Michael Gray, CPA’s Option Alert #64

An irregular alert for issues relating to employee stock options

January 9, 2009
© 2009 by Michael Gray, CPA
ISSN 1931-2768

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Happy New Year!

2009 is here, at last! We know this will be a year of challenges, so roll up your sleeves!

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Tax preparation materials are on the way

We are mailing instructions to those of you who use the online Tax Notebook this week. If you use a paper organizer, you should have already received it. If we prepared your tax returns last year and you haven’t received instructions by January 15 or you would otherwise like to receive instructions, call Dawn Siemer weekday afternoons at 408-918-3162.

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Make your tax preparation appointment now

If you would like to schedule an appointment for a tax preparation interview, also please call Dawn Siemer weekday afternoons at 408- 918-3162.

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Yes, we do prepare income tax returns!

With our free newsletters and the information we make available at no charge on the web, some people wonder how we make a living. We prepare income tax returns and provide tax and business consulting services. We are accepting selected new clients and are thrilled when our clients and friends refer their friends, associates and family members to us. To inquire about becoming a client of our firm, please call Dawn Siemer at 408-918-3162 or send an email to her at mgray@taxtrimmers.com. We must receive your tax information by March 1 to guarantee delivery by April 15.

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Final 2008 estimated tax payment is due January 15

Remember the final estimated tax payment for calendar-year individuals, estates and trusts is due January 15. You might want to check with your tax advisor about reducing the payment if you had much lower capital gains in 2008 than in 2007, you are entitled to the increased federal refundable minimum tax credit or your facts have otherwise changed.

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’Tis the season to exercise ISOs?

Since stock received from exercising an incentive stock option has to meet two holding period tests (more than two years after grant and more than one year after exercise) to avoid having the excess of the fair market value over the option price taxed as ordinary income, exercising early in the year can be advantageous when you decide to hold the stock after exercise. The reason is you have the alternative of selling the stock before the end of the year of exercise and possibly avoiding the alternative minimum tax if the value of the stock drops after exercise. I call this tax strategy the “escape hatch.”

Be careful about blackouts. Last December, I had some individuals call me who wanted to use the escape hatch, only to discover they were prohibited from selling their shares because they were subject to an employee blackout. Sometimes blackouts can happen unexpectedly, like when an employer becomes a party to a lawsuit. There’s no magic solution in these cases – you could be stuck with a significant tax liability.

For many people, the exercise and immediate sale of the shares is the most comfortable alternative, even if the tax bill is higher.

Also remember the wash sale rules can spoil an “escape hatch” transaction. You can’t repurchase the shares or even receive an employee stock option or buy a put option during the period starting 30 days before the sale to 30 days after the sale.

Another advantage of an exercise early in the year is to be able to meet the holding period requirements and sell the shares before the tax is due on April 15. But check the estimated tax payment requirements to avoid penalties for late estimated tax payments. (The alternative minimum tax liability can also be payable as an estimated tax liability.)

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Certain W-2 reporting of deferred compensation postponed again

The IRS has issued guidance about reporting deferred compensation under Internal Revenue Code Section 409A. The guidance again suspends the requirement to report all deferrals for 2008 under a nonqualified deferred compensation on Form W-2, Box 12 using code Y. A payer is also not required to report the deferrals in Box 15a of Form 1099-MISC.

However, amounts currently taxable as wages are required to be reported in box 1 of Form W-2 and the quarterly payroll tax returns, Form 941. These amounts representing taxable deferred compensation are also reported at box 12 of Form W-2, using code Z. Taxable deferred compensation for nonemployees is included in taxable income at box 7 of Form 1099-MISC and the taxable deferred compensation part is also reported at box 15b of Form 1099-MISC.

Withholding for employees relating to taxable nonqualified deferred compensation should be paid for the fourth quarter 2008 and included on the fourth quarter payroll tax form.

The IRS is permitting employers to pay the tax on behalf of employees and add the payments to the employee’s taxable income.

The IRS also stated that until the Treasury Department and the IRS issue further guidance, compliance with the provisions of the proposed regulations with respect to the calculation of the amount includable in income under §409A(a) and the calculation of the additional taxes under § 409A will be treated as compliance with the requirements of this notice, provided the taxpayer complies with all the provisions of the proposed regulations.

(Notice 2008-115, 2008-52 I.R.B.)

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Guidance issued on computing taxable amounts under 409A

The IRS has issued proposed regulations that are supposed to explain how to compute taxable amounts for nonqualified deferred compensation plans under § 409A. My printout of this document is 65 pages long, so I’m not going to explain them in detail. If you are involved with one of these plans, you should discuss the proposed regulations with your tax advisor.

The proposed regulations state that if at any time during a taxable year a nonqualified deferred compensation plan fails to meet the requirements for tax deferral, it is treated as being disqualified for the entire taxable year.

The proposed regulations do not state that the income from a non- qualified stock option is only taxable when it is exercised. These rules are more clearly explained in ILM 200728042, which isn’t widely available. The authority for not reporting the income until exercise is Internal Revenue Code Section 83, which evidently trumps § 409A until the option is exercised. This is an area where we need some clear guidance, and it’s a big hole in these regulations.

Each taxable year is analyzed independently, so the IRS may elect to make a “catch up” assessment for back years as a current year adjustment. The taxpayer may amend tax returns for open years to report the adjustments for the years they should apply to.

The proposed regulations also provide that service providers who were required to include an amount in income for a nonqualified deferred compensation plan and the benefits are later permanently forfeited under the plan’s terms may claim a tax deduction for the previously taxed amount for the year of forfeiture. The deduction is a miscellaneous itemized deduction.

(REG-148326-05, 73 FR 74380, December 8, 2008.)

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Voluntary correction program for deferred compensation plans explained

The IRS has issued guidance for how certain employers who have operational failures with their nonqualified deferred compensation plans can correct them.

One of the items included is the correction of the exercise price of a stock option.

The failure can be corrected by changing the exercise price of the stock option to not less than the fair market value of the underlying stock on the date of grant before the option is exercised and not later than the last day of the service provider’s taxable year in which the service recipient granted the service provider the stock option. The penalty waiver doesn’t apply to any shares received by exercising the option before the correction is made.

The relief for operational failures is much more generous for non- insider service providers than for insider service providers.

Directors and officers of the service recipient and direct and indirect owners of more than 10% of any class of equity of the service recipient are insiders for this purpose.

Individuals who administer these plans and their advisors should study this notice carefully.

(Notice 2008-113, 2008-51 I.R.B.)

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Questions and Answers

To our readers:

The answers to many of your questions can be found in our free reports, “Executive Tax and Financial Planning For Non-Qualified Stock Options”and “Executive Tax and Financial Planning For Incentive Stock Options”.


Do I have to file 1040-ES and 540-ES for my 2008 disqualified disposition of ISO stock? Will there be any penalty for not doing so?



There will be no penalty if you paid through withholding 100% of the tax on your 2007 income tax returns, or 110% if your 2007 adjusted gross income was more than $150,000.

See IRS Form 2210 and instructions at the IRS web site, http://www.irs.gov.

(By the way, the 2009 California estimated tax rules will be much more complex. You might want to study them at that web site if you expect to have to make estimated tax payments in addition to withholding. http://www.ftb.ca.gov)


For years, I received some ISOs, NQOs and restricted stock from a publicly-traded company. Last year, our division was sold and I had 90 days to exercise my options. I exercised and sold on the same day within the 90 day period.

I paid some estimated tax on my NQOs and restricted stock, but nothing for the ISO shares. I know I owe additional taxes.

I have some capital losses in my other accounts. Can I offset any of the gains on the NQOs and restricted shares with the losses? I know I can’t for the ISOs.


Probably not. If you sold the shares immediately when you received them, all of your income will be taxed as ordinary wages. Capital losses can only be applied to capital gains, plus $3,000 to other income.


I saw your article, “Employee Stock Purchase Plans Compared To Incentive Stock Options.”

Are these rules still in effect, or has the tax law changed?

I am consider selling my ESPP shares immediately after exercise and collecting the 15% gain.

I want to use the money for a downpayment on a home.


Yes. The basic rules are the same. The 15% discount will be taxed as additional wages, and added to your cost of the stock. Any difference between the net selling price of the stock and the cost (including the 15% income) will be a short-term capital gain or loss and should be very small.


I obtained shares of my company by exercising an ISO during March 2008. My company is now sold and the closing date will be early in January 2009. The acquiring company will pay a fixed amount per share for the stock effective on the closing date.

This means I probably won’t be able to meet the holding period requirements to avoid a disqualifying disposition.

Is there a way to postpone the receipt of the payment to get the benefit of long-term capital gains?


No. Even if the payment is postponed, you will merely have an installment sale. It’s questionable whether an installment sale postpones recognition of ordinary income for a disqualified disposition of ISO stock.

It appears you will definitely have a disqualified disposition. However, you might have a minimum tax credit for the alternative minimum tax that is payable relating to the exercise of the ISO during 2008 to offset the 2009 tax.

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 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.

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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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