Michael Gray, CPA’s Option Alert #65

An irregular alert for issues relating to employee stock options

February 5, 2009
© 2009 by Michael Gray, CPA
ISSN 1931-2768

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Tax season is here! Make your appointment now!

There are only about two and one-half months left before the tax return due date. Time to get started now!

If we prepared your income tax returns last year, you should have already received instructions in the mail. If you haven’t, please call Dawn Siemer at 408-918-3162.

To have us prepare your income tax returns, start with the online Tax Notebook organizer. Call Dawn Siemer at 408-918-3162 for instructions to get started. We also have a paper organizer, if you prefer. We still need your documents (W-2s, 1099s, receipts for donations) to prepare your income tax returns.

We can prepare most income tax returns using information provided online and by mail. If you wish a personal meeting, please call Dawn Siemer at 408-918-3162 to schedule an appointment. Our calendar is filling up fast!

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Federal stimulus proposal is in process

President Obama is encouraging Congress to pass an economic stimulus package, including significant tax provisions, by February 15. The House of Representatives has passed its version of the legislation, and the Senate is now working on its version. The tax changes would mostly apply starting in 2009. I’ll provide some details when it passes.

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Deduction disallowed for redemptive dividends to ESOP

The Eighth Circuit Court of Appeals reversed a federal district court ruling and said that dividends paid to an ESOP in order to redeem stock so that benefits could be paid in cash to an ESOP participant were not tax deductible for the corporate sponsor. This decision is contrary to a ruling by the Ninth Circuit Court of Appeals in Boise Cascade (329 F. 751 (9th Cir. 2003)).

According to the Eighth Circuit, the deduction that would otherwise be allowed under Internal Revenue Code (IRC) § 404(k)(1) is barred by IRC § 162(k)(1). “Except as provided in paragraph 2, no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred by a corporation in connection with the redemption of its stock.” § 162(k)(1) was enacted two years after § 404(k)(1).

The Ninth Circuit and the taxpayer in this case, General Mills, emphasized the two-steps required of paying the dividend to the ESOP and the redemption of the stock as distinctive and creating an exception from § 162(k)(1). The Ninth Circuit said the Trustee’s duty to pay the participant was not contingent on the company’s payment to the Trustee for the redeemed stock. The Ninth Circuit also said the disallowance should only apply to expenditures “necessary and incident” to stock redemptions.

The Eighth Circuit said the committee reports indicated the statute should be applied broadly. It also said the “two steps” were so intertwined that they couldn’t be separated. It was clear the dividend was paid for the purpose of redeeming the stock.

Since we have a disagreement between Courts of Appeal, the stage is set for a Supreme Court ruling, should this case be further appealed.

(General Mills, Inc. v. U.S., (CA 8 1/26/2009.)

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Non-Qualified Options aren’t “qualified deferred compensation” for state tax reporting

The California State Board of Equalization upheld the California Franchise Tax Board in denying a claim for refund by a taxpayer relating to California-source income that was taxable when a non- qualified stock option (NQSO) was exercised.

The taxpayer lived in California from April 1998 until May 2002. In January 2001, he was granted NQSOs by his employer. After working for the employer for more than 22 years, the taxpayer retired on March 22, 2002 and moved to Florida. In 2005, the taxpayer exercised the option, realizing $78,769 of option income, which was reported on his 2005 Form W-2.

The taxpayer filed a refund claim, stating the NQSO income should not be taxable income because it was retirement income that should not be taxable in the former state of residence under 4 U.S.C. § 114. Alternatively, the taxpayer said California should only be able to tax the portion of the value of the NQSOs that occurred while the taxpayer was domiciled in California.

The SBE cited an U.S. Supreme Court ruling, LoBue, in finding that the income from the exercise of the NQSO was taxable wages, not retirement income.

In addition, the income from exercising the NQSO is sourced to the state where the services were performed. Since the services were only performed in California, the income was totally taxable in California.

(Appeal of Grubic, (December 16, 2008) Cal. St. Bd. Of Equal. Case No. 3804188 (not to be cited as precedent).)

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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”.


I am no longer a resident alien because I now live in Singapore and gave up my green card. I want to exercise non-qualified options for services that were rendered when I was living in California for a U.S. company. I no longer have to file U.S. taxes, but would this be a taxable event?


I’m not an expert on tax matters for non-residents of the United States. Based on what you have said, this is U.S. source income and California source income, subject to income tax by the U.S. and California. Your former employer should withhold income taxes relating to the exercise of the options and issue a W-2 for the taxable wages.


Your web site was GREAT/helpful for explaining the 2008 ISO AMT change enacted by Congress!

Were any similar reforms enacted for ISO/AMT by the State of California.


No. California has not conformed to these changes and, considering its financial condition, I don’t expect California to conform. Unused minimum tax credits aren’t as big of a problem for California because the regular tax rate for the sale of stock (9.3%) is greater than the AMT rate (7%). There is still a problem when a huge value at the time an incentive stock option is exercised is erased by a declining stock market.


I made a same day sale during 2008 of shares received when I exercised an incentive stock option granted in 2001. The income was reported on Form W-2 by my employer.

    1. Can this be treated as capital gain, eligible for reduction by my capital losses?
  1. I didn’t make estimated tax payments for the tax relating to the exercise and sale of the stock. Will there be a penalty?


I suggest that you read my report, “Executive Tax Planning For Incentive Stock Options” (see above), or get a copy of our book, Employee Stock Options – Executive Tax Planning.

    1. No. The income is taxable as wages, not capital gains. That’s why it’s reported on Form W-2. Remember to increase the tax basis of your stock on Schedule D for the related wages when your report the sale of any shares reported on Form 1099B.
  1. Assuming your 2007 adjusted gross income was more than $150,000, as long as you paid at least 110% of your 2007 income taxes through withholding, there won’t be a penalty for underpayment of estimated tax. Otherwise, a penalty could apply. It’s like interest, not a serious penalty.


I received company options while working for a company in the state of Washington. My company was bought by a California company, which offered me a position in California. After two years, I left California, bought a house in Washington and registered to vote. My company withheld California state taxes. We petitioned in submitting our return and were given back income taxes paid for 2004. Over the last six months, the Franchise Tax Board is asking for a portion of that money back plus interest.

Am I responsible for paying this? None of the options exercised were granted in California.


Some of the option income is probably taxable in California. Even though the options were granted, you continued working for the company for a period of time in California. See Franchise Tax Board Publication 1004, Stock Option Guidelines. The web site is http://www.ftb.ca.gov.

If you need additional support on a fee basis, let me know.

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

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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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