Michael Gray, CPA’s Option Alert #99
An irregular alert for issues relating to employee stock options
March 12, 2012
© 2012 by Michael Gray, CPA
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Table of Contents
- Tax season is here!
- Late return reminder
- ‘Tis the season to exercise ISOs?
- Medicare tax for 2012 changes ISO tax planning picture
- New channel broadcasts Financial Insider Weekly
- Senators propose limiting corporate deductions for ESOs
- Financial Insider Weekly broadcast schedule
- Questions and Answers
- Follow me on Twitter, Facebook and LinkedIn!
- Check out my blog
- Do you know about our other newsletters?
- IRS Circular 230 Disclosure
- Consult with a tax advisor
- Subscribe to Michael Gray, CPA’s Option Alert!
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 have a secure internet portal for sending documents. Email Dawn Siemer at email@example.com for instructions.
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!
Late return reminder
The IRS has issued a reminder that the last day to file a late income tax return for 2008 and receive a refund is April 17, 2012. After that date, the refund is forfeited.
‘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.”
(See the next article. The Medicare contribution tax has changed the picture for 2012.)
Be careful about blackouts. I have had some individuals call me who wanted to use the escape hatch during December, 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 requirements to avoid penalties for late estimated tax payments. (The alternative minimum tax liability can also be payable as an estimated tax liability.)
Since the Bush tax cuts are scheduled to expire after 2012, 2012 is an especially difficult year for tax planning. We don’t know the alternative minimum tax exemption for 2012. We don’t know what the tax rates for long-term capital gains will be for 2013. We don’t know what the tax rates for ordinary income will be after 2012. We probably won’t have the answers to these questions until after the 2012 Presidential election – maybe not until the year is over!
At least by exercising early in the year, you will have the flexibility to make adjustments later.
Medicare tax for 2012 changes ISO tax planning picture
Part of federal Health Care Reform was a funding mechanism – a 3.8% Medicare contribution tax, effective in 2013. There are two parts of the tax increase. (1) There is an increase in the Medicare employment tax on wages for high-income individuals. (2) A 3.8% tax will apply to unearned “investment income” for high- income individuals.
These taxes apply for married couples with “modified adjusted gross income” exceeding $250,000, single persons with modified adjusted gross income exceeding $200,000 and married persons filing separate income tax returns with modified adjusted gross income exceeding $125,000.
For investment income, the tax applies to the lesser of the investment income or the excess of modified adjusted gross income over the threshold amounts.
Since the tax applies to an amount of modified gross income, it is not an “income tax” that can be offset by the minimum tax credit and itemized deductions don’t reduce the tax. (It’s a “flat tax”! Hooray?)
The tax changes the planning picture for incentive stock options.
Ordinary income from a disqualified disposition of an incentive stock option is considered to be wages, but isn’t subject to employment taxes, such as Medicare tax. (This also applies to ordinary income from the disqualified disposition of stock purchased through an employee stock purchase plan.)
Long-term capital gains from the qualified disposition of ISO stock will be subject to the 3.8% Medicare contribution tax.
If you report ordinary income from the exercise and immediate sale of ISO stock during 2012, the maximum federal income tax will be 35%. (After 2012, the rate is scheduled to increase to 39.6%)
If you exercise and hold ISO shares during 2012 and later sell them for a long-term capital gain in 2013, you will pay 28% federal alternative minimum tax for the “spread” at exercise (excess of the fair market value of the stock at exercise over the option price), plus eventually a 3.8% Medicare contribution tax for the long-term capital gain, or a total of 31.8% on the spread. So, your “tax savings” for holding onto the stock if the value holds up is 3.2%. Is that enough to compensate you for the risk of holding onto the stock? (I don’t think so!)
Unless Congress takes action, the federal tax rate for any long- term capital gains in excess of the initial spread would be 20% “regular tax” + 3.8% “Medicare contribution tax” = 23.8%. This will be a 58.67% increase from the current 15% maximum federal tax rate that currently applies. What a Brave New World we will live in!
MidPeninsula Media Center broadcasts Financial Insider Weekly.
We have added another public access station to the group broadcasting my weekly show. It’s Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton. The show is broadcast on Saturdays at 9 a.m. and 6 p.m.
Senators propose limiting corporate deductions for employee stock options.
Senator Carl Levin, D-Mich., chairman of the Senate Permanent Subcommittee on Investigations, and Kent Conrad, D-N.D., chairman of the Senate Budget Committee, have introduced the Cut Unjustified Tax Loopholes Act of 2012.
Under this proposed legislation, the corporate tax deduction relating to ordinary income reported by employees relating to the exercise of non-qualified stock options and disqualified dispositions of incentive stock option shares would be limited to the amount reported as an expense on the corporate financial statements. Financial reporting relating to employee stock options is completely disjointed from the current corporate tax deduction, which is the amount the employee reports as ordinary income.
The proposed legislation would also include the ordinary income from stock options in the amount subject to the $1 million overall limit on corporate tax deductions that applies to other forms of compensation.
These senators are not our friends. They are seeking to kill a goose that lays golden eggs. Employee stock options are performance-based compensation, and shouldn’t be subject to the $1 million limit.
Write to your representatives in Congress to oppose this proposed legislation.
Financial Insider Weekly broadcast schedule for March and April.
Financial Insider Weekly is broadcast in San Jose and Campbell on Fridays at 8:00 p.m., Pacific Time. You can watch it on Comcast channel 15 for San Jose and Campbell. The show is broadcast as streaming video at the same time at www.creatvsj.org.
Here are the scheduled interviews for March and April:
- March 9, 2012, Lamarr Baxter, The Entrust Group, “Making alternative investments besides real estate using your Roth or IRA account”
- March 16, 2012, Alan L. Nobler, attorney at law, “How a collaborative team can help preserve your legacy”
- March 23, 2012, Raymond Sheffield, attorney, Sheffield Law Office, “Estate and gift tax problems for a non-citizen spouse”
- March 30, 2012, Raymond Sheffield, attorney, Sheffield Law Office, “Estate planning for retirement accounts”
- April 6, 2012, Raymond Sheffield, attorney, Sheffield Law Office, “A survey of estate planning basics”
- April 13, 2012, Robert E. Temmerman, Jr., attorney, Temmerman, Cilley & Kohlmann, LLP, “I’m an executor! Now what?”
- April 20, 2012, Robert E. Temmerman, Jr., attorney, Temmerman, Cilley & Kohlmann, LLP, “I’m a trustee! Now what?”
- April 27, 2012, Richard H. Lambie, professional fiduciary, “The role of the professional fiduciary”
Financial Insider Weekly is also broadcast as follows:
- Sunday at 5:30 a.m. on Comcast Channel 27 in Santa Cruz County and on Charter Communications Channel 73 in Watsonville and Capitola
- Monday at 3:30 p.m.on Comcast Channel 27 in Santa Cruz County and on Charter Communications Channel 73 in Watsonville and Capitola
- Monday at 4 p.m. and 7 p.m. Pacific Time on cable channel 19 in Morgan Hill. Broadcast on the internet at the same time as streaming video at www.mhat.tv
- Monday at 7:30 p.m. on Comcast channel 15 in Saratoga
- Tuesday at 4 p.m. and 7 p.m. Pacific Time on cable channel 19 in Morgan Hill. Broadcast on the internet at the same time as streaming video at www.mhat.tv
- Tuesday at 9:00 p.m. on Comcast channel 26 and AT&T U-verse channel 99 in Marin County
- Wednesday at 8 p.m. on Comcast channel 28 in Hayward, Alameda and Fremont and on AT&T U-Verse Channel 99, Hayward public access TV 28 in California
- Thursday at 5:30 p.m. on Comcast channel 27 in Santa Cruz County and Charter Communications channel 73 in Capitola and Watsonville
- Friday at 4 p.m. on cable channel 15 in Cupertino, Los Altos and Mountain View
- Friday at 4:30 p.m. on Comcast channel 15 in Los Gatos
- Friday at 6:00 p.m. on Comcast and Astound channel 29 in San Francisco, online streaming video at www.bavc.org, “public access TV”
- Friday at 8:00 p.m. on Comcast channel 28 in Hayward, Alameda and Fremont and on AT&T U-Verse Channel 99, Hayward public access TV 28 in California
- Saturdays at 12:30 p.m. on Comcast channel 27 in Santa Cruz County and on Charter Communications Channel 73 in Watsonville and Capitola
- Saturdays at 9:00 a.m. and 6:00 p.m. on Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton
Past episodes are available at https://www.youtube.com/user/financialinsiderweek.
Let me know any ideas that you have for topics or guests. Guests will usually have to be located in or near the Silicon Valley in California.
Hope you can watch or record the show. Please tell your friends about it!
Michael Gray regrets he can no longer personally answer email questions. He will answer selected questions in this newsletter.
For your questions about dependent exemptions, see IRS Publication 501 at www.irs.gov.
Questions and Answers
Michael Gray regrets he can no longer answer emails personally. He will answer selected questions in this newsletter. Email your questions to firstname.lastname@example.org.
I am ready to exercise my stock options that were incentive stock options when they were granted. I took early retirement a couple of years ago. The stock options administration department at my former employer has informed me that the options are now non- qualified stock options, and will be subject to income tax withholding.
Is this true? Have the rules changed?
Yes, it’s true.
The rules haven’t changed.
Under Internal Revenue Code Section 422(a)(2), in order for an option to be an incentive stock option at the time of exercise, the individual must have been an employee of the corporation granting the option or a parent or subsidiary of the corporation during the period from the grant of the option to the date three months before the date of exercise.
You are actually fortunate that your former employer allowed you to convert the options to non-qualified stock options and keep them beyond the three-month period after terminating employment. In most cases, ISOs lapse after that period.
Count your blessings.
If a retiree from a company exercises non-qualified stock options, can the income reported on Form W-2 with respect to the options be considered “earned” for making a contribution to a Roth IRA?
The IRS answered a similar question relating to a contribution to an IRA some time ago.
They said income from exercising a non-qualified stock option is considered to be a form of nonqualified deferred compensation, not qualifying for computing a Roth or IRA contribution.
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Do you know about our other newsletters?
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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.
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.)