Michael Gray, CPA’s Option Alert #110

An irregular alert for issues relating to employee stock options

March 14, 2013
© 2013 by Michael Gray, CPA
ISSN 1931-2768

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

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Make your tax preparation appointment now

If you would like to schedule an appointment for a tax preparation interview, please call Dawn Siemer on a Monday, Wednesday or Friday at 408-918-3162. (Appointments are generally scheduled on Tuesdays and Thursdays.)

We will do our best to have tax returns submitted to us by March 15 completed by April 15. We will probably apply to extend the due dates for any tax returns for which we receive the information after March 15.

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IRS efiling delayed for some tax returns

IRS efiling programming has been delayed for several forms. The IRS says it should be able to process most of them by the end of this week. The software vendors will also have to update their software to process the forms for efiling. Unfortunately that will delay completing the tax returns and delivering them to clients.

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Unhappy results from late filing of income tax returns

I have been having some new clients coming to me to catch up on filing late income tax returns, and also have some continuing clients who have gotten behind.

Be aware that the IRS and Franchise Tax Board can prepare income tax returns for you, called a Substitute For Return. Although you can amend a Substitute For Return, any tax due for that year can’t be discharged in bankruptcy.

Also, when a tax return is more than two years late, you lose any refund that you may be entitled to.

Avoid being late with your tax return filing. It leads to continuing to be late in future years, and is a very bad habit.

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Amended returns deadlines

Sometimes corrections need to be made for tax returns that have already been filed. For example, a refundable minimum tax credit may have been missed. Another example is a taxpayer may wish to make a claim for a refund for an aggressive tax position with limited time for the tax authorities to raise other issues.

The deadline for filing an amended return for a 2009 federal individual income tax return filed by April 15, 2010 is April 15, 2013. The California deadline is one year later, April 15, 2014. (So amended 2008 California individual income tax returns are due April 15, 2013.)

The deadline for a 2009 federal corporate income tax return filed by March 15, 2010 is March 15, 2013. The California deadline is one year later, March 15, 2014. (So amended calendar year 2008 California corporate income tax returns are due March 15, 2013.)

Tax season is a hard time for working on amended income tax returns, but sometimes it’s necessary. If you think you might need an amended income tax return prepared, tell your tax return preparer now.

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Common employee stock option reporting errors

As we move into the last month of tax season, here are some timely reminders of common errors when reporting stock option transactions.

  1. For non-qualified stock options, reporting the option price as the cost of the shares on Schedule D. Since the ordinary income from exercising a non-qualified stock option is usually included as wages on Form W-2, this will result in double-reporting the income. Add the compensation amount to the tax basis of the stock reported on Schedule D.
  2. For non-qualified stock options, reporting the entire gain as capital gain. The compensation portion, usually the excess of the fair market value on the date of exercise over the option price, is ordinary income (usually wages), and isn’t eligible for offset by capital losses.
  3. Reporting withholding at exercise as withholding relating to the sale of the stock. The withholding at exercise should be included in the withholding amounts reported on Form W-2, so the withholding amount could be doubled up, resulting in later correspondence with the tax authorities.
  4. Omitting the alternative minimum tax adjustment for exercise of an incentive stock option on Form 6251. The information should be reported by the employer on information return Form 3921.
  5. Reporting the alternative minimum tax adjustment when the ISO stock is sold during the year of exercise. When there is a disqualified disposition during the year of exercise and there was no “wash sale” for the stock, the AMT doesn’t apply because ordinary income (additional wages) is already reported for the taxable year.
  6. Missing disqualified dispositions of ISOs and ESPP shares made after the employee leaves employment. These transactions should be reported to the former employer and the income from the disqualified disposition reported as additional wages on Form W-2.
  7. Omitting reporting ordinary income for a qualified disposition of ESPP shares. The lesser of the 15% discount based on the fair market value on the grant (subscription) date or the gain from the sale of the stock should be reported as ordinary income. This amount is added to the cost of the stock for the tax basis on Schedule D.
  8. Failing to report ordinary income for ESPP shares owned at death on the final income tax return. The 15% discount based on the fair market value on the grant (subscription) date is taxable on the final income tax return. (Missed by almost everybody.)

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Summary judgment in favor of the IRS for option valuation case

Internal Revenue Code Section 409A, classifying non-qualified stock options issued at a discount as deferred compensation subject to a 20% penalty tax, was enacted during 2004. IRS issued some preliminary guidance in Notice 2005-1 and final regulations were issued during April 2007.

Dr. Sehat Sutardja was granted non-qualified stock options by Marvell Semiconductor, Inc. on December 26, 2003. He exercised the options during January 2006.

The IRS issued a Notice of Deficiency, claiming that Dr. Sutardja was subject to the 20% tax in the amounts of $3,172,832 and $304,456.

Dr. Sutardja requested a summary judgment from the U.S. Court of Claims to the effect that first, Section 409A shouldn’t apply to discounted nonqualified stock options, at least until the IRS issued final regulations, based on an earlier Supreme Court ruling in Smith (45-1 USTC 9817.) The Court found language in the Smith ruling to the effect that options granted at a discount may in fact be taxable.

Dr. Sutardja tried other arguments, that non-qualified stock options aren’t defined as “deferred compensation” under the FICA regulations, and that the options didn’t represent a “legally binding right”, which were also rejected by the Court. He also claimed the short-term deferral exception should apply, but the Court said a short-term deferral wasn’t included in the option agreement.

So, the IRS has won an early case under Internal Revenue Code Section 409A. There will probably be a follow-up case for Dr. Sutardja to determine the discount subject to the penalty tax. These cases will help “fill in the gaps” of our understanding of how Section 409A works.

(Sehat Sutardja and Weili Dai v. US, U.S. Court of Federal Claims, 2013-1 U.S.T.C. 50,214, February 27, 2013.)

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Fight California assessment for small business stock?

The California Franchise Tax Board is sending Notices of Proposed Assessment (NPA) to taxpayers who claimed an exclusion from taxable income for gain from selling small business stock, based on the decision in Cutler v. Franchise Tax Board (August 28, 2012.)

Some taxpayers and their advisors don’t agree with the Franchise Tax Board’s interpretation that the entire California small business stock statute is invalid, and want to contest the NPA.

In order to contest the NPA, taxpayers who receive one should consider filing a waiver for the statute of limitations for the applicable tax year.

Consult with a tax attorney about whether to contest the assessment and whether extending the statute of limitations makes sense for you. Contesting this issue will be expensive, so it may be less expensive to simply pay the bill.

(Spidell’s California Taxletter®, March, 2013, page 9, “Late-breaking developments on the small business stock issue”.)

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Please share your good experiences with Michael Gray, CPA

As you know, more and more people are going to the internet to find information about service providers. We hope you will share some good words about experiences that you have had with our firm. Some of the sites where you can share your experiences include yelp.com, siliconvalley.citysearch.com, and Google+.

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Community public access television needs our help

As you can see below, public access television is a vital part of our educational outreach to various communities. These are usually nonprofit, charitable organizations, like public television stations. Unlike those stations, most of the programming for the public access stations comes from local producers.

This programming includes the local arts, productions by students at local schools, community outreach by churches, independent local producers discussing current social issues, educational programming by local providers like ourselves and much more. In other words, public access television makes a unique, important contribution to the communities it serves.

With the difficult times we are experiencing, many public access stations are facing severe financial challenges, and might not survive without more community financial support. I urge you to consider making a donation to your local public access television station.

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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 15, 2013, attorney Bernard Vogel III, Silicon Valley Law Group, “Alternative forms for businesses”
March 22, 2013, attorney Michael W. Malter, Binder & Malter, LLP, “What you should know about bankruptcy for individuals”
March 29, 2013, Tom W. Anderson, President, Retirement Industry Trust Association, “How to invest in real estate using your Roth or IRA account”
April 5, 2013, Tom W. Anderson, President, Retirement Industry Trust Association, “How to make alternative investments besides real estate in your Roth or IRA account”
April 12, 2013, Michael Jones, CPA, Thompson Jones LLP, “Community property issues for retirement accounts”
April 19, 2013, attorney Jeffrey Hare, APC, “How to settle legal disputes out of court”
April 26, 2013, attorney Jeffrey Hare, APC, “Using a checkbook LLC to invest Roth & IRA funds”

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 1:30 p.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27
  • 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 and broadcast on the internet at the same time as streaming video at www.mhat.tv
  • Monday at 6:30 p.m. on Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton
  • 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 p.m. on Comcast channel 26 and AT&T U-verse channel 99 in Marin County.
  • Wednesday at 3 p.m.on Comcast channel 27 in Santa Cruz County and on Charter Communications Channel 73 in Watsonville and Capitola
  • 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 11:30 a.m. on Comcast channel 27 in Santa Cruz County and Charter Communications channel 73 in Watsonville and Capitola
  • Friday at 1:30 p.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27
  • Friday at 3:30 p.m. on KCAT, Comcast channel 15 in Los Gatos
  • Friday at 4 p.m. on cable channel 15 in Cupertino, Los Altos and Mountain View.
  • Friday at 6 p.m. on Comcast and Astound channel 29 in San Francisco, online streaming video at www.bavc.org, “public access TV”
  • Friday 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
  • Saturday at 9 a.m. and 6 p.m. on Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton
  • Saturday at 1:30 p.m. on Comcast channel 26 and AT&T U-verse channel 99 in Marin County.

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!

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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.

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Follow me on social media!

If you enjoy Twitter, please follow me at twitter.com/michaelgraycpa. I would especially appreciate retweets of our messages announcing episodes of Financial Insider Weekly.

I’m also on Facebook and Linked In. You can also follow me on other social media sites, www.facebook.com, www.linkedin.com/in/michaelgraycpa, and Google+.

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Check out my blog.

I have also started a blog at michaelgraycpa.com. Check it out!

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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. To subscribe and read a sample issue, visit realestatetaxletter.com.

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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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Subscribe to Michael Gray, CPA’s Option Alert!

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.

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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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