commissioner (125 T.C. 37 (2005)) and has appealed that decision to the Ninth Circuit Court of Appeals. The Tax Court held an IRS adjustment including stock based compensation in the pool of shared costs to be “arbitrary and capricious” because they were contrary to the arm’s length standard mandated by Treasury Regulations Section 1.482-1(b).

The Xilinx case relates to regulations issued during 1995, which were later updated in 2003.

The IRS says a qualified cost-sharing arrangement must reflect all relevant costs, including stock based compensation.

(LMSB-04-0208-005, March 24, 2008.)

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Are either you or your spouse not a US citizen?

If either you or you spouse are not a U.S. citizen, you should read our article, “Having a non-citizen spouse can result in gift tax headaches.” It was included in the April 2, 2008 issue of Michael Gray, CPA’s Tax and Business Insight.

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Questions and Answers


I just realized that my employer has been reporting my ordinary income from disqualifying sales of ISO shares on my W-2 for past years. Not realizing this, I also reported the sales from Form 1099B into Turbo Tax. The software didn’t ask whether the proceeds were included in W-2 wages. As a result, I have double reported the income.

I know other people who have made the same error.

What should we do?


You should file amended income tax returns to recover the overpaid tax.

The federal form is Form 1040X.

Assuming you filed by April 15, 2005, your deadline for an amended 2004 income tax return is April 15, 2008.

We do this all the time. It’s a common error.


I exercised incentive stock options (ISOs) in February, 2007 and sold the shares in the same year (June, 2007.) I left the company during February, 2007.

Should the gain have been reported on my W-2 from the company or Form 1099? (I received the 1099-B statement for the sale but the income was not on my W-2.)

Am I subject to Medicare taxes for the ordinary income?


Your former employer should have reported the income on your W-2. In order for them to do this, you would have to notify the employer of the date of sale and the selling price for your sale of the stock.

The sale is still reported on Schedule D. Add your ordinary income to the option price to get the tax basis or “cost” of the stock to report on Schedule D.

The ordinary income from the disqualifying disposition of ISO stock is not subject to employment taxes like Medicare tax.


The company for which I hold ISOs was delisted from NASDAQ in 2005 because the company did not file its 10K with the SEC in 2004. Unless the company can file its delinquent financial reports, we will not be able to register shares with the SEC to eliminate the Restriction on Transfer for exercised ISO shares.

If I exercise ISOs, do I have to pay AMT when I file 2008 income tax returns?


If the fair market value of the stock on the date of exercise exceeds the option price, the additional AMT income must be reported on Form 6251.

However, since the shares can’t be sold on an exchange, the fair market value of the stock should be reduced for lack of liquidity and lack of control. Your company should have a valuation study done to determine the fair market value, including these valuation reductions.


I exercised non-qualified stock options for 40 shares of stock. The ordinary income was included in wages on my W-2 form. Do I still need to report the sale on Schedule D?


If you received a Form 1099-B for the sale, you still need to report the sale on Schedule D. Add the ordinary income included on your W-2 to the option price to compute to tax basis or “cost” for Schedule D, which should eliminate the gain on that form. If you don’t report the sale, the IRS will probably send you a letter saying you underreported your income.


Can stock option plans of foreign corporations qualify as ISOs?


Yes. However, there are a lot of technical requirements to qualify to be an ISO, including stating on the option grant that it is an ISO. If a foreign company wants to issue employee stock options qualifying as ISOs for their U.S. citizen or U.S. resident employees, it should have a good lawyer help it create and implement the plan.

Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter.

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Do you know about our other newsletter?

For general tax developments, tax planning ideas, business development ideas and book reviews, subscribe to Michael Gray, CPA’s Tax & Business Insight.

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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 author of Secrets of Tax Planning For Employee Stock Options, Stock Grants and ESOPs.)

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