In general, companies are required to withhold income tax from compensation income paid to employees and report the amount on form W-2.  This requirement applies only to employees of the company.  It does apply to non-employees such as outside directory, consultants, or independent contractors.

Withholding is required when an employee has compensation income from exercising a non-qualified stock option or from a restricted stock grant.  However, there is no tax withholding from the exercise of incentive stock options (ISO’s) or employee stock purchase plans (ESPP’s).

In addition, employees are also subject to Social Security tax to the Social Security wage base 7.65% as well as Medicare tax of 1.45% on total compensation.  There is no Social Security tax and Medicare withholding for the exercise of ISO’s or ESPP’s.
With the Social Security and Medicare tax, the company pays an equal amount (7.65% and 1.45% respectively), so the total amount paid is 15.3% for Social Security and 2.9% for Medicare.

Dan’s Moral:  When exercising options it is important to understand the withholding to avoid —– surplus after it’s too late.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC

Part 5:  Five Part ISO Series

During my preparations writing this ISO series, I gathered these final points to  finish up  with a couple of strategies on exercising ISO’s:

1.  The first strategy is to exercise your ISO option up to the AMT buffer amount.  As I had mentioned in my previous blog, if the ISO shares are held through the end of the calendar year at exercise, the option holder will be required to report AMT tax on the bargain element at the time of exercise.  The AMT buffer is the amount by which the option holder’s regular income tax is projected to exceed his tentative minimum tax (TMT).  In this case, the option holder only pays AMT when their TMT exceeds their regular income tax.  Therefore, the AMT buffer can be used to determine how many shares can be exercised without having to pay AMT.

Example:

•     Projected Regular Income Tax: $72,000
•     Projected TMT: $60,000
•     2,000 shares issues: $25/ share
•     Current Price of Stock: $40/share
•     Bargain Element: $15/share ($40-$25)
•     AMT Buffer: $12,000 ($72,000-$60,000)
•     #Shares to exercise with no AMT: 800 ($12,000$15/share)

This is a hypothetical example and is not representative of any specific investment. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

2.  The second strategy is based on the timing of the exercise.  As indicated in last week’s blog, if the shares of ISO Stocks are sold before the end of the calendar year, the option holder will avoid any AMT tax liability.  Therefore, it is best to exercise the ISO shares as early in the year as possible so the qualifying sale period starts early in the year.  In addition, the executive will be able to sell their shares by December 31st to avoid AMT tax in case the stock drops substantially.

For a more detailed example, see my white paper on our website “Avoiding nightmares when exercising ISO’s.”

Dan’s Moral: Take advantage of the AMT buffer amount by exercising additional ISO shares without incurring any AMT.

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Part 4: 5 part ISO Series:

As I discussed in last week’s blog, the option holder can either have a qualifying disposition if he plans to hold the shares and take advantage of the special tax rate or he can sell the shares before the end of the year, if the stock goes down in a disqualifying disposition and avoid the AMT Tax.  In this blog I will discuss the effect of AMT on exercising ISOs.

Let’s examine the effects should the option holder hold the exercised shares through the end of the year.   In this scenario, he will be required to report income equal to the bargain element (gain) on the date of exercise for purposes of AMT.  For regular tax purposes, the option holder’s basis in the ISO Stock is the amount he paid to purchase it.  However, under the AMT, the basis of the stock is the amount of income reported in the year of exercise.  In other words, he will have a different basis under the two tax systems.

Example:
Joe exercises an ISO buying $100,000 worth of stock for $40,000.  The following year he sells the shares for $110,000 in a qualifying sale.  Under the regular income tax, he would report a long-term capital gain of $70,000 ($110,000 proceeds – $40,000 paid).  Under the AMT, his basis for the shares includes the $60,000 bargain element ($100,000 – $40,000) he reported as part of his AMT income in the year he exercised.  His capital gain under AMT is only $10,000 ($110,000 – $100,000).

Summary:

This is a hypothetical example and is not representative of any specific investment. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Dan’s Moral:  Understanding the different tax basis for AMT and regular tax could provide significant tax savings.

I hope you have enjoyed this ISO Series.  My final blog (Part 5 of the Five Part ISO Series) will discuss specific strategies on exercising ISO’s.

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This is Part Three of a Five Part ISO Series:

As indicated in Part 1 of the Series, in order to qualify for special tax treatment the option holder has to satisfy the special holding period for a qualifying disposition.  No disposition occurs within two years from the grant date and no disposition occurs within one year after the shares are exercised.  Importantly, both requirements must be satisfied for it to be a qualifying sale.

Example: Joe is granted an option of 5,000 shares with an exercise price of 20/per share on April 1, 2012.  He exercises the shares on May 10, 2016 with a stock price of $50/share.  He had to pay $100,000 (5,000 @ $20/share).  The following year he sells the 5,000 shares at $45/share in a qualifying sale for $225,000 (5,000 @$45).  He would report a long-term capital gain of $125,000 ($225,000 proceeds less $100,000 basis).

The price at the time of exercise is irrelevant for regular tax purposes.  However, the value is important in determining the alternative minimum tax.

In the above example, if the options were non qualified, the option holder would have been required to report $250,000 (5,000@ $50/share) of compensation income when he exercised the shares for the tax year 2016.  This additional income would also be subject to tax withholding and social security.  Further, if he held the shares for 12 months and sold them for $45/share ($225,000) he would have a capital loss of $25,000 on the sale.  Unless he has capital gains to offset the loss, he is limited to a $3,000/year deduction.

With ISO’s , the option holder can use the income limitation rule that would permit him to make a disqualifying disposition of ISO shares and report compensation income only on the actual profit.

Example: In the previous example, when Joe exercises his shares at $50/share on May 10, 2016, if he sells at $40/share in December of that year he will only report the actual gain of $100,000 ($100,000 exercise (basis) proceeds $200,000) and would avoid any AMT tax.

These are hypothetical examples and are not representative of any specific investment. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

My Next blog (Part 4 of the Five Part Series)  will discuss how AMT effects the exercise of ISO’s.

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This is Part 2 of 5 in a Five Part ISO Series

Sometimes it is not always clear whether the option is a non qualified option or an ISO.  For an option to qualify as an ISO it must meet four requirements:

1.   The exercise price of the option cannot be lower than the value of the stock when the option is granted.
2.   The term of the option cannot be longer than ten years.  However, the option can be shorter but not longer than ten years.
3.   The option cannot be transferable except at the death of the option holder.  Once the option has been exercised, the stock may be transferred but not the option itself.
4.  If the option holder owns more than 10% of the voting stock in the company, the exercise prices of the option has to be at least 110% of the value of the stock when the option was granted and the term of the option cannot exceed five years.                                                             Lastly, the option holder must have been an employee of the company at the time the option was granted (as opposed to an outside consultant or director).  Also, the option holder must exercise the option while they are still employed by the company or within three months after their termination date.  However, if the option holder is disabled, the favorable tax treatment is extended for one year versus three months following termination of employment.

My next blog (PART 3) will focus on the Tax Treatment of ISO’s

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This is Part 1 of 5 in a Five Part ISO Series

Definition:  Incentive Stock Options (ISO’s) are options that meet certain requirements that are eligible for favorable tax benefits.
The main benefit is the ability to convert the bargain element (gain) from regular income to long-term capital gain.  In order to take advantage of this tax benefit, the option holder is required to hold the shares after exercise for a specific period of time, exposing them to additional concentration risk.

Additionally, the option holder is subject to alternative minimum tax (AMT) in the year they exercise the options exposing them to additional tax risk.

** Most executives don’t take full advantage of exercising ISO’s to minimize tax — Why? Between the concentration risk, the AMT risk, and the complexity of putting together a sound strategy generally prove good reason for missing out.

The tax benefits of ISO’s over non qualified stock options are as follows:
•    For regular tax purposes, the option holder reports no income at the time they exercise the ISO.
•    If the shares are held long enough after exercise, any profit from the sale of the shares are taxed at long-term capital gains rate.
•    If the shares are not held long enough to avoid a disqualifying disposition, the option hold may be able to limit the amount of income to the actual profit from the date of exercise.
•    The profit from the exercising an ISO or selling the shares is not subject to tax withholding or social security tax.

Disqualifying Disposition:  This is a disposition of shares that occurs before the special holding period requirements.  To avoid a disqualifying disposition, the option holder must meet both of the following requirements:
•    No disposition occurs within two years from the grand date of the option.
•    No disposition occurs within one year after the option has been exercised.
If both of these holding periods are met the sale is considered a qualifying sale.

Part II of the Series will discuss the qualifications for an option to be an ISO.

Dan’s Moral: Taking advantage of the special tax treatment for ISO’s requires an overall understanding of the tax structure but could be a tremendous tax savings.

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Rounding out our Four Part Series on 83b Elections — let’s explore the preparation of the 83b Election…

As mentioned in my previous blog, the most important thing in making the 83b election is that it must be done within 30 days after the transfer of the shares.  The 30 day period is simply 30 calendar days including weekends and holidays.  There is no specific IRS form required when making the election.  The executive makes the election by filing a statement that includes the specific information indicated in the tax regulations.
(Reg: 1.83-2)

Many of employees may have been furnished with a form been designed by their attorneys.  If a form such as this is not available, you can simply create one for this purpose yourself.  At the top, the document should state:  “Section 83b Election.”  Then begin with the words: “The taxpayer hereby elects under section 83b as follows.”

This form should provide the following information:
•    Name, address, and social security number
•    Description of the shares (3,000 shares of ABC Company).
•    Date the shares were received and the taxable year for which the election is being made.
•    The specific restriction of the stock (example: forfeit is employment terminates before May 1, 2015).
•    Fair value of the share at the time it was received.
•    The amount, if any, paid for the stock.

Tips:

1. I would suggest that the election be sent certified mail and retain the receipt with the date of it.
2. Also, the executive must provide a copy of the election to the company and attach a copy of the election to their tax return for that year.

Dan’s Moral: Check with the company for an in-house 83b election form first and make sure it is filed within 30 days after the shares are transferred.

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This, our 3rd Part in a 4 Part Series on 83b Election risks:

As explained earlier, the 83b Election works great if the shares appreciate from the time the election is filed until the shares vest.  So what are the risks of filing the 83b election?

• Decline in Value:  In last week’s example, if Mary filed the 83b election when the shares were worth $50,000 in 2012, she would report that $50,000 as compensation income on her 2012 taxes.  Fast forward to 2015 — When the shares vest in 2015, and if at the time they are worth only $20,000, the bottom line is that she had paid tax on $50,000 for shares that are only worth $20,000.  If the shares are sold upon vesting Mary would have a capital loss of $30,000, unless she has capital gains from another source, she will only be able to deduct $3,000 of the loss and carry the remaining forward.

Termination of Employment:  In our previous example, if Mary’s employment were terminated, the shares would then be forfeited.  It would seem logical that Mary would get a deduction to offset the income she reported because she filed the 83b election, but the tax code says different.  “If such property is substantially forfeitured, no deduction shall be allowed in respect of such forfeiture.”
Therefore, Mary would get no ordinary income deduction as well as no capital loss deduction.

This rule only applies to a forfeiture of the shares but would not apply if the shares are sold at a loss or is the shares become worthless.

Dan’s Moral:  Understanding the negative consequences if shares are forfeited before they become vested.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC
IRC: 83(b)(1)

In this second edition of my Four Part Series on the 83b Election, I delve into the driving factors that make the 83b Election a good choice for the executive.

As mentioned in Part 1, the executive has 30 days from the date of transfer to make an 83b Election.  Once the election is made, they are treated as receiving the shares at the time of transfer even though they are still subject to a vesting schedule.

You might ask yourself, why would an executive do this?

The main reason would be to have the potential future appreciation taxes of long-term capital gains rate.

Example:   Mary received shares in 2012 valued at $50,000, vesting in 3 years.  If she does nothing, she will not report any income until they vest in the year 2015.  The amount Mary will report will be based on the value when they vest in 2015.  For this example, we will assume the shares are worth $80,000 in 2015.  Mary would report $80,000 as compensation income in 2015 and that would be her new basis for future sales.  Her holding period starts on the day the shares vest to determine whether the share will be taxes as long-term or short-term capital gains.
However, if Mary had filed the 83b election in 2012 she would have reported compensation income of $50,000 in 2012 and when the shares vest in 2015, she would report nothing.  The $30,000 in appreciation would be taxed at the long-term capital gains rate if she were to sell the shares.

As you can see, if the share appreciates, by filing the 83b election the executive can convert the appreciation from compensation income to long-term capital gains rate.

This is a hypothetical example and is not representative of any specific investment. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Dan’s Moral: Filing the 83b Election has the potential for substantial tax savings but has a fair amount of risk too.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

This is the first of a  4 part series:

When a company issues Restricted Stock, there is usually a vesting schedule attached to those shares.  Shares are considered vested when the executive no longer has to provide additional services to the company to avoid losing some or all of the value of the shares.  If the shares are not vested when they are received, there is no tax implication until the vesting date.

As mentioned in an earlier blog, income is reported when shares vest, even if the stock has not been sold.  The amount of income they must report is the fair value of the shares on the vesting date less the amount (if any) was paid for the shares.

If the executive decides to file an 83b election within 30 days after the transfer of the shares, they are treated as the owner of the shares when they receive them — even though they are still subject to a vesting schedule.  Once again, timing is important to consider.  Because the executive reports income at the time they receive the shares,  they would report nothing when the shares vest.

Summary

When receiving non-vested shares:
Executive Does Nothing: No tax consequence until the shares become vested.

Taxpayer makes 83b Election: Taxed as receiving the shares at the time of transfer.

By definition, transfer is when the company acts to transfer ownership to the executive.  The shares may be put in an escrow account until they become vested.  This transfer is the start of the 30 day period to make the 83b election.

Questions?  You may be asking, why would anyone want to pay the taxes earlier by making the 83b election?

This will be the topic of my next blog.

Dan’s Moral: When receiving restricted stock, know that an alternative tax strategy can be important.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC