Tag Archives: Incentive Stock Options

From Tax Returns to Tax Planning

Many colloquially refer to the Winter and early Spring as “tax season.” To my mind, that is short sighted. Yes, for most the time from late January to mid-April are when their tax return is prepared and filed. But the most impactful tax work is not tax return preparation — it’s tax planning!

Below I discuss ways to use your current tax return as a springboard to tax planning. 

Before we get started, two notes. First, there is some tax planning that can be “do it yourself” and some tax planning that is best considered and implemented with the help of a tax planning professional. When in doubt, the concept is probably the latter. Second, it is helpful to keep in mind the correct use of this blog or any other blog–as a tool to raise awareness. Blogs are not a substitute for professional advice, and are not advice for any particular person. Rather, this post and others should be viewed as a way to increase knowledge and help faciliate more informed conversations with professionals. 

Your 2020 Tax Return

Your 2020 tax return is a great springboard for tax planning. Look at the following items on your tax return to jump start your tax planning.

Schedule D Line 13 Capital Gain Distributions

Everyone should review their own tax returns for the past few years and look at this line. If there is a substantial number on this line, it should raise a red flag.

I previously discussed capital gain distributions here. Generally, they come from mutual funds and ETFs in taxable accounts. These financial securities pass gains out to the shareholders, creating capital gains income on the shareholders’ tax returns. Actively managed funds tend to have much greater capital gain distributions than passively managed index funds.

The planning opportunity is to review the accounts that are generating significant capital gain distributions. If the realized gain in such accounts is low (or if there is a realized loss in those accounts), it might be advisable to sell the holding and replace it with a fund likely to have lower capital gain distributions. Taxpayers considering this strategy should be sure to fully understand the gain or loss in the securities before selling. Financial institutions do not have to report to investors (and the IRS) basis in mutual funds purchased prior to 2012, so sometimes it can be difficult to determine the taxable built-in gain or loss on older holdings.

Form 8889 Line 14c Distributions

Form 8889 is the tax return form for a FI favorite: the health savings account. Amounts other than $0 on Line 14c of Form 8889 should appear, in my opinion, only if the taxpayer is elderly or found themselves in a dire situation during the tax year. It is generally not optimal, from a tax perspective, to take distributions from an HSA to fund medical expenses when one is neither elder nor in a dire situation. 

Amounts other than $0 on Line 14c can be a learning and planning opportunity. Future routine medical expenses are usually best paid from one’s checking account (a regular taxable account), and taxpayers should save the receipt. In the future, taxpayers can reimburse themselves tax free from their HSA for that expense. In the meantime, the money has grown in the HSA and enjoyed many years of tax free compounding. 

Form 1040 Line 4b IRA Distributions Taxable Amount

Taxpayers who did a Backdoor Roth IRA and have a large amount on Line 4b of Form 1040 should review their transactions to make sure everything was correctly reported. Part of the idea behind a Backdoor Roth IRA is that, if properly executed, it should result in a very small amount of taxable income (as indicated on Line 4b). 

It may be the case that the tax return improperly reported the Backdoor Roth IRA (and thus, the taxpayer should amend their return to obtain a refund). Or, it may be the case that the taxpayer did the steps of the Backdoor Roth IRA at a time they probably should not have (because they had a significant balance in a traditional IRA, SEP IRA, or SIMPLE IRA). 

Discovering the problem can help effectively plan in the future, and if necessary take corrective action. 

For those executing Roth Conversion Ladders, a large amount on Line 4b is the equivalent of Homer Simpson’s Everything OK Alarm. Roth Conversion Ladders are intended to create a significant amount of taxable income, and Line 4b is where that income is reported on Form 1040. Note further that all Roth IRA conversions require the completion of Part II of the Form 8606. 

Schedule A Line 17 Total Deductions

Those who claimed itemized deductions in 2020 should review Line 17 of Schedule A. Is the number reported for the total itemized deductions close to the standard deduction amount (for 2021, single taxpayers have a standard deduction of $12,550 and married filing joint taxpayers have a standard deduction of $25,100)?

If so, there a tax planning opportunity. Why is that number what it is? Is it because of charitable contributions? If so, the donor advised fund might be a good opportunity. Here’s how it might work:

Example: Joe and Lisa file married filing joint. In 2020, they itemized based on $10K of state taxes, $9K of mortgage interest, and $6K of charitable contributions ($500 a month to their church). Thus, at $25,000 of itemized deductions, they were barely over the threshold to itemize. In 2021, they move a sizable amount into a donor advised fund ($25,000). They use the donor advised fund to fund their 2021, 2022, 2023, and 2024 monthly church donations. 

From a tax perspective, Joe and Lisa itemize in 2021 (claiming total deductions of $44K – the state taxes, mortgage interest, and a $25K upfront deduction for contribution to the donor advised fund). In 2022, 2023, and 2024, they would claim the standard deduction, which is (roughly speaking) almost equivalent to their 2020 itemized deductions. 

By using the donor advised fund, Joe and Lisa get essentially the same deduction in 2022 through 2024 that they would have received without the donor advised fund, and they get a tremendous one year increase in tax deductions in 2021. 

Form 8995 or Form 8995-A Line 2

Those with any amount on Line 2 of the Form 8995 or the Form 8995-A should likely consider some tax planning. This line indicates that the taxpayer has qualified trade or business income that may qualify for the new Section 199A qualified business income deduction. Taxpayers in this situation might want to consider consulting with a professional, as there are several planning opportunities available to potentially increase any otherwise limited Section 199A qualified business income deduction.

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

Taxpayers should review line 11 (adjusted gross income or “AGI”) on their Form 1040 in concert with reviewing their stimulus checks. For those taxpayers who did not receive their maximum potential stimulus payments in 2021, there can be opportunities to lower AGI so as to qualify for additional stimulus payments and/or increased child tax credits. I blogged about one planning opportunity in that regard here.

The Shift to Tax Planning

Tax planning can take many shapes and sizes. But it needs to be driven by goals, not by tactics. Bad tax planning begins something like this: “I need a Solo 401(k), how do I set it up?” N.B. Opening a Solo 401(k) when you do not qualify for one is a great way to create a tax problem for yourself. 

Good tax planning begins more like this: “I want to achieve financial independence. How do I best save for retirement in a tax advantaged way? I’ve heard a Solo 401(k) is a great option. As part of this process, we should consider it as a possible way to help me achieve my goal.”

Another point: I find there is far too much focus on “I had to pay [insert perceived sizable amount here] this year in taxes” and far too little focus on lifetime taxes. To my mind, the goal should not be to pay less tax in any one year. Rather, the goal should be to legitimately reduce lifetime tax burden. Sure, there can be tax planning that does both, but the best tax planning (whether DIY or with the help of a professional) places reducing lifetime tax burden as its primary goal.

Below are just some areas where taxpayers can begin their tax planning considerations.

Retirement Planning

This is a big one. Taxpayers should understand whether they contribute to a traditional IRA and/or Roth IRA, and why or why not. This post helps explain whether taxpayers qualify to make an annual contribution to a traditional IRA and/or a Roth IRA. 

Taxpayers should consider their workplace retirement plans, which can provide several planning opportunities. 

Small Business/Self-Employment Income

For those with a small business and/or significant self-employment income, tax planning is very important. I have written several posts about just some of the tax planning available to those with small businesses. People with small businesses often benefit from professional, holistic tax and financial planning. 

Stock Options

Stock options and employer stock grants provide some good tax planning opportunities. I’ve previously written about ISOs, but all kinds of stock option programs can be an opportunity to do some tax planning, which often should be with a professional advisor. 

Conclusion

Filing timely, accurate tax returns is important. But the best way to optimize one’s tax situation is to do quality, intentional tax planning. Tax planning should prioritize goals over tactics. There is some tax planning that can be done by yourself, but many areas of tax planning strongly benefit from professional assistance.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here. 

The Tax Challenges of ISOs

Incentive stock options (“ISOs”) are a great employee benefit. ISOs are very powerful because they provide the possibility of compensating employees at preferential long term capital gains rates instead of at ordinary income tax rates, and they avoid Social Security and Medicare taxes. ISOs can also help build wealth by allowing employees to purchase employer stock at a discount. However, ISOs can create several tax challenges, and reporting them on your tax return can be confusing.

Incentive Stock Options

Employers grant employees incentive stock options as an incentive to stay with the company. The company grants the employee an option to purchase the stock of the company at a certain price (the “exercise price” or the “strike price”). That price is no less than the company’s current stock price (i.e., the stock price on the grant date, defined below). 

There is a $100,000 annual limit on the fair market value of stock subject to ISO treatment per employee. If an employee leaves the employer’s employment, he or she must exercise or forfeit their ISOs within three months.

Three dates matter when considering ISOs. 

Grant Date: The date the employee is granted the option (i.e., the first date the employee has the option to purchase the stock at the strike price).

Exercise Date: The date the employee exercises the ISO (i.e., the date the employee purchases the stock of the company under the terms of the ISO at the strike price). 

Disposition Date: The date the employee sells the stock acquired by the previous exercise of the ISO.

Tax Treatment

Grant: There is no tax consequence to the employee upon the grant of the ISO.

Exercise: Upon exercise, there is no income tax consequence to the employee. However, the difference between the fair market value of the ISO and its strike price is an adjustment that creates income for alternative minimum tax purposes (the dreaded AMT). Fortunately, the late-2017 tax reform bill increased AMT exemptions (i.e., the amount of income below which the AMT does not apply), thus reducing, but not eliminating, the potential negative impact AMT can have on ISO exercises. 

Further, the AMT issue is removed if the exercise and later stock disposition occur in the same year. As a practical matter, it is often the case that the later stock disposition occurs almost instantaneously after exercise, which takes the AMT issue off the table. 

Dispositions: ISOs have very favorable tax treatment upon disposition if the disposition of the shares satisfies both of the following rules.

  1. The disposition is at least two years from the grant date; and,
  2. The disposition is at least one year from the exercise date.

If both rules are satisfied, the employee has long term capital gain or loss upon the disposition of the shares. Long term capital gains are taxed at preferential rates for federal income tax purposes.

Example: Gary works for Acme Explosives, Inc. Acme grants Gary 10,000 ISOs at an exercise price of $10 per share on January 1, 2018. Gary exercises the ISOs on June 1, 2018 at a time when the fair market value of the stock is $15 per share. On February 1, 2020, Gary sells each share acquired through the ISO exercise at a price of $20 per share. Assume that Gary was not subject to AMT in 2018. 

Because Gary sold the Acme shares at least one year after exercise and at least two years after the ISO grant, Gary’s sale qualifies entirely for long term capital gain treatment (creating a $100,000 capital gain — $200,000 sales proceeds less $100,000 basis) and creates no taxable ordinary income.

Early Dispositions

Often employees will dispose the ISO stock before the time required to get favorable income tax treatment. As a practical matter, employees often exercise the ISO and immediately sell the stock. 

Employees are exposed to the economic performance of their employer through their job and possibly other equity holdings. Thus, they often want to reduce the risk associated with their employer’s performance and dispose of their ISO stock as soon as possible. Most view the tax cost as well worth it considering that (i) the employee immediately pockets (net of tax) the difference between the fair market value of the stock and the strike price, and (ii) the diversification benefits of investing the ISO proceeds into other investments.

If the employee disposes of the ISO stock early (referred to as a “disqualifying disposition”), what result? The difference between the strike price and the fair market value of the stock at exercise becomes ordinary income to the employee reported to the employee as compensation income included in Box 1 of the employee’s Form W-2. The remaining amounts create long or short term capital gain or loss.

Example: Angela works for Acme Anvils, Inc. Acme grants Angela 10,000 ISOs at an exercise price of $10 per share on January 1, 2019. Angela exercises the ISOs on June 1, 2019 at a time when the fair market value of the stock is $15 per share. On December 1, 2019, Angela sells each share acquired through the ISO exercise at a price of $20 per share. 

Because Angela’s December 2019 sale violates both timing tests, Angela’s sale does not qualify for long term capital gain treatment. Thus, Angela has $50,000 of compensation income ($15 fair market value less $10 strike price times 10,000 shares) of ordinary compensation income. The remaining $50,000 of gain is short term capital gain. 

Fortunately, the compensation income is not included in compensation income for purposes of Social Security and Medicare payroll taxes (and, thus, is not included in Boxes 3 and 5 on the Form W-2). Because Angela sold the ISO shares in the same year she exercised the ISOs, there will not be a separate AMT consequence of the ISOs. 

Tax Reporting

Staying with Angela’s example, the $50,000 of ordinary income will be reported as compensation income in Angela’s Form W-2 Box 1, but not in Boxes 3 and 5. Box 14 should indicate “ISO DISQ” and $50,000 as the amount.

Angela should also receive two other tax reporting documents. First, Angela should receive a Form 1099-B. The form should indicate $200,000 of sales proceeds ($20 per share times 10,000 shares) and should indicate a basis of $100,000 (Angela’s historic cost basis, as she paid $10 per share for 10,000 shares). Angela should also receive a Form 3921. This form should indicate the exercise price per share ($10) and the fair market value per share on the date of the exercise ($15).

The IRS will expect to see at least two numbers on Angela’s tax return. First, the compensation income must be reported on Angela’s Form 1040 box 1. Second, the $200,000 stock sale should be reported on Schedule D and on Form 8949. 

This is where it gets interesting. If Angela simply reports $200,000 as gross proceeds and $100,000 as basis on her Schedule D and her Form 8949, she is going to have a very bad tax result. Why? Angela’s W-2 includes $50,000 of the overall $100,000 of income she recognized on the ISO exercise and disposition. If she simply reports a $100,000 gain on her Schedule D/Form 8949, her total reported income will be $150,000, creating $50,000 in over-reported taxable income. 

Thus, Angela must increase the basis she reports on Schedule D and Form 8949 by the $50,000 of ordinary compensation income reported on her Form W-2. Her Schedule D and Form 8949 should report both the $200,000 of gross proceeds and $150,000 of basis in the disposed of Acme shares. 

Estimated Taxes

Even though the gain on a disqualifying disposition of an ISO is taxable as ordinary income in Box 1 of the Form W-2, there is no requirement that the employer withhold any income tax with respect to the gain. Thus, the onus falls to the employee to ensure he or she pays the proper amount of federal and state estimated income tax to avoid penalties. The good news is that there is a safe harbor under which employees can avoid underpayment penalties. 

For federal income tax purposes, there will not be an underpayment of estimated tax penalty if the employee has paid in at least 90 percent of their current year total tax liability and/or 100 percent of their prior year total tax liability. If current year income is $150,000 or more, 100 percent becomes 110 percent. 

Regardless of whether there is a qualifying disposition triggering long term capital gain or a disqualifying disposition triggering ordinary income, the employee should endeavor through a combination of estimated tax payments, additional workplace withholding, and/or additional spousal workplace withholding to ensure that he or she has withheld enough during the year to avoid federal and state underpayment penalties. 

Conclusion

ISOs can be a great wealth building tool. But because of the tax rules and at times confusing tax reporting, they present a challenge. Anyone with ISOs (or with clients that own ISOs) should step back and fully understand the tax ramifications of selling them. It is often advisable to work with a professional advisor as you sell ISOs and manage the tax ramifications of the sale. 

Further Reading

The IRS provides some tax resources on ISOs starting on page 12 of Publication 525.

FI Tax Guy can be your financial advisor! FI Tax Guy can prepare your tax return! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters.