Michael Gray, CPA’s Option Alert #131

An irregular alert for issues relating to employee stock options

March 11, 2015
© 2015 by Michael Gray, CPA
ISSN 1931-2768
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The Section 83(b) election and incentive stock options

Stock acquired by exercising an incentive stock option (ISO) has quite different treatment under the regular tax and the alternative minimum tax (AMT). The different treatment can have quite surprising results and can be viewed as a tax trap.

Under Internal Revenue Code Section 56(b)(3), the regular tax rules for incentive stock options don’t apply for the alternative minimum tax. That means stock acquired by exercising an incentive stock option is taxed under the rules for nonqualified stock options.

Under Internal Revenue Code Section 83(a), ordinary income is generally recognized for the exercise of a non-qualified stock option on the later of the date the option is exercised or the date the stock is vested.

Under Internal Revenue Code Section 83(b), a taxpayer may elect within 30 days of exercising a nonqualified stock option to disregard the vesting date (and other restrictions) and report the income from exercising the option on the date of exercise.

Under Internal Revenue Code Sections 422(a) and 421(a), no income is reported (for the regular tax) when an incentive stock option is exercised. If the stock is held more than two years after the grant date and more than one year after the exercise date, all of the gain is taxed as long-term capital gain. If the holding period requirements aren’t met, there is a disqualified disposition and the excess of the fair market value of the stock over the option price is taxed as ordinary income.

Under Internal Revenue Code Section 422(c)(2), if the stock is sold during the year of exercise, the ordinary income from the disqualified disposition is limited to the excess of the amount realized from the sale over the option price. This limitation doesn’t apply if a loss wouldn’t otherwise be deductible for the transfer, such as for a wash sale.

The IRS has made it clear in Treasury Regulation Section 1.422-1(b) that a Section 83(b) election is not effective for regular tax reporting for stock acquired by exercising an incentive stock option, but is effective for the alternative minimum tax. As a result, when an early exercise (before vesting) of an incentive stock option is allowed and done and there is a disqualified disposition of the stock, the fair market value for computing ordinary income and the holding period for the stock is determined based on the vesting date. Once the holding period requirements are met, the disposition is qualified and vesting is disregarded for the ISO stock for regular tax reporting.

The results can be confounding.

For example, Jane Employee makes an early exercise of an incentive stock option on January 1, 20X1 and makes a Section 83(b) election. The grant date is also January 1, 20X1. The fair market value of the stock is the same as the option price on the date of exercise. 20% of the grant vests one year after the grant date. Jane sells vested shares on January 2, 20X2, for a $100,000 gain. For regular tax reporting, Jane has $100,000 of ordinary income. For AMT reporting, Jane has $100,000 of long-term capital gain. Jane has realized no tax savings for this sale from making a Section 83(b) election.

For a second example, John Employee makes an early exercise of an incentive stock option on January 1, 20X1, but doesn’t make a Section 83(b) election. 20% of the grant vests one year after the grant date and 2% per month thereafter. John continues to hold the stock. There is no taxable income for the regular tax until the stock is sold or otherwise transferred in a nonqualifying transfer. For the AMT, John must report as ordinary income the excess of the fair market value over the option price for the vesting shares. For this example, let’s say that’s $100,000 for 20% of the shares on January 1, 20X2 and $10,000 per month for the rest of 20X2, for a total of $210,000. The $210,000 is added to the cost of the vested shares for AMT reporting when John eventually sells the shares. If John sells the shares after holding them more than two years after the grant date and more than one year after the date of exercise, all of his gain will be long-term capital gain for regular tax reporting. Some of his (smaller) gain may be short-term capital gain for AMT reporting, based on the holding period for the various blocks of stock as they vested.

As you can see, a Section 83(b) election can still be helpful to reduce or avoid the alternative minimum tax from future appreciation of the stock when an employee makes an early exercise of an ISO.

Remember, the ordinary income reported to compute the AMT is added to the tax basis (cost for computing gain and loss) on Schedule D for computing the AMT, but not for the regular tax. Also, under Internal Revenue Code Section 83(b), the ordinary income relating to the exercise of the option is lost as a tax deduction if the stock is forfeited, such as if the employee is terminated. This is a serious disadvantage of making the election that should be considered before going ahead with the election when the ordinary income is significant.

When the holding period requirements aren’t met and the stock sold at a gain is held more than a year after exercise, an employee would have been better off having a nonqualified stock option and making a Section 83(b) election at exercise.

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Make your tax return preparation reservation now!

It’s tax season! Before we know it, it will be April 15!

Our clients should have received their organizers and many have already brought their tax information to us. If you bring your information after March 15, plan on having an extension done.

To make your appointment for a meeting now, call 408-918-3162.

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Dawn Siemer returns!

After being away for a month recovering from surgery on her wrist, Dawn Siemer returned March 4th. We are happy and relieved that she will be here for the rest of Tax Season!

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We are seeking opportunities to speak before groups. Topics include recent tax developments, tax issues relating to real estate, how estate planning has changed recently, tax issues relating to alternative investments using retirement accounts, and marketing topics such as “How I created a public access television show broadcast on eleven Bay Area stations.” To make arrangements, call Michael Gray at 408-918-3161.

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Financial Insider Weekly broadcast schedule for January and February.

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 January and February:

January 2, 2015, Bettie Baker Marshall, attorney at law, “Legal considerations of caring for incapacitated relatives and friends”
January 9 and 16, 2015, Kate Levinson, “Emotional currency”
January 23, 2015, Peggy Martin, CLU, The Family Wealth Consulting Group, “Life insurance basics”
January 30, 2015, David Beck, CFP®, Bay Area Planners, “Financial aid for a college education”
February 6, 2015, Jennifer Cunneen, attorney at law, Hopkins & Carley, “Should a family trust be terminated considering recent federal tax law changes?”
February 13 and 20, 2015, Jennifer Cunneen, attorney at law, Hopkins & Carley, “California real estate reassessment change of ownership rules”
February 27, 2015, Richard Schachtili, attorney at law, Hopkins & Carley, “Succession planning for a family business”

Financial Insider Weekly is also broadcast as follows:

    • Sunday at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27
    • Sunday at 1 p.m. on Comcast channel 26 in Santa Cruz County and on Charter Communications Channel 72 in Watsonville and Capitola
    • Monday at 7:00 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
    • Monday at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27
    • Tuesday at 10:30 a.m. on Comcast channel 26 in Santa Cruz County and on Charter Communications Channel 72 in Watsonville and Capitola
    • Tuesday at 2:30 a.m. and 12:30 p.m. on Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton
    • Tuesday at 7:00 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

  • Wednesday 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
  • Thursday at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27
  • 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 4:00 p.m. on KMTV cable channel 15 in Cupertino, Los Altos and Mountain View
  • 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
  • Saturday 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
  • Saturday at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27
  • Saturday at 1:00 p.m. on Comcast channel 26 and AT&T U-verse channel 99 in Marin County

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 answer emails personally. He will answer selected questions in this newsletter. Email your questions to mgray@stockoptionadvisors.com.

See the books mentioned at http://http://www.siliconvalleypublishingcompany.com/products/secrets-of-tax-planning-for-employee-stock-options-2014-edition or the Special Report, Nonqualified Stock Options – Executive Tax and Financial Planning Strategies at http://www.stockoptionadvisors.com/non-q_stock.shtml.

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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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