©2011 Langdon & Langdon Financial Services, LLC 1-1 Primer on Income Tax Planning “Taxes are what we pay for a civilized society.” - Justice Oliver Wendell Holmes “There is no such thing as a good tax.” - Sir Winston Churchill 1-2 1-3
©2011 Langdon & Langdon Financial Services, LLC
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Primer on Income Tax Planning
“Taxes are what we pay for a civilized society.”
- Justice Oliver Wendell Holmes
“There is no such thing as a good tax.”
- Sir Winston Churchill
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©2011 Langdon & Langdon Financial Services, LLC
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Income tax rates beginning at one percent and rising to seven percent for taxpayers with income in excess of $500,000. Less than one percent of the population was subject to the income tax.
The Sales Pitch: Tax the Rich
The Revenue Act of 1913
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Today:
“I want to provide a tax cut for 95% of Americans. If you make less than a quarter of a million dollars a year, you will not see a
single dime of your taxes go up. If you make $200,000 a year or
less, your taxes will go down..”
- Barack Obama, 2008 Presidential Campaign
Have Things Changed ?
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Functions of the Income Tax System
Produce Revenue
Management of the Economy effectuate fiscal policy
encourage desired behavior
Social Function redistribution of wealth
Regulatory Function discourage undesirable activities
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Adam Smith’s Criteria for Evaluating Tax Systems
Equality
Convenience
Certainty
Economy
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Tax Structure
Tax Base: amount to which tax rate is applied
Tax Rate: applied to Tax Base to determine tax liability Proportional
Progressive
Regressive
Incidence of Tax: degree to which total tax burden is shared by taxpayers
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Tax Structure
Examples:
Income $10 $20 $30
Proportional Tax $3 (.3) $6 (.3) $9 (.3)
Progressive Tax $3 (.3) $7 (.35) $12 (.4)
Regressive Tax $3 (.3) $5 (.25) $6 (.2)
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Types of Taxes
Transaction (usually state tax)
Estate & Gift
Generation Skipping Transfer
Property (ad valorem)
Income
Employment
Other
Estate Planning
Income Tax
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U.S. Federal Tax System
3 Separate Tax Systems
Income Tax Estate & Gift
Tax
Generation- Skipping Transfer
Tax
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Taxable Income Income
Active Portfolio Passive
Wages, Salaries, &
Active Business
Income
Interest,
Dividends,
Capital Gains
Partnerships,
Real Estate
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3 Essential Tax Principles
Doctrine of Constructive Receipt
Economic Benefit Doctrine
Doctrine of the Fruit & The Tree
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Federal Income Tax Formula
Income (broadly conceived)
Less: Exclusions
Gross income
Less: Deductions for AGI (Above-the line deductions) Adjusted Gross Income (“The Line”)
Less: Itemized or Standard deduction (Below-the line deductions)
Less: Personal and Dependency Exemptions
Taxable Income
Tax on taxable income
Less: Tax credits Tax due (or refund)
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Employment Taxes
FICA taxes Paid by both employee and employer
In 2014, Social Security rate is 6.2% on a max of $117,000 of wages.
Medicare rate is 1.45% with no cap
Self-employment tax Rate is 15.3%, base is net self-employment income, and
deduction (FOR AGI) is allowed for 1/2 of self-employment tax
Number of Returns Filed
Type of Return 2009
Individual 144,103,000
Estate Tax 47,000
Gift Tax 245,000
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Internal Revenue Collections
Type of Tax Gross Collections*
for 2008
Percent of
2008 Total
Individual Income Tax $1,190,382,757 50.8%
Employment Taxes $858,163,664 36.6%
Estate and Gift Taxes $24,677,322 1.1%
* Money amounts are in thousands of dollars.
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Working with the Tax Law
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Sources of Tax Law
Admin Action
Judicial Decisions
Statutory Law
The 16th Amendment to the U.S. Constitution High
Low
Priority
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Who makes better tax rules…
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The Three Stooges or…..
The Three Wise Men?
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The Treasury’s Functions
Enact regulations
official Treasury interpretation of the Code
to the extent the regulations are consistent with the Code, they have the force and effect of law
Issue Revenue Rulings and Private Rulings
Issue Revenue Procedures
Issue Determination Letters
Manage conflict with Taxpayers
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Regulations – Stage of Adoption
Proposed Preview of final regulations
Do not have legal precedence
Temporary Issued when guidance is needed quickly
Same authoritative value as final regs
Final Have force and effect of law
Binding on Taxpayers and Treasury
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Final Regulations
Procedural Housekeeping instructions
Interpretive Implement intent of committee reports and code
Legislative Allows Treasury to determine the details of the
law
Congress must specifically delegate authority
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Revenue Ruling
facts common to many taxpayers
binding on the IRS
taxpayers can
rely upon the rulings
challenge the rulings in court
courts are not bound by Revenue Rulings
published weekly in the Internal Revenue Bulletin
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Private Ruling (PLR)
issued at the request of the taxpayer
the IRS is bound by its determination in the ruling
made available to the public after deletion of certain materials
cannot be relied on by other taxpayers as precedent
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Determination Letters
issued by District Directors for returns filed in their respective districts
must be a completed transaction
issued only if answer is covered specifically by statute
Treasury decision or regulation
ruling opinion or court decision published in the IRB
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Revenue Procedure
describe internal practices and procedures within the IRS
published in the Internal Revenue Bulletin
generally state changes in techniques and administrative procedures used by the IRS
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Judicial Sources of Tax Law
Courts
interpret statutory ambiguity
Cannot issue advisory opinions
Need “Case or Controversy”
Court opinions are binding on lower courts, the IRS, and taxpayers
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Information Available in Basic Tax Research Services
Internal Revenue Code (IRC)
Treasury Regulations (Treas. Reg.)
Practice Aids (offered by RIA publications)
IRS Manual
Court Citations
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Statute of Limitations
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©2009 Money Education 2-32
Periodicals as a Source of Tax Information
Federal Tax Articles (CCH)
Journal of Taxation
Taxes - The Tax Magazine
Tax Notes
Monthly Digest of Tax Articles
Journal of the Society of Financial Services Professionals
Estate Planning
Trusts & Estates
Journal of Financial Planning
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Keeping Up with New Developments
CCH & RIA
Accounting Firm Websites
www.TaxAlmanac.com
The Daily Tax Report, published by the Bureau of National Affairs
Database Services
LEXIS and Westlaw
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Basic Tax Planning Principles
1. Receive income in a tax-exempt (excludible) form.
2. Shift income to related taxpayers in lower marginal tax brackets.
3. Receive income that is taxed at favorable capital gains tax rates.
4. Defer Income taxes until later.
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Basis Rules, Depreciation, & Asset Categorization
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Income vs. Capital
Tax is levied on income, not capital
Capital is income that has already been taxed
The Tax Toll-Booth
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Realized vs. Recognized Income
Gains must be “realized” before they can be taxed
A gain is not usually realized unless
there is a disposition of property
there is a segregation of the gain
When a gain is taxed, it is “recognized”
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Calculating the Gain (I.R.C. § 1001)
Amount Realized
- Adjusted Basis
= Realized Gain
Cost of Property
+ Capital Additions
- Cost Recovery
= Adjusted Basis
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Amount Realized
The sum of money received, plus
the FMV of property received in the exchange, plus
liabilities shed
Results from Sale or other disposition Trade-ins
Casualties
Condemnation
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Basis
Purpose Keep track of after-tax dollars (capital) that
is tied up in an investment Allows investor to recoup capital tax-free
upon sale
Uses Determine gain/loss Determine depreciation deductions Determine the amount an investor has “at
risk” under the passive loss rules
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Determining Basis
Cost Basis
Initial capital used to purchase the investment
Includes
Cash
Cost of property given in exchange
Recourse Debt used for financing
Costs necessary to acquire the asset (sales tax, freight,
installation)
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Adjustments to Basis
Increases to Basis
Capital infusions
Amortization of discount bonds
Profit of pass-through entities
Liabilities assumed
Decreases to Basis
Return of capital
Distributions from pass-thru entities
Depreciation
Amortization of bond premium
Liabilities shed
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Basis of Personal Assets
Initial Basis = Cost
Basis increased by capital additions
Capital is recovered when asset is sold
Depreciation is not allowed
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Basis of Property Acquired by Decedent
Basis = fair market value at
the date of death, or
the alternative valuation date
sometimes called “stepped-up” basis
applies to testamentary transfers of property whose value is included in the decedent’s gross estate
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Section 1014 & Joint Tenancy
Applies to
Joint Tenancy with Right of Survivorship
Tenancy by the Entirety
The property passes outside of probate
the surviving joint tenant is deemed to receive the property from the decedent
Basis is stepped up to the extent that the value of the property is included in the gross estate of the decedent
Results in a partial step-up in basis
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Stepped-Up Basis Rule Exceptions
Contemplation of Death Rule Appreciated property is acquired by a decedent
as a gift
within one year of death, and the property passes from the donee-decedent to the
original donor or donor’s spouse
Income in Respect of a decedent property (IRC
Sec. 691)
Annuity payments transferred from the decedent to a beneficiary
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Basis of Gifted Property
General Rule: Carryover basis
Changes in basis result from
Payment of gift tax
Gift of property with FMV<adjusted basis on date of gift
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Impact of Gift Tax on Basis
Donee’s basis is increased by a portion of gift taxes paid by the door if
the donee sells the property
for more than the donor’s original basis
Net Appreciation in Value of Gift
Value of Gift at Transfer x Gift Tax Paid
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Example
Cathy received a gift from Darren on June 15 of this year that had a FMV of $20,000. Darren’s adjusted basis in the asset was $15,000, and he paid a gift tax on the transfer of $800.
Cathy’s basis in the gifted property is $15,200
Calculation: $15,000 + ($5,000/$20,000 x $800)
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Gifts of Loss Property
If FMV of gifted property < the donor’s adjusted basis on the date of the gift, a Dual Basis Rule applies
To determine Loss, the adjusted basis of the donee is the lesser of
FMV of the property on the date of gift
the adjusted basis of the transferor
To determine Gain, the basis of the donee is the adjusted basis of the donor (plus an adjustment for gift taxes paid, if applicable)
If the FMV at date of gift < AR < Adjusted basis of transferor, no gain or loss is recognized.
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Example 10.18
Wally purchased 100 shares of Hyde, Inc. five years ago for $5,000. He just gave those shares to his son, Junior, when the value of the 100 shares was $1,000.
$5,000 Wally’s Adj. Basis
$1,000 FMV at date of Gift
Gain Basis
Loss Basis
No Gain/No Loss Corridor
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Example 10.18, Continued
Junior sells the shares for $6,000
Gain is $1,000 (Use $5,000 as basis)
Junior sells the shares for $750
Loss is $250 (Use $1,000 as basis)
Junior sells the shares for $3,000
No gain/loss corridor
1-53 ©2010 Langdon & Langdon Financial Services, LLC.
Holding Period For Gifted Property
General Rule:
Holding period in the hands of the donee includes the holding period in the hands of the donor
Exception:
If dual-basis asset is sold for a loss, holding period for donee starts on date of gift
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Basis & Spousal Transfers
All transfers between spouses & incident to a divorce are treated as gifts.
Basis carries over
Husband and wife are treated as a single economic unit
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Related Party Transactions
Related Party Spouse, ancestors & descendants, brothers & sisters (of the
whole or half blood)
Sales If a gain results, normal rules apply
If loss results, double basis rule applies Holding period resets
Gifts Gain property – Carryover Basis Loss Property – double basis rule applies
Holding period resets only if loss basis is used
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Depreciation (Cost Recovery)
Allows taxpayer to recover capital over useful life of asset
May be claimed for assets Used in a trade or business Held for production of income
Capital invested in personal assets is recovered when the asset is sold
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Taxation of Investment Income
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Interest & Dividends
Interest
Taxed at ordinary rates when received
EXCEPTION: OID
Dividends
General Rule: taxed at ordinary rates
Qualified Dividends taxed at 15%
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Capital Gains General Rule: maximum rate of 15% (20% +
surtax of 3.8% for high income taxpayers in 2013) for long-term gains TP in 15% (or lower) bracket - 0%
Exceptions: Collectibles - 28% (28%)
Unrecaptured Sec. 1250 Gain - 25% (25%)
Effective rate may be more than maximum capital gains increase a taxpayer’s AGI
increased AGI may lead to phaseouts
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Special Rules for Capital Transactions
Sec. 1202
Excludes 50% of gain on small business stock held for 5 years
Aggregate gross assets less than $50 M
C-Corporation
Active conduct of Trade/Profession
Taxable portion subject to 28% capital gains tax
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Limitation on Capital Losses
Ordinary Portfolio Passive
($3,000)
Income
Lifetime: $3,000 per year
Amounts left over at death are lost
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Limitation on Passive Losses
Exceptions
Dispose of activity
Meet requirements for $25,000 Loss Deduction
Ordinary Portfolio Passive
($25,000)
Income
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The AMT & Investment Transactions
Adjustments made for AMT purposes
Excludible portion of 1202 stock is subject to 7% tax for AMT Taxpayers
Private Activity Municipal Bond Interest becomes taxable
Incentive Stock Options
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Stock Investing
Sale or transfer is realization event
Splits
Generally not taxable event
Basis spread among total shares
Taxable if
Can receive distribution in stock or cash
Distribution changes proportionate interest
Distribution in form of preferred stock
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Stock Investing
Warrants & Rights
allow purchase of shares at discounted price
Same tax rules as splits
Spin-offs
Generally not a taxable event
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Stock Investing
Short Sales
Used if price expected to go down
Purchase of stock to close transaction is realization event
If gain, purchase date
If loss, settlement date
HP depends on length of time underlying property was held
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Stock Investing
Short Sales
Special Rules
Gain is ST if on date of original short sale, underlying security was held for 1 year or less
Loss is LT if on the date of the original short sale, substantially similar securities were held for more than one year
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Stock Investing
Shorting against the box
Formerly used to defer recognition
Treated as constructive sale
Gains are recognized
Losses are deferred
Possible Alternative
Purchase put at the money
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Stock Investing
Wash Sales (Sec. 1091)
Used to recognize loss without changing economic position
30-day window before & after
Consequences:
No loss recognition
Unrecognized loss added to basis of replacement property
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Determining Basis of Stock Sales
First-in First-out (FIFO) IRS Approach
Specific Identification Must adequately identify shares
Keep good records
Average Cost Method Tends to lower gain if security increased in value over time
Once elected, must continue to be used for that security
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Taxation of Bonds
Interest (Coupon)
Marginal ordinary income tax rate
Original Issue Discount (OID)
Exception to constructive receipt doctrine
Accrued interest included in income
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Taxation of Bonds
Market Discount Bonds Investor Election
Amortize discount and increase basis Recognize discount when sold
In either case, treated as interest income
Market Premium Bonds Investor Election (applies to all bonds for the tax year)
Amortize premium over remaining life Do not amortize, and add to basis
If sale results in gain, premium returned tax free If sale results in loss, treated as capital loss
If tax exempt bond, no amortization is permitted, but basis will be reduced by the bond premium
1-73 ©2010 Langdon & Langdon Financial Services, LLC.
Taxation of Bonds
Municipal Bonds
Coupon payments are generally exempt
AMT status causes coupon payments to be taxable on all but public purpose municipal bonds
Gain/Loss is subject to tax
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Taxation of Bonds
Government Bonds
Coupon is subject to federal, but not state, taxation
Series EE Bonds for Education
Exempt if
Purchaser was 24 years old
Bond is registered in name of bond owner
MAGI falls below specified limit
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Taxation of Open-End Mutual Funds
2 Sources of gain
Increase/decrease in value
Capital transaction
Distributions
Interest
Dividends (Qualified or non-qualified)
Long-Term Capital Gains
Short-Term Capital Gains
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Taxation of Closed-End Mutual Funds
Usually purchased in secondary market
Generally capital treatment governs
If elect to be taxed as a regulated investment company, tax rules follow open-end mutual funds
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Unit Investment Trusts
Similar to mutual funds, but not actively managed
Tend to hold securities that self liquidate over time
Gains/losses follow normal rules
Investment Income
Grantor Trust – all income taxable to owners
Regulated Investment Company – taxed in same manner as open-end mutual fund
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Taxation of Real Estate
If held for business or rental use, treated as Sec. 1231 asset Depreciation is available
Depreciation recapture calculated on sale
Principal Residence
Sec. 121 Exclusion
Playing monopoly
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Taxation of Real Estate
Tax deductions derive from
Depreciation
Interest on loans
Property tax
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Taxation of REITs
Mutual fund for real estate
Most are Publicly traded
closed-end investment companies
Exempt from tax at entity level if 75% of income comes from real estate
Distributes 90% of income in form of dividends on an annual basis
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Taxation of Option Contracts
Depends on Long/short position in contract
Type of option held
Manner of disposition
Purchase of an option Not a taxable event
Basis = Cost + Commission
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Disposition of Long Option Contracts
Sale Calculate gain/loss
Generally STCG (9 month contracts)
LEAPs can be LTCG
Exercise No realization event
Call - Investor’s basis in stock purchased is increased by basis in option contract
Put – sale of underlying stock is taxable event; AR is reduced by basis in the put option
Character determined by HP of stock, not the option
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Disposition of Long Option Contracts
Expiration
Option premium paid is a capital loss
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Disposition of Short Option Contracts
Receipt of Premium Not a taxable event
Exercise by purchaser Call – seller adds premium received on sale of
option to AR to determine gain/loss HP determined by length of time stock was held
Put – no immediate taxable event Reduce basis in stock purchased by option premium
received HP begins on the date of exercise
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Disposition of Short Option Contracts
Expires
Premium is STCG
If position is closed
Recognize STCG/L = Option Premium Received – Option premium paid
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Employer Stock Options and Stock Plans
Stock Options – The right to buy stock at a specified price for a specified period of time. Agreement must be in writing, and holder has no obligation
to exercise
Option price = FMV at date of grant
Vesting – Right to exercise options only after certain period of time, performance, or occurrence.
Types of Options Incentive Stock Options (ISOs)
Nonqualified Stock Options (NQSOs)
Stock Appreciation Rights (SARs)
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Incentive Stock Options (ISOs)
statutory Stock Option ties employee benefit to stock price of the
company may provide special taxation may only be granted to employees. aggregate FMV of ISO grants must be less
than $100,000 per year per executive. For ISO special tax treatment, individual must
hold stock two years from date of grant, and one year from date of exercise.
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Taxation of ISOs
Grant Date No taxable income unless exercise price is less than fair
market value at date of grant.
Upon Exercise No regular tax.
AMT adjustment equal to appreciation over the exercise price.
Upon sale of stock Long-term capital gain treatment for stock appreciation over
exercise price.
Negative AMT adjustment.
Employer does not have a tax deduction related to the ISO.
1-89 ©2010 Langdon & Langdon Financial Services, LLC.
Disqualifying Disposition
Selling stock acquired from an ISO before two years from grant date or one year from exercise date.
Loss of favorable tax treatment. Appreciation over exercise price at exercise date =
ordinary income (reported on W-2). Appreciation after exercise date = capital gain
(short/long based on holding period beginning at exercise date).
Employer has a tax deduction equal to the executive’s W-2 income.
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Cashless Exercise
Very common
Third-party lends cash
Executive repays the lender almost immediately with the proceeds and has W-2 income for the excess value over the exercise price.
A cashless exercise is a disqualifying disposition.
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Nonqualified Stock Option (NQSO)
Option that does not meet requirements of an ISO.
Ties an employee benefit to the performance of the company stock.
Exercise does not receive favorable tax treatment.
No statutory holding period requirements. Employer’s may place holding period requirements
on the stock.
1-92 ©2010 Langdon & Langdon Financial Services, LLC.
Taxation of NQSOs
Grant Date No taxable income unless exercise price is less
than fair market value at date of grant.
Upon Exercise Executive will have W-2 income for the
appreciation over the exercise price. Employer has income tax deduction for same
amount.
Upon sale of stock Executive will have capital gain/loss with a holding
period beginning at the exercise date.
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Gifting of ISOs and NQSOs
ISOs
Unexercised ISOs cannot be gifted.
Can only be transferred after exercise date.
NQSO
May be gifted if allowed by employer.
When donee exercises -
Employee will have W-2 income.
Employer will have tax deduction.
Donee’s basis equals W-2 amount.
1-94 ©2010 Langdon & Langdon Financial Services, LLC.
Stock Appreciation Rights (SARs)
Rights that grant the holder cash in an amount equal to the excess of the fair market value of the stock over the exercise price.
Ties an employee benefit to the value of the employer’s stock.
Essentially a cashless exercise without any right to purchase the stock.
No taxation at grant Unless employee elects IRC Section 83(b) – discussed below.
Employee - W-2 income for excess value over exercise price.
Employer – Tax deduction for W-2 amount.
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