Michael Gray, CPA’s Option Alert #115

An irregular alert for issues relating to employee stock options

August 16, 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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Extension season is here

If you would like us to prepare your extended 2012 income tax returns, please call Dawn Siemer Mondays, Wednesdays or Fridays from 9 a.m. to 5 p.m.

We can also prepare amended income tax returns to clean up tax returns that were previously filed.

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Third quarter estimated tax payment date approaches

The federal estimated tax payment for the third quarter is due September 16. If you are making your payments based on this year’s tax information, it’s time to get in touch with your tax advisor. California doesn’t have a third quarter payment for individuals, because the payments for the first two quarters are “front loaded.”

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Now is the time for tax planning

With many tax changes this year, especially for taxpayers with high incomes or high net worths, now is a good time for income and estate tax planning. To make an appointment, call Dawn Siemer Mondays, Wednesdays or Fridays from 9 a.m. to 5 p.m.

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Watch option lapse dates when leaving employment

When you leave employment, you really need to be alert about when your stock options lapse. Although the tax laws give guidelines about what is allowed, the terms of the plan override those guidelines.

I have had employees tell me that, under the terms of their employers’ plans, their options lapsed at termination!! This can create a real problem when you are fired or laid off. You could lose the right to exercise your options immediately. Have you really read your options agreement? Maybe you should again.

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Options can “morph” after termination

In some cases, employers are generous and give employees an extended time to exercise their stock options after termination. Employees may not be aware that the nature of their stock option can change.

In order to qualify as an incentive stock option, the holder must have been an employee during the three-month period before exercise. Because of this guideline, many employers have a policy that employees’ incentive stock options lapse three months after termination. It’s not required that the option lapse. The IRS has ruled that when the option is extended beyond three months after termination, the option becomes a nonqualified stock option.

As a reminder, here are some of the features of incentive stock options (ISOs) and nonqualified stock options (NQOs) for your comparison.

ISOs

  • When an incentive stock option is exercised and the stock is not sold during the year of exercise, there is no current taxable income for the regular tax computation. There is taxable income equal to the excess of the fair market value of the stock over the option price for the alternative minimum tax computation. Some states, including California, have an alternative minimum tax and others do not.
  • The alternative minimum tax for an ISO exercise isn’t withheld at the time of exercise, and might not have to be paid until the original tax filing date (April 15 of the next year).
  • When ISO stock is held for the required period of more than two years after the grant date and more than one year after exercise, the entire gain from the sale will be long-term capital gain. A minimum tax credit might be available to offset the tax on the gain up to the AMT income when the option was exercised. This means the federal tax on that part of the gain is about 28%, and the federal tax on the additional long-term capital gain is about 20%.
  • The new 3.8% tax on investment income will apply to the entire long-term capital gain from the sale of ISO stock when you meet the income thresholds, with no minimum tax credit offset. That means the total federal tax on the gain at exercise becomes 31.8% and the federal tax on the additional gain becomes 23.8%.
  • If ISO stock is sold in the year of exercise, there will be a disqualified disposition. Most or all of the gain will be taxed as additional wages, potentially subject to the maximum federal tax rate of 39.6%.
  • A special break for ISOs is the additional wages from a disqualified disposition aren’t subject to income tax withholding and aren’t subject to employment taxes like social security or Medicare taxes, and aren’t subject to the 3.8% federal tax on net investment income. (Of course the tax still must be paid by the original tax filing date (April 15 of the next year).

NQOs

  • When a vested nonqualified stock option is exercised, the excess of the fair market value of the stock over the option price is taxable as additional wages, potentially subject to the maximum federal tax rate of 39.6%. The income is currently taxable for federal and state income tax reporting (unless the state has no income tax.)
  • For employees, income tax withholding is required at the time the option is exercised.
  • Sometimes the withholding isn’t enough to cover the total tax due, and employees are surprised to learn they owe additional tax for the option exercise on the tax filing date, April 15 of the next year.
  • For employees, the additional wages from the exercise of a NQO is subject to employment taxes like social security and Medicare taxes. If the stock isn’t sold, the employee will have to pay the employer these “withholding” amounts.
  • When NQO shares are sold, the “cost” of the stock will equal the fair market value of the stock at the date of exercise. (Technically, the option price plus the additional compensation added to wages for the exercise.) If the stock is held for more than a year, any additional gain should be taxable as a long-term capital gain, probably subject to the 20% federal tax rate plus the 3.8% net investment income tax, or 23.8%.
  • The additional wages from the exercise of a NQO isn’t subject to the net investment income tax (but is subject to the Medicare tax).

The problem of stock that isn’t publicly traded or in a lockout

  • When the stock can’t be sold, employees who exercise employee stock options may find themselves in a cash bind. They have to pay the option price plus income taxes.
  • When the stock can’t be sold, employees are at risk that the value of the stock may drop, leaving them “holding the bag” to pay for the stock and taxes without being able to recover the funds.

Can you afford to take a loss if this doesn’t work out?

Does it make sense to put your family in financial distress? Think about it. Maybe you should only exercise part of the options available to you.

Would you like a “sanity check” to understand your situation?

That’s what we’re here for. Call Dawn Siemer for an appointment Mondays, Wednesdays and Fridays at 408-918-3162.

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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, Citysearch, 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. Here is a link for a list of public access television stations in California: http://www.communitymedia.se/cat/linksca.htm.

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New time for Financial Insider Weekly in San Jose and Campbell, and online

The broadcast time for Financial Insider Weekly in San Jose and Campbell is changing to 9:30 p.m. Pacific Time, effective this Friday, August 16. The program is broadcast as streaming video at www.creatvsj.org at the same time.

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Financial Insider Weekly broadcast schedule for August and September.

Financial Insider Weekly is broadcast in San Jose and Campbell on Fridays at 9:30 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 the rest of August and September:

August 16, 2013, Craig Martin, CFP®, The Family Wealth Consulting Group, “How to make sure your retirement portfolio outlives you”
August 23, 2013, David Beck, CFP®, Bay Area Planners, “Funding For A College Education Using Federal Tax Benefits”
August 30, 2013, David Beck, CFP®, Bay Area Planners, “Government financial help for families of deceased veterans”
September 6, 2013, attorney Naomi Comfort, Silicon Valley Elder Law, PC, “Tax planning for elders and their caregivers”
September 13, 2013, attorney Naomi Comfort, Silicon Valley Elder Law, PC, “Retirement and long-term care planning”
September 20, 2013, attorney Ray Sheffield, “Estate planning for retirement benefits”
September 27, 2013, Richard Lambie, professional fiduciary, “Selection and compensation of a 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 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 (Starting at 1 p.m. from June 15)

Past episodes of Financial Insider Weekly are posted on YouTube. One way to watch them is to go to our web site, www.financialinsiderweekly.com, and click on “Past Episodes.”

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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