Tax Prophet FAQ January 23, 1996

Frequently Asked Tax Questions -- February 1996, part 1

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Tuesday, Jan. 23, 1996

DOLLARS & SENSE

ROBERT L. SOMMERS

Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

Questions

Question: As part of my compensation package, I will receive 1,000 shares of stock (currently worth $1 per share), but I must remain an employee for three years. When am I taxed? When I sell the stock for a profit, do I receive ordinary income or capital gains? [Answer]
Question: Rather then giving me the stock directly, what if my company gave me options on 1,000 shares at $1 per share, exercisable only if I remained employed for at least three years? [Answer]
Question: My employer has an incentive stock option plan in which I will receive an option to purchase 1,000 shares of stock as of my first date of employment. Is this offer different than the previous question? [Answer]
Question: As a California resident, I have a small personal service corporation. I am the sole corporate shareholder and employee, and all my work is performed in California. Would incorporating in Nevada save me taxes and provide greater protection against creditors? [Answer]

Answer to Question #1: : Internal Revenue Code Section 83 provides that a taxpayer who receives property, including stock, in return for services - whether as an employee or independent contractor - has gross income that includes the property's fair market value, upon receipt of the property. When that stock is subject to a "substantial risk of forfeiture," however, the taxpayer usually includes the stock as gross income at the time the forfeiture lapses.
In your case, the three-year employment requirement constitutes a substantial risk of forfeiture; you would report the fair market value of the stock as gross income at the time the restriction lapses.

If we assume the stock is worth $10 per share at the end of three years, you would report $10,000 of additional income at that time.

Under Section 83(b), however, you may elect to treat the stock as gross income at the time you receive it (your first days as an employee), rather than when your three-year restriction lapses.

In your case, if you make a Sec. 83(b) election, you would report $1,000 of income when you received the stock. Thereafter, if the stock climbs to $10,000 in value, you could then sell it for a capital gain (profit) of $9,000. If, however, the stock is worth less than $1,000 when you sell it, you cannot claim your loss.

Under Sec. 83, should you leave your job before 36 months, you would not have to return any dividends received; you would only forfeit your ownership of the shares back to the company.

Employers are entitled to a deduction for compensation paid in the amount of income includable in the taxpayer's income. Example: If this taxpayer's gross income is $10,000, then the employer has a $10,000 deduction for compensation paid. Conversely, if the taxpayer made a Sec. 83(b) election, the employer's deduction is limited to $1,000.

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Answer to Question #2: When options are transferred to employees (or contractors) in connection with the performance of services, there is usually no taxable event until the option is exercised, at which time the stock is subject to Sec. 83.
Typically, receipt of an option to acquire stock is a nontaxable event. In this example, since the three-year restriction applies to the option, the option can only be exercised after the restriction lapses.

Once the option is exercised, the taxpayer must claim the full value of the stock as income, less the amount paid for the option. Example: If the stock is worth $5 per share at the time of exercise, then your additional taxable income would be $4,000 ($5,000 of stock, less the option price of $1,000).

In the unusual case where the option itself has a "readily ascertainable fair market value," Sec. 83 applies. You must include as income the fair market value of the option; thereafter you are considered an investor. In your case, if Sec. 83 applied and if you elected to be taxed immediately under Sec. 83(b), you would include $1,000 as income. Later, if you exercised the option and subsequently sold the stock for $5,000, then $4,000 would be your capital gain.

But be careful. In a recent 9th Circuit decision, Cramer vs. Commissioner (Sept. 11, 1995), the taxpayer unsuccessfully challenged regulations relating to readily ascertainable fair market value.

The value of the stock had greatly increased between the time he was offered the option (which he declared as having a zero value under Sec. 83(b) ) and when he sold the stock. Rather than treating the sales proceeds as ordinary income, he argued that the stock sale produced capital gains - and a much lower tax. The court upheld penalties for negligence and substantial understatement of income against him, in addition to treating the entire gain from the sale of stock as ordinary income. The Cramer case reaffirms the difficulty in claiming a readily ascertainable fair market value for stock options.

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Answer to Question #3: If the employer establishes an incentive stock option plan under IRC Sec. 421(a) (a "statutory option" ) as distinguished from options subject to Sec. 83 ( "non-statutory options" ), the employee is not taxed upon the grant or exercise of the option, but is taxed when the stock is sold; profit is usually long-term capital gain. Under such a plan, however, the option price must equal the stock's fair market value on the date the option is offered. Numerous other restrictions relating to the exercise of the option and sale of the stock apply.
The employer, however, cannot treat the stock option or exercise thereof as a compensation payment to the employee; consequently, the employer is not entitled to any deduction under a statutory option plan.

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Answer to Question #4: There is a cottage industry in Nevada currently extolling the virtues of incorporating there. For California companies such as yours, incorporating in Nevada is, at best, a waste of time and money. At worst, it is a recipe for disaster. This would produce no real tax benefits and only cost you money. Becoming a C corporation (as these Nevada companies usually recommend) places your personal service corporation in the highest federal income tax bracket (a flat 35 percent on all corporate income).

Contrary to claims, one cannot "upstream" (shift) income from California to Nevada to escape California taxes.

Under California income tax law, any corporation, regardless of its state of incorporation, deriving income from California sources is subject to full California income tax.

If all income is derived from California sources, then the total net income is subject to taxes. Also, a Nevada corporation must register as a "foreign" corporation in California and would pay the same annual minimum tax (currently $800) as every other corporation incorporated in California.

Therefore, your corporation will pay the same taxes in California whether or not it changes its state of incorporation to Nevada and, in addition, will have to pay annual filing fees (currently $85), plus whatever fees the company that sold you the Nevada corporation concept charges.

Another empty selling point for forming a Nevada corporation is that Nevada does not share tax information with the IRS.

So what? Since Nevada corporations pay no state income tax, there is no information to disclose to the IRS in the first place. California shares tax auditing information with the IRS. Because your corporation will already be subject to California tax audits, Nevada offers your company no audit benefits or protections.

Finally, under new California laws, your company can protect its shareholders against becoming liable with respect to corporate lawsuits and minimize its federal and state income tax liability. California's new limited liability company act provides excellent protection against creditors, permits flexible and straightforward tax planning, and should be an early alternative considered by those concerned about their assets.

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