Michael Gray, CPA’s Option Alert #155

An irregular alert for issues relating to employee stock options

May 5, 2017

© 2017 by Michael Gray, CPA

ISSN 1931-2768

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Hello! It’s time for cleanup and extensions.

It’s been a while since we’ve issued a newsletter. We are coming out of the fog of tax season. Maybe you have an issue for which you would like a second look on the income tax returns you just filed. Maybe you have extended income tax returns that you need to have prepared. Or maybe you have some planning issues for which need advice. To make an appointment, call Dawn Siemer on Mondays, Wednesdays or Fridays from 9 a.m. to 5 p.m. at 408-918-3162.

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S corporation restricted stock upheld as deferring income.

In a complex case for which I can only discuss some highlights, the Tax Court ruled against the IRS on several issues and in their favor on another.

Larry Austin and Arthur Kechijian restructured their previous business operations as an S corporation during December 1998. An ESOP was created at that time as a 5% shareholder, leaving each of them with 47.5% of the stock. The stock was subject to an “earn-out” restriction requiring continuous employment by the corporation for five years, so the stock was fully vested on January 1, 2004.

During March 2004, Austin and Kechijian tried to avoid taxation of the excess of the fair market value of the stock over their tax basis by “surrendering” the stock and simultaneously “purchasing” replacement stock for close to the fair market value in exchange for promissory notes, which were subsequently funded using a “dividend” from the S corporation.

The Court ruled in favor of the taxpayers that the stock was subject to restrictions so that income with respect to the issuance of the shares wasn’t taxable until the restrictions lapsed on January 1, 2004. The individual taxpayers didn’t have sufficient control for the restrictions to be disregarded, and there were sufficient conflicts of interest among the taxpayers and the ESOP that the restrictions would be enforced.

The Court ruled in favor of the taxpayers that the ESOP was legitimate and formed for a valid business purpose, and therefore would be recognized as a legitimate shareholder of the S corporation.

The Court ruled in favor of the taxpayers that all of the earnings of the S corporation before January 1, 2004, including the sale of corporate assets in another restructuring, were allocated to the ESOP as the sole vested shareholder, and therefore exempt from income tax.

The Court ruled in favor of the IRS that the “surrender” and “repurchase” of the shares lacked economic substance. Each of the taxpayers had $45,714,868 of taxable compensation income on January 1, 2004 when the shares vested.

This case is well worth studying. It also involved the use of irrevocable grantor trusts for estate planning. The taxpayers mostly acted with good tax advice. They just were a little “piggish” in trying to avoid taxable income when the shares vested, so they suffered a negligence penalty.

(Austin and Kechijian v. Commissioner, T.C. Memo. 2017-069, April 24, 2017.)

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Be careful when modifying the terms of an incentive stock option.

Sometimes events happen where an employer wants to extend the term of an incentive stock option, such as an incentive to keep a key employee.
Such an extension can have disastrous consequences.

According to Internal Revenue Code Section 424(h), the modification, including an extension, of an incentive stock option is considered the grant of a new option. If the option price isn’t changed to the fair market value on the date of the extension, the option probably won’t qualify as an incentive stock option (Internal Revenue Code Section 422(b)(4)). The option will also probably violate the option pricing rules under Internal Revenue Code Section 409A, resulting in severe penalty taxes for the employee!

Look before you leap!

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Accelerated vesting isn’t a modification of an ISO.

According to Internal Revenue Code Section 424(h)(3)(C), the accelerated vesting of ISOs isn’t a modification.

This is helpful, since many companies accelerate the vesting of ISOs if the company is acquired.

However, if the option price of ISOs that are initially exercisable for the year exceeds $100,000, some of the ISOs will be converted to non-qualified stock options (NQSOs). (Internal Revenue Code Section 422(d).) The exercise of the NQSOs will result in ordinary compensation income, subject to withholding and employment taxes.

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President Trump reveals tax proposals.

On April 26, the Trump administration released an outline of its tax proposals for Congress. The proposal includes a steep tax cut for corporations and businesses from 35% (39.6% for individual owners) to 15%. The maximum rate for individuals (other than for business income) would be reduced from 39.6% to 35%, and the 3.8% net investment income tax and the alternative minimum tax would be repealed. The thresholds for the tax rates haven’t been specified.

No “border tax” for imports is proposed at this time. Corporations would move from a tax on worldwide taxable income to a “territorial” tax system, which would subject them to U.S. tax only for U.S. income.

On the deductions side, the standard deduction would be doubled to $24,000 for a married couple, and all itemized deductions would be repealed except the deduction for home mortgage interest and charitable contributions. (So with almost all deductions repealed, who needs an alternative minimum tax?)

A side effect of the increased standard deductions and repealing the deduction for real estate taxes is to eliminate the tax benefits of home ownership for almost all Americans except for those in very high cost areas like the San Francisco Bay Area.

With the high standard deduction, most taxpayers won’t receive a tax benefit for making charitable contributions.

For many taxpayers who live in states like California, the state income tax deduction is their biggest tax deduction. It would be eliminated under this plan, and they might discover they will pay higher income taxes under these proposed changes.

Although the Trump administration proposes to provide more tax benefits for child care, single parents will probably find that is more than offset by a tax increase from the elimination of head of household status.

Another feature of the proposal is to repeal the federal estate tax, which currently only applies to the very wealthy, since a married couple already has almost an $11 million exclusion. The proposal didn’t specify whether the federal gift tax would be repealed or not.

Many details still need to be provided, and the devil is in the details. The bare bones of this proposal would result in a huge tax windfall for the wealthy and tax deficits for the nation.

These proposals are only the beginning of a huge negotiation battle in Congress. Let your representatives in Congress know the changes that you favor and the changes you oppose. Here is a web site with contact information. https://www.usa.gov/elected-officials

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Trump calls tax regulations into question.

President Trump has signed an Executive Order, “Identifying and Reducing Tax Regulator Burdens.” The Treasury Department (IRS) has been told to reevaluate all significant tax regulations issued on or after January 1, 2016. Any regulation that doesn’t comply with specified policy standards regarding “undue compliance costs, complexity or overreaching of the IRS’s authority” should be “revised or eliminated.”

President Trump seems to be determined to reverse almost everything that was done during the last year of President Obama’s term of office.

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Due date automatically extended for foreign account report.

The due date for FinCEN Form 114, Report of Foreign Bank and Financial Accounts, was recently changed to April 15. According to the instructions for Form 114, FinCEN (which administers these compliance rules) has automatically granted an extension of time to file Form 114 to October 15 each year. A specific request for an extension isn’t required.

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For our readers who are CPAs.

I’m developing an initiative just for CPAs in public practice and need your contact information. Please send an email to mgray@taxtrimmers.com or call Dawn Siemer on Mondays, Wednesdays or Fridays at 408-918-3162. Just say “I’m a CPA in public accounting who reads your newsletter” and give your name, address, telephone number and email address. Thanks!

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Trump budget blueprint cuts IRS funding.

President Trump has submitted a budget blueprint to Congress for the fiscal year ending in 2018. The proposal includes cutting the budget for the IRS by $239 million. The IRS’s budget has been decreased every year since fiscal year ending 2010.

This is like trying to run a growing company while reducing staffing for accounts receivable (collections). It makes no sense.

Tax cheats are getting off free because the IRS can’t administer the tax laws.

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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 and siliconvalley.citysearch.com.

We use Angie’s List to assess whether we’re doing a good job keeping valued customers like you happy. Please visitAngiesList.com/Review/4258970 in order to grade our quality of work and customer service.

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Financial Insider Weekly broadcast schedule for May and June.

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 May and June:

May 5 and 12, Paul Duren, Bridge Bank, “Small business financing”
May 19 and 26, Jeffrey Hare, attorney at law, “Alternative dispute resolution”
June 2 and 9, Michael Jones, CPA, Thompson Jones, LLP, “Beneficiary designations for retirement accounts”
June 16, Peggy Martin, CLU, ChFC, The Family Wealth Consulting Group, “Long-term care insurance”
June 23 and 30, Peggy Martin, CLU, ChFC, The Family Wealth Consulting Group, “Life insurance basics”

Financial Insider Weekly is also broadcast as follows:

  • Sundays at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
  • Sundays at 1 p.m. on Comcast channel 26 in Santa Cruz County and on Charter Communications Channel 72 in Watsonville and Capitola
  • Sundays at 10:00 p.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
  • Mondays at 1:30 p.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27
  • Mondays at 6:30 p.m. on Midpeninsula Media Center, Comcast Channel 28 in Palo Alto, East Palo Alto, Stanford, Menlo Park & Atherton
  • Mondays 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
  • Mondays at 7:30 p.m. on Comcast channel 15 in Saratoga
  • Tuesdays 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
  • Tuesdays at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
  • Tuesdays 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
  • Wednesdays 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
  • Thursdays at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
  • Fridays at 11:00 a.m. on Comcast channel 26 in Santa Cruz County and on Charter Communications Channel 72 in Watsonville and Capitola.
  • Fridays at 3:30 p.m. on KCAT, Comcast channel 15 in Los Gatos
  • Fridays at 4:00 p.m. on KMTV cable channel 15 in Cupertino, Los Altos and Mountain View
  • Fridays at 6:00 p.m. on Comcast and Astound channel 29 in San Francisco. Online streaming video at www.bavc.org, “public access TV”
  • Fridays 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 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
  • Saturdays at 10:00 a.m. in San Mateo County on PenTV, Comcast Channel 26 and Astound Channel 27.
  • Saturdays 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 www.employeestockoptionsecrets.com or the Special Report, Nonqualified Stock Options – Executive Tax and Financial Planning Strategies at www.stockoptionadvisors.com/non-q_stock.shtml.


Follow me on Twitter, Facebook or LinkedIn!

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

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Check out my blog.

I have also started a blog at www.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.)