Michael Gray, CPA’s Option Alert #161
An irregular alert for issues relating to employee stock options
November 15, 2017
© 2017 by Michael Gray, CPA
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Table of Contents
- Tax reform legislation threatens nonqualified stock options
- Proposal – excessive compensation limit expanded
- If you exercised ISOs during 2017, should you use the “escape hatch”?
- Year end planning – should you “harvest” losses before the year end?
- The year will soon be over. Will you be ready?
- Please share your good experiences with Michael Gray, CPA
- Financial Insider Weekly past episodes
- Follow me on social media!
- Check out my blog
- Interested in our other newsletters?
- Consult with a tax advisor
Tax reform legislation threatens nonqualified stock options
The Senate Finance Committee has released the Chairman’s Mark of the Tax Cuts and Jobs Act. One of the provisions would, effective after December 31, 2017, accelerate the taxation of deferred compensation, including income relating to nonqualified stock options and stock appreciation rights, to the date there is no substantial risk of forfeiture of the rights to the compensation.
For nonqualified stock options, this appears to mean that the excess of the fair market value of the stock over the option price on each vesting date would be currently taxable. (Restricted stock units are already taxed like this.)
Deferred compensation earned before 2018 would be grandfathered.
This would create a real hardship for employees with nonqualified stock options in private companies who can’t sell their stock.
Note this legislation isn’t final. The bill is being “marked up” by the Senate Finance Committee this week. The House Ways and Means Committee deleted a similar provision from its version of the bill.
If you are unhappy with this development, I suggest you contact your Senator. It would be especially helpful for option holders in the “red states” to speak up. Democrat representatives are being ignored.
Proposal – excessive compensation limit expanded
Publicly traded corporations are limited to a tax deduction of $1 million per year for certain “covered employees.” Under the current tax laws, certain “performance based” compensation, including compensation relating to employee stock options, isn’t subject to the limit.
Under both the House and Senate tax reform proposals, the performance based compensation exception would be repealed, eliminating a significant tax deduction for companies like Ebay, Google, Apple, Oracle, and the Walt Disney Corporation.
Compensation paid to another individual, such as for inherited stock options or options given to a former spouse pursuant to a domestic relations order, would also be subject to the $1 million limitation for the employee.
The principal executive officer and the principal financial officer of a publicly held corporation would be added to the list of “covered employees.”
When an individual is a covered employee with respect to a corporation for a taxable year beginning after December 31, 2016, that individual would remain a covered employee for all future years.
If you exercised ISOs during 2017, should you use the “escape hatch”?
Remember if you exercised ISOs during 2017 and didn’t sell the stock, your AMT adjustment will be based on the fair market value of the stock on the date of exercise. However, if you sell the stock before the end of the year of exercise, the AMT adjustment is eliminated. Ordinary income is reported for the excess of the selling price over the option price. I call this strategy “the escape hatch.”
For example, Jean Employee exercised an ISO for 1,000 shares of XYZ stock on March 1, 2017. The fair market value of the shares on March 1, 2017 was $55 per share and the option price was $5 per share. If Jean didn’t sell the stock, she would report additional AMT income of $55 – $5 = $50 X 1,000 shares = $50,000. On December 15, 2017, Jean sells the stock for $15 per share. The AMT adjustment is eliminated and Jean reports $15 – $5 = $10 X 1,000 shares = $10,000 of ordinary income for regular tax and AMT.
There is an important requirement to get this tax benefit. A loss would have to be “allowable” if the stock was sold at a loss. A common transaction that would disqualify an escape hatch is a wash sale. A wash sale happens when replacement shares or an option to acquire replacement shares are acquired during the period 30 days before or 30 days after the sale.
For example, if Jean purchased 1,000 shares of XYZ Software for $16 per share on December 10, 2017, she would still have a disqualifying disposition of the ISO shares, but she would have $50,000 of ordinary income because the escape hatch wouldn’t apply. Her short-term capital loss of $15 – $55 = $40 X 1,000 shares = $40,000 would be disallowed as a current deduction. The disallowed loss would be added to the tax basis of the replacement shares. Therefore, the tax basis of the replacement shares would be $16 + $40 = $56 X 1,000 shares = $56,000.
If you are going to use this “escape hatch” strategy, I suggest not waiting until the last minute. One of my clients was thinking of doing this, and an employee unexpectedly sued the company for an employment-related matter. The company’s stock was locked up for employees because of the lawsuit. My client wasn’t able to use the “escape hatch” strategy.
Year end planning – should you “harvest” losses before the year end?
The stock market has been very active this year. If you have sold securities (or other assets) for capital gains, review the securities (or other assets) you are holding for potential capital losses. If you sell the loss shares before the end of the year, you can offset the losses against your gains. This is even more important if you could be subject to the 3.8% federal net investment income tax. You could bring your adjusted gross income below the $250,000 threshold for married persons filing joint returns or $200,000 for singles.
Remember the wash sale rules. If you purchase shares of the same security during the period 30 days before and 30 days after a sale at a loss, the loss is disallowed for the same number of shares.
The year will soon be over. Will you be ready?
It’s time for year end tax planning. With the holidays, Michael Gray’s availability will be limited. Call Dawn Siemer weekday mornings at 408-918-3162 to schedule your year-end tax planning appointment now.
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Financial Insider Weekly past episodes
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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.
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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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(Michael Gray is the author of Secrets of Tax Planning For Employee Stock Options, Stock Grants and ESOPs.)