The Incentive Stock Option Tax Trap

With the recent nCino initial public offering and stock market surging back to pre-pandemic highs, we are receiving a lot of questions about tax planning for incentive stock options (ISOs).   From a tax perspective, ISOs are arguably the most complex type of stock option.  The purpose of this article is to cover some of the high-level tax considerations for ISOs and highlight the need for income tax projections and income tax planning when it comes to ISOs.

ISOs are defined in the Tax Code as an option granted to an employee of a corporation (private or public) to purchase stock of the corporation if certain conditions are met[1]. Those who earn ISOs may seek to diversify their portfolio if a majority of their net worth is tied up in their company’s stock – say, for example, when their company has a successful IPO and the value of the stock is showing hockey stick type growth.  They may also desire to simply liquidate and cash out on the growth.  In either case, they are left wondering how to plan for taxes.

Generally, ISOs are not subject to ordinary income tax upon exercise.  Ultimately, if the shares are held 1 year after exercise and 2 years after the grant date the employee can qualify for long-term capital gains treatment on the sale of the stock – otherwise known as a qualifying disposition.

Easy enough, right?

Wrong—c’mon, we’re talking about taxes here!  As is turns out, there are two tax systems every individual taxpayer must keep track of: the “regular” income tax system (the one most of us think of) and the alternative minimum tax system (AMT).  Generally, if your AMT tax is higher than your regular tax, you must pay AMT equal to the amount over regular taxes (you end up paying the higher of the two).

AMT is much different than the “regular” income tax system with its own income recognition rules and disallowance of certain “regular” tax deductions.  It also has its own flat tax rates of either 26% or 28%, depending on the level of income.

For ISOs specifically, “regular” tax and AMT are essentially inverses of each other.  Upon exercise, income is not recognized for “regular” tax purposes but is recognized for AMT purposes.  Note this does not mean you will automatically owe AMT tax, it just means that your alternative minimum taxable income (AMTI) will increase and you have a higher risk of paying AMT.  The amount included in AMTI is the difference in value between the exercise price and the grant price.

Thankfully, Tax Reform has helped mitigate AMT tax issues for many taxpayers after its passing which took effect beginning with tax year 2018.  Some of these changes to the AMT rules benefitting taxpayers were inadvertent such as the cap on state and local tax itemized deductions which are disallowed for AMT purposes and some advertent such as changes to AMT exemptions and thresholds.  However, those earning over $200K in income still need to be engaging in some form of tax planning to ascertain if they will be subject to AMT upon exercise of ISOs. Those earning over $1M are the most at risk[2].  Other factors, such as filing as married-filing-separately may further increase the risk of paying AMT.

To plan how much in ISO value to exercise before experiencing AMT requires detailed federal and state income tax planning iterations.  The goal is to exercise as many options as you can without triggering AMT.  If there is a need to exercise more than that, see below for additional tax planning opportunities.

If you have already exercised a significant amount of ISOs but have not sold them, there are still several tax planning options to consider in the year of exercise, assuming you would otherwise be subject to AMT.

We discussed qualifying dispositions already but what about disqualifying dispositions?  Disqualifying dispositions generally occur when you don’t meet the 1 year holding requirement following the date of exercise.  However, if you would otherwise be paying AMT tax it may actually be preferable to a qualifying disposition.

When a disqualifying disposition occurs (ideally within the year of exercise) the ISOs become Nonqualified Stock Options (NQSOs), you pay “regular” income tax on the sale, and have a favorable adjustment for AMT purposes (reduced AMTI).   However, it’s not an all or nothing decision.  You can execute disqualifying dispositions for some of the ISO tranches and not others.

The question then becomes: how many shares do you need to sell through disqualified dispositions in order to achieve the optimal amount of tax mitigation by reducing the AMT to zero? Again, this is a complex question that requires doing tax projections – an estimate of your total taxable income and tax liability for a given period – to understand the overall impact on your taxes under different scenarios.  It is necessary to evaluate the options for each specific tranche of ISOs as opposed to viewing them as a single investment tool.

Tax Reform also introduced an opportunity to defer tax recognition for up to 5 years by making an §83(i) election.  However, this is only available for private companies and is somewhat narrow in its application.

ISO holders following the status quo by holding and selling shares without a tax plan in place may end up getting surprised when they file their tax returns the following year.  It’s recommended that you involve all members of your personal advisory team including your CPA, Financial Planner, and Estate Planner.

Contact us at Adam Shay CPA, PLLC to figure out the best tax plan for you.  We start with your specific goals in order to tailor a tax planning strategy that will help you meet those goals.

This article was contributed by Chris Massey, CPA (NC License Number 39147), a tax manager at Adam Shay CPA, PLLC.

[1] §422(b)

[2] https://www.taxpolicycenter.org/briefing-book/who-pays-amt#:~:text=Taxpayers%20pay%20the%20higher%20of,percent%20top%20statutory%20AMT%20rate.

NC Annual Report Scheme

If you own a business in NC, you may have recently received a Solicitation to file your NC Annual report for a fixed fee that is above and beyond the cost to do so with the Secretary of State (SOS). While the mailings appear to be official, they are not affiliated with the NC SOS. Similar mailings were sent out last year and the NC SOS posted an alert warning business owners about the scheme. We are advising clients NOT to have this company file your annual report, due to risks listed in the NC SOS alert (linked below). We recommend filing your NC Annual Report online via the NC SOS website.

NC SOS: Solicitation for Services Alert: https://www.sosnc.gov/imaging/dime/webportal/54023612.pdf
NC SOS: How to File An Online Annual Report: https://www.sosnc.gov/divisions/business_registration/annual_report_how_to_file
NC SOS: Filing Online Annual Reports: https://www.sosnc.gov/divisions/business_registration/annual_report

Should Companies Participate in Social Security Tax Deferrals?

On August 8th, President Trump signed an executive order that would allow employees that make less than $104,000 to defer the collection of the employee side Social Security taxes.  The Treasury Secretary has indicated that an employer can decide if their company will participate or not.  As an employer, should you?  It’s tough to say, but we’ll try to lay out the pros and cons of each possibility.

 

If your company participates:

  • Employees that make less than $104,000 will have more cash in their pockets.  The employee cash increase would be 6.2% of each paycheck.
  • There is the possibility that the deferral is forgiven.

 

What are some risks in participating?  A lot of guidance and details need to be released about the executive order.  What happens if an employee defers Social Security taxes and leaves their position?  Who is responsible for paying the deferral—the employer or the employee?  Without more guidance there is risk that employers could be on the hook for employee deferrals.  That’s the greatest potential downside.

 

Our hope is that more information and guidance will be available before you have to make a decision.  If you have questions about this particular topic or are interested in working with a CPA firm that will provide you with proactive advice and help you stay on top of the ever changing 2020 landscape, feel free to reach out to us @ [email protected].

On December 21, 2019 President Trump signed into law a spending bill that included good news for taxpayers in Southeastern NC. The spending bill included retroactive major disaster related tax relief that we know will put more money back into taxpayers’ pockets. The legislation also included some retroactive implementations of previous expired tax deductions and credits as well as changes to retirement plans. With retroactive tax changes on income tax years already filed, amended returns will be required.

We are going to walk through some of the changes, starting with those we think will have the biggest dollar impact on our client base. This is an early analysis and as the dust settles some of the specific details may change, but the legislation looks favorable for taxpayers.

There are several Disaster Tax Relief retroactive changes passed that will lead to large refunds, especially for business owners.

Business Owners – Disaster Relief
This one is HUGE. There is a credit for employers for retaining employees in an area impacted by major federal disasters, such as Hurricane Florence in 2018 or even Hurricane Dorian in 2019. We expect that this will bring significant refunds for businesses with employees.

Here is how the credit generally works: it is a credit of 40% of wages from the first day inoperable to the date at which the trade or business resumed significant operations. The wages for the credit are capped at $6,000 per employee. This credit will be significant for many companies with employees.

Individuals – Disaster Relief
There are also some retroactive individual changes that will result in found money. They have made it easier to deduct casualty theft and losses from 2018 and 2019 federally declared major disasters. Since they’ve made it easier, taxpayers will typically receive more money back than they would have without this change. This is one of the big ones that taxpayers were waiting on prior to filing their 2018 income tax returns.

Tax Extenders
There were several retroactive tax changes which are known as tax extenders. These portions of the tax code are typically extended at the last minute, hence the name. However, they were not extended for 2018 but now have been done so retroactively beginning with 2018. Here is a list of them:

  • Ability to exclude from income the forgiveness of debt related to primary residence.
  • Mortgage Interest Insurance is deductible again (assuming that you itemize deductions).
  • Qualified tuition deduction is allowed in lieu of education tax credits.
  • Several credits related to energy efficiency, renewable energy, and alternative fuel (think electric cars).

Retirement Plan Rule Changes
There are some changes to retirement plan rules for 2020 and beyond that taxpayers need to be aware of:

  • Starting for individuals who turn 70 ½ in 2020 or later, the mandatory Required Minimum Distributions (RMD) age will be 72 years old. This is the age when you are required to start taking money out of retirement accounts unless you want to be penalized for not doing so.
  • Inherited retirement plans will no longer have as much flexibility on how long you have to withdraw funds (unless a surviving spouse). It will now generally be limited to 10 years.
  • The age cap on contributions to IRAs for someone over 70 ½ has been removed (assuming they are still working).
  • You will able to withdraw penalty free up to $5,000 within a year of the birth or adoption of a child.

Our goal today was to highlight to you the retroactive federal income tax benefits from disaster relief and tax extenders.  With the amount of retroactive changes and the size of the impacts, we expect there will be a lot of 2018 amendments filed in 2020.

You’ve Received an Incorrect Business Property Tax Listing Assessment- Now What?

In October, North Carolina county property tax offices send out business property tax assessments for property tax on items like computers, desks, etc.  Those assessments are based upon property tax listings that must be submitted to the county by January 31st.

What if your county doesn’t have a property tax listing submission from you?  In New Hanover County, if they do not have a property tax listing for the current year and you didn’t have a listing in the prior year, they will assess you a value based upon some unknown formula.  It usually seems to be somewhere in the range of $40,000-$60,000 worth of equipment.

Why would they not have a property tax listing for you?  There are a couple of reasons:

-You did not submit a listing.  This rarely happens with our clients as we have a process for businesses that includes this.

-They lost or did not process your submission.

-You did not know that you needed to submit one.  This most often happens with a new entity that is not active.  If you have an LLC or Inc you are not using you would not consider it an active business, while New Hanover County combs the Secretary of State business registrations to look for entities without business listings.

What do you do if you received a notice?  We can help you navigate that process- whether it is submitting a listing or corresponding with the county property tax office to let them know that the business is not active and does not have any business assets.

Are you:

-Tired of having no books (accounting records).

-Tired of doing it yourself?

-Tired of having messy books or a problem you can’t solve?

We can help- we now offer bookkeeping services.  Reachout to us @ [email protected] to find out how we can help.

Eliminating Affordable Care Act (ACA) Penalties

We have implemented a legal but little known strategy to help our clients prevent income tax return penalties for not having health insurance. It saves the average person in that situation thousands of dollars. We can apply this strategy to both current year income tax returns as well as previously filed returns for the prior 2-3 years. Let us know if you want to discuss!

Does Your Business Need a Checkup?

If I asked you how much cash flow your business generated last month, would you know? How about for last year? If you constantly feel like you are working for nothing, or if you have no idea what your business is really making for you, it’s time to make some changes. Let’s discuss some ways you can start being more proactive and ways you can start improving.

First and foremost, there are some ground rules that every business owner needs to abide by:

1. Your books have to be reconciled monthly on a timely basis. Set a closing date to have the prior month’s activity input and reconciled. The sooner you can have the books closed the better.

2. You have to review your financials at least monthly, once the books are closed. If you wait to review everything when you are having your tax return prepared, you’ve already missed an entire year that you could have fixed any issues! If you don’t have time to devote, hire us as your Virtual CFO!

3. You must have internal controls established. They help mitigate the risk of fraud, and are a core foundation to your business.

Once you can start operating under these guidelines you can implement your plan to start having a better understanding of how your business is performing. Now that you have your current up-to-date books, you can take a look at your current figures and determine your cash flow. If your cash flow is weak, you need to review where the money is going each month. Are you highly leveraged with debt? Are you spending money on unnecessary items? Are you using credit cards that carry high balances? If all of those check out, are you in a good location? Is your marketing strategy working? Are your employees being productive? Are your employees being utilized to their maximum extent? There are lots of areas that can impact your ultimate cash flow, and sometimes you have to look beyond just what the actual financials show.

Once you determine what your areas of focus need to be, you pick 3-5 metrics, or Key Performance Indicators (KPIs), that will help you track your progress towards the goals. KPIs can be ratios such as office supplies as a percentage of revenue, salaries as a percentage of employee production or debt to equity ratio (there are endless possibilities). You then track your actual ratios compared against your target/goal ratio (which is often based on industry ratios). Of course, you have to have a game plan in place of how you will improve these ratios and you have to be accountable for what you should be doing. Sometimes you have to implement something new, sometimes you have to change habits, and sometimes you have to change processes.

If you are curious whether or not your cash flow could improve, please reach out to us at [email protected] We will do a complimentary evaluation for you.

Important 1099 Information

As we embark on the start of 2019, tax preparers are preparing for the start of busy season.  With January comes due dates for 1099s and W-2s.  Most of the time, taxpayers do not realize that they need to prepare any 1099s.  Within the last few years we have seen the following questions appear on Schedule Cs, Schedule Es, and business tax returns:

1.)        Did you make any payments in 20XX that would require you to file Form(s) 1099?

2.)         If “Yes,” did you or will you file required Forms 1099?

As paid preparers, we have to make sure that we answer these questions correctly, which means verifying with you, the taxpayer, whether or not you had any required 1099s to be filed.  The penalty for not filing a 1099 ranges from $50 per 1099 to $100 per 1099, depending on when the forms are filed.

 

Do You Need to Prepare 1099s?

If you have paid someone over $600 for services (including subcontractors, repairs, computer service and any other service someone provided you) or for rent, then you most likely need to send them a 1099.  However, if you paid a corporation or paid them via credit card, debit card, Paypal or Stripe, then you are not required to send a 1099.  Some corporations are still required to receive a 1099, such as attorneys.  We advise all clients to have people who are providing services for them to fill out a W-9.  This helps us determine if they need to receive a 1099 because they have to tell us what type of entity they are by checking a box.  The following payments would require issuance of a 1099:

-Rent over $600 – reported on 1099-Misc

-Royalties over $10 – reported on 1099-Misc

-Other Income over $600 – reported on 1099-Misc

-Nonemployee Compensation over $600 (Independent Contractors) – reported on 1099-Misc

-Gross Proceeds Paid to an Attorney over $600 (this is reported in Box 14 of 1099-Misc  it typically applies if you paid out a settlement, any other legal services would be reported in Box 7 on 1099-Misc)

-Interest on Business Debt to Someone over $10 (excluding interest on an obligation issued by an individual) – reported on 1099-Int

-Dividends or other distributions to a company shareholder over $10 (most applicable to C Corporations) – reported on 1099-Div

 

What Do We Need to Prepare a 1099?

As mentioned previously, you should have anyone fill out a W-9 who will be receiving payment for any of the items listed above.  On the W-9, they list their legal name, federal ID or social security number, address and type of entity.  I cant stress the importance of having the W-9 before you pay the person.  If you pay somebody one time for $2,000 and do not have any of their information, and then in January you are not able to reach the person to get their information, youre in trouble and potentially could face penalties from the IRS for not submitting a complete 1099.

Please feel free to reach out to us if you have any questions regarding 1099s.

How to Make S Corporation & C Corporation Income Tax Payments

If you owe a balance for your Corporate income tax return, you have several options to pay.

 

If you are a C Corporation and owe federal, you must pay that via EFTPS.  We can point you in the right direction to set this up if you don’t have it already.  If you are an S Corporation, you should not owe anything with the federal income tax return.

 

Your first option to pay is by mailing a check with payment vouchers.  If we had an in-person completion meeting with you, we provided you a printed voucher at that time.  The voucher is also available on your Sharefile as a separate PDF file.  You write the check and mail it in with the voucher.  The voucher typically also lists helpful information for who to make the check payable to, where to mail it, and important information to include on your check.  We advise sending certified return receipt.

 

You may also pay your taxes online.  Below you will find step by step instructions for paying the NC balance.

 

NC

Go to https://eservices.dor.nc.gov/cdv/

  1. Fill in your contact info and click next.
  2. Select Calendar Year or Fiscal Year. If your return reports January-December, you are a calendar year taxpayer.
  3. Fill in all information.
  4. For franchise tax due and corporate income tax due, refer to the vouchers we provided you. The voucher indicates whether it is franchise tax or corporate income tax, as well as the amount that needs to be paid. Enter the amount you are paying and click next.
  5. If you are only paying Franchise Tax, select File CD-V and Pay Franchise Tax Only. If you are only paying corporate income tax, select File CD-V and Pay Corporate Income Tax Only. If you are paying both, select File CD-V and Pay Franchise and Corporate Income Tax.  Click next.
  6. Choose payment selection and continue through remaining prompts and screen until you receive confirmation. Please be sure to print a copy of the confirmation and save for your records.