Edward A. Lyon, JD
TaxTuneup.com, Inc.
3416 Shaw Ave #5
Cincinnati OH 45208
513.321.2821
elyon@taxtuneup.com
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S Corporation
Subchapter "S" corporations are
a special category of corporations that don't pay income tax themselves.
S-corps file
Form
1120S reporting income, expenses, capital gains and losses,
charitable gifts, and the like. Then they pass the results directly on to
the shareholders on Schedule K1. Shareholders, in turn, report these items
on Schedule E. S-corporation income and loss may be considered passive
income or loss if you don't materially participate in the corporation's
business.
S-corporations can have up to
100 shareholders, all of whom must be individuals (no nonresident aliens),
estates, or certain trusts. There may be only one class of shares;
however, an S corporation can own a taxable subsidiary or a "qualified
subchapter S" subsidiary.
S-corporations give you
several opportunities to cut your business income tax:
-
Since there's no tax on
corporate income, you avoid the risk of double taxation you'd face with a
regular taxable corporation.
-
You can take income from the
corporation in the form of dividends, rather than wages, and avoid payroll
taxes on the dividend. You should still pay yourself a reasonable salary
to avoid having the IRS recharacterize your dividend as salary. That
amount varies by industry; however, the Congressional Joint Committee on
Taxation reports that the average S-corporation owner draws 42% of their
income in the form of salary.
This may not work if you have co-shareholders that don't participate in
the business and would receive dividend income in proportion to their
ownership, despite their lack of participation. And "personal service
income" from law, medicine, accounting, and consulting, is treated as
ordinary income even inside an S corporation. Also, you limit your ability
to make qualified retirement plan contributions based on a percentage of
your income. If funding a retirement plan is important, consider choosing
a 401(k) to contribute up to $15,500, not limited to any percentage of
your income.
-
You can use S corporation
losses (but not regular taxable corporation losses) to shelter income from
other sources. This can be especially valuable for start-ups that you
expect to lose money at first. See
Net Operating Loss.
For more information, see
IRS
Publication 542, "Corporations."
Safe Deposit Box Fees
Safe Harbor 401(k) Plan
(See
Qualified Plan)
Sales Tax
Sales tax is a deductible
Itemized Deduction if
you don't deduct State and Local Income
Tax.
You can deduct your actual sales
tax for the year. This is likely to be tough to verify unless you bought
something especially expensive. Or you can use IRS tables based on adjusted
gross income. For more information, see
IRS
Publication 600, State and Local General Sales Taxes.
When you buy assets for business
or investment, you
can add sales taxes to your Basis
for figuring Capital Gains
on sales, Depreciation,
and First-Year Expensing.
Samples
Free samples you receive from vendors as a prospective customer are nontaxable
income.
Free product samples that you
give to prospective customers of your trade or business are deductible as
business expenses on Schedule C, Form 1065, or Form 1120. You can't deduct
samples you keep for yourself. Contrary to some claims, free samples
aren't a way to convert personal expenses into deductible business
expenses.
Scholarships and Fellowships
Scholarships and fellowships you
receive
are generally nontaxable income for full-time students working towards a
degree. This exclusion doesn't apply to payments for teaching, research, or
other services for the school. For more information, see
IRS
Publication 520, "Scholarships and Fellowships."
Section 83(b) Election
(See Stock Options)
Section 105 Plan
(See
Medical Expense Reimbursement Plan)
Section 125 Plan
(See Flexible
Spending Plan)
Section 412(i) plan (See
Qualified Plan)
Section 529 Plan
Section 529 plans are
tax-advantaged college savings plans administered by individual states.
These plans offer high contribution limits, tax advantages, and favorable
financial aid treatment. As such, they are probably the best college savings
vehicles for most families.
There are actually two types
of Section 529 plans. Traditionally, states have offered "prepaid tuition"
plans that let you buy a specific unit of tuition--a credit hour, a
course, or even an entire year--at any of the sponsoring state's public
universities. If your child chooses not to attend a participating school,
you can use the account for out-of-state public and private schools. Newer
"college savings" plans let you invest your contributions in mutual funds
for potentially higher growth. You can then use your account balance for
tuition and expenses at any accredited college or university. Here are the
rules:
-
Your earnings grow
tax-deferred until you withdraw them for college.
-
Your withdrawals are treated
first as a return of your original investment, with no tax due until your
total withdrawals top your total investment in the program.
-
Withdrawals exceeding the
investment in the program are taxed to your child at your child's lower
rate.
-
You yourself are taxed only if
you get a refund exceeding your initial investment.
-
Contributions are considered
complete gifts for gift tax purposes. Parents or grandparents can put up
to $12,000 per year into the program and owe no gift tax. A special rule
lets you give up to $60,000 in a single year ($120,000 for couples) so
long as you don't contribute for the next four years.
-
There are no income limits on
your ability to contribute to a child's account.
-
Each state sets its own limit
on plan contributions. These limits currently range from $100,000 to
$310,000 per child, indexed for inflation.
-
Many states let you deduct
Section 529 Plan contributions from your state taxable income.
-
When it comes time to apply
for financial assistance, assets in a Section 529 account will be
considered yours, not the child's.
There's no need to choose your
own state's program. And the new generation of mutual fund programs may be
the best college savings strategy available. The fund managers invest your
savings, and the program managers adjust the portfolio mix as your child
approaches college--all tax-free.
Section 105 Plan
(See
Medical
Expense Reimbursement Plan)
Section 1031 Exchange
(See Tax-Deferred Exchange)
Section 1035 Exchange
(See Tax-Deferred Exchange)
Section 1244 Stock
(See Small Business Stock)
Seeing-Eye Dog
Deductible Medical
Expense subject to the 7.5% floor, including food, training, and veterinary care.
Self-Employed Health Insurance
(see
Health Insurance)
Self-Employment Tax
Self-employment tax is a
substitute for Social Security contributions if you earn money from your own
proprietorship, partnership, or limited liability company. Self-employment
tax is partially deductible as an adjustment to income if you have
self-employment income. It's a tax on "net" self-employment income that
replaces Social Security withholding for self-employed workers. For 2008, it
equals 15.3% of your first $102,000 of "net" self-employment income, plus
2.9% on anything above that. "Net" self-employment income equals 92.35% of
gross self-employment income (to reflect the 7.65% Social Security and
Medicare tax that an employer would have withheld if your income had been
paid as wages. The deduction is equal to one half of the self-employment tax
you pay.
If you and your spouse both
have self-employment income, you must both have to figure and pay the tax.
Partners in a partnership pay self-employment tax on their share of net
partnership income. However, if you have income from wages as well as
self-employment, you can subtract your wage income from your
self-employment income to figure your self-employment tax.
Example:
In 2008, you report $52,000 in wages and $20,000 from part-time
consulting. Your spouse reports $72,000 in wages and $4,800 from teaching
aerobics. You'll owe 15.3% self-employment tax on $16,200 (the $68,200
wage base minus your $52,000 in wages) plus 2.9% tax on the remaining
$3,800 of consulting income. Your spouse will owe 2.9% tax on the $4,800
from teaching aerobics.
For more information, see
IRS
Publication 533, "Self-Employment Tax."
Seminars
Separate Accounts
Separately accounts are an
alternative to Mutual Funds
and Unit Investment
Trusts for investors who seek
the tax advantages of holding individual securities. When you buy a mutual
fund or UIT, you choose a money manager, then give them your
money in exchange for a piece of a single security--the fund itself. You can
hold the security with the fund company, or you can hold it in a brokerage
account. Your manager directs the fund, and the fund itself owns the
underlying investments. You can track the fund's daily closing price in the
newspaper or on the Internet. Managers report specific holdings
semiannually, and it can be difficult to get information on specific
holdings..
When you open a separate
account, you choose a money manager, then give them your money to
establish a separate account of your own. (Typically, you'll establish an
account in your own name with a discount broker like Schwab or
Waterhouse.) Your manager manages the portfolio, while you actually own
the underlying investments. You can track your holdings as often as you
like in the newspaper or the Internet. This may seem like a subtle
difference. But it offers important advantages:
-
Separate accounts let your
manager invest specifically for taxable or tax-deferred accounts. Mutual
funds accept both taxable and tax-deferred money, and most manage solely
for pre-tax returns.
-
Separate accounts for taxable
investors give you more control over your holdings than mutual funds, UITs,
and hedge funds. You can direct your manager to avoid tobacco stocks,
casinos, and the like.
-
Separate accounts can serve as
"completion funds" to round out large holdings in a single company or
industry. If you've retired from Procter & Gamble with a big block of
their stock, the last thing you need is more P&G stock. Separate accounts
let you avoid P&G specifically, or the entire consumer goods sector, while
exposing you to technology, finance, utilities, and other sectors.
-
Separate accounts don't carry
embedded capital gains like mutual funds. The average mutual fund carries
an embedded gain of about 20%. Separate accounts establish separate cost
bases and holding periods for each security you buy.
-
Separate accounts give you far
more control over after-tax returns than funds. You can choose tax-managed
accounts that avoid turnover, match gains and losses, and sell high-cost
basis stock first. You can direct your manager to realize gains or losses
on your schedule, to manage your tax liability.
-
Separate accounts insulate you
from other investors. If the market tanks, you don't have to worry about
other investors bailing ship, forcing the manager to sell stocks and, in
turn, forcing you to pay tax on a commingled fund's
Capital Gains.
-
Separate accounts offer
declining fees as assets rise. In contrast, funds charge you the same fee
on expense on every dollar under management.
-
Separate accounts let you
carve out a specific portion of your holdings to sell or give to charity.
-
Many separate account managers
will open an account with securities. This is important because you don't
have to liquidate existing holdings and pay immediate tax on your gains in
order to participate.
-
If your manager is a bust, you
can transfer your assets to another manager without liquidating holdings
and recognizing capital gains. With mutual funds, in contrast, you have to
sell your shares in the dog and pay all your taxes before giving the money
to the new manager.
There are several ways to hire
separate account managers:
-
You can find a manager
yourself. This is the least expensive path. But it obviously involves the
most work--both to select your manager and to monitor their performance
against competitors and benchmarks. Separate account managers include
local "boutiques," regional and national powerhouses with billions under
management, bank trust departments, and specialized trust companies with
widely ranging account minimums, fees, and track records.
-
You can hire a consultant to
find a manager. This lets you access more managers than you can
comfortably research yourself.
-
Finally, you can open a "wrap
account" for an entire bundle of investment management services. These
accounts include financial planning, investment management, performance
reporting, trading commissions, and account maintenance fees. Typical
participants may include a broker, who provides financial planning
services, a "third-party asset management provider," or consultant, who
chooses a specific money manager from a pre-approved list, and finally the
money manager itself.
The best programs include dozens of managers and investment styles. Extra
services might include conference calls and road shows to meet the
manager. These accounts open the door to money managers and investment
styles that you might not otherwise be able to afford. For example, one
manager I've recommended to my own clients requires a $5 million portfolio
to establish a tax-aware portfolio directly--but lowers that minimum to
just $100,000 for clients of a specific third-party asset management
consultant. Wrap accounts have historically cost more than funds.
Published fees generally run around 2%, although most brokers and
financial planners can discount these rates. But wrap accounts fees have
become more competitive with funds. And they're far better than variable
Annuities for most investors
who qualify! If your portfolio is large enough to qualify, take a look at
the various separate account programs available through your full-service
broker or financial planner. Separate account fees are
deductible as an
Investment Expense, up to the amount of investment income, subject
to the 2% floor on
Miscellaneous
Itemized Deductions. You can also write off account costs, such as
IRA custodial fees. Include commissions to buy and sell individual
securities in your adjusted cost basis and sales prices for figuring gains
and losses on sales. Some aggressive advisors are also capitalizing
account fees, periodically adding them to the cost basis of the account's
holdings in order to avoid the 2% floor on adjusted gross income.
Sex Counseling
Sex counseling is a deductible
Medical Expense, subject
to the 7.5% floor, if prescribed by a licensed healthcare professional. This includes hotel room and travel costs (mileage,
tolls, parking, etc.) if the therapist prescribes a change of scenery.
Silver
(See Commodities)
SIMPLE IRA Contributions
A SIMPLE IRA is a "super-IRA" that let you
squirrel away more than the usual $5,000 IRA contribution limit.
Your employer may let you choose where to establish the account, or may
establish the account for you. Once established, you can contribute under
these rules:
- You can contribute 100% of your earned
income up to $10,500 (2008). if you're age 50 or older, you can make an
additional $2,500 "catchup" contribution.
- Your employer can choose to contribute of
2% of your earnings, whether you contribute or not. Or they can match 100%
of your contribution up to 3% of your earnings.
If they choose the match, they can reduce it as low as 1% for 2 out of every
five years. They have to deposit your match is due by the date for filing
their business tax
return, including extensions.
- Your contributions and employer
contributions or matches are "vested" immediately. That means they're
yours to keep, even if you leave your job or the business closes.
There's no need to report SIMPLE IRA
deferrals on your tax return. Your employer will deduct them from the
amount reported as "wages" on your year-end Form W-2.
SIMPLE 401(k)
(See 401(k) Contributions, Qualified Plans)
Simplified Employee Pension
(See Qualified Plans)
Small Business Stock,
Section 1244 stock is a special
kind of corporate stock that lets you write off losses as ordinary income,
rather than Capital Loss.
Single taxpayers can offset up to $50,000 of ordinary income; joint filers
can offset up to $100,000. Any excess loss is deductible as a capital loss;
there's no carryover to a future year.
To qualify, the stock has to
meet these tests:
-
You bought it
directly from the corporation for money or property other than stock or
other securities.
-
The corporation's equity
was no greater than $1 million when the stock was issued.
-
During the past five years,
the corporation earned more than 50% of its income from sources other
than rents and royalties, dividends and interest, annuities, and sales or
exchanges of stock or securities.
Use
Form
4797 to claim the loss.
Social
Security
Social Security benefits you
receive are nontaxable
income for most recipients. However, there's a special retirement earnings
test that may cut your benefits if you keep working while you receive Social
Security. Also, benefits are taxable if your "provisional income" exceeds
certain limits.
If you're between age 62 and
65, and you work while you collect Social Security, you'll lose $1 of
Social Security for every $2 of earned income above the $10,080. (The
earnings penalty has been repealed for workers age 65 and above.) This
penalty applies to earned income from wages, salaries, commissions, and
self-employment income. It can wipe out the advantage of starting early,
particularly if you work between ages 62 and 65.
There are several strategies
you can use to hold down earned income, particularly if you own your own
business. You can pay yourself in the form of loans, rents, or equipment
leases, rather than straight earned income. You can create a special class
of stock, or consider selling shares back to the business. (The Social
Security Administration may ask you to file a Self-Employment Corporate
Officer Questionnaire to verify that you're actually retired.) If you plan
to earn income while you receive benefits, be sure to include this benefit
reduction in your plans. You can actually lose money by working while you
collect benefits.
Social Security is intended as
a "backup" retirement income along with pension plans and personal
savings. You don't owe tax on your benefits unless your "provisional
income" exceeds certain limits. Provisional income includes regular
taxable income, tax-exempt interest income, and 50% of your Social
Security benefits. You'll owe tax on 50% of your benefits if your
provisional income exceeds $25,000 ($32,000 for joint filers). You'll owe
tax on 85% of your benefits if your provisional income exceeds $34,000
($44,000 for joint filers). This extra tax can be a real blow to your
income, as well as artificially spiking your tax bracket. A single dollar
of Social Security can add $1.85 to your taxable income. If your federal
and state combined rate is 33%, you'll owe 61 cents tax on that extra
dollar of income.
For more information,
including worksheets to calculate your taxable benefit, see
IRS
Publication 915, "Social Security and Equivalent Railroad Retirement
Benefits."
Software (See
Computer)
Sole Proprietorship
A sole proprietorship is a
business you operate yourself, under your own name or a trade name, without
benefit (or burden) of a separate business entity.
As a sole proprietor, you're
personally liable for all business debts and obligations. If you're sued,
your personal assets, include your home and investments, may be at risk. For
this reason, many advisors recommend establishing a corporation or Limited
Liability Company any time your business exposes you to potential liability.
As a sole proprietor, you're
considered self-employed. You can establish a
Qualified Plan for
yourself (and your employees, if any) and write off your personal
Health Insurance as an
Adjustment to Income,
but you generally won't qualify for employee benefits. (If you're married,
consider hiring your spouse to qualify for
De Minimis Fringe
Benefits, a
Medical
Expense Reimbursement Plan, and similar benefits.)
You'll owe ordinary tax and
Self-Employment Tax on net income.
Report proprietorship income and expenses on
Schedule C. Carry the net income to
Schedule SE.
Spousal IRA
(See Individual
Retirement Account)
State and Local Taxes
State and local income taxes are
generally deductible on
Schedule A.
You can deduct income tax or sales tax, but not both.
If you deduct your state tax payments,
then receive a refund of a portion of your payment, the refund will be
taxable the year you receive the refund. Report the refund as income on
Form
1040.
If you pay state and local taxes
with quarterly estimates, your last payment is generally due by January 15
of the following year. You may find that prepaying it before January 1
saves you more on this year's return than it costs you on
next year's. See
Bunching Deductions.
State and local taxes are a
"preference item" for the
Alternative Minimum Tax.
Sterilization
Deductible Medical
Expense, subject to the 7.5% floor.
Stock Appreciation Rights
(See Stock Options)
Stock
Corporate stock represents
ownership in a corporation. When you buy stock, you're actually buying a
piece of the corporation.
Corporate stock generates two
kinds of income: dividends, generally taxed at preferential rates when paid;
and Capital Gain, taxed
at preferential rates when you choose to sell. Together, your dividends and
capital appreciation equal your total return. Stocks are considered a
tax-advantaged investment because most of that total return is taxed at
reduced rates.
Dividends Paid in Cash
Dividends paid in cash are taxed as
ordinary income the year the company pays the dividend. Tax on
Qualified
Corporate Dividends is capped at 15%, regardless of your regular
marginal rate.
Dividends Paid in Stock
Dividends paid in stock
generally aren't taxed when you receive them. Instead, they're taxed as
Capital Gains when you sell the dividend shares. Your basis for figuring
gain or loss is your original cost in the stock, divided by your total
number of shares. Your holding period for determining short- or long-term
gain is the date you bought the original stock.
Example:
On January 1, 2007, you bought 100 shares of Conglomerate.com for $1,100.
On December 31, the company pays a dividend of 10 additional shares. On
August 1, 2008, you sell the dividend shares for $20 each. Your basis in
the new shares is $10 each, which equals your $1,100 purchase price
divided by 110 total shares. Your gain on the shares is $10 each, taxed as
long-term capital gain.
However, these stock dividends
are taxed when they're paid:
-
If you choose to reinvest cash
dividends in a dividend reinvestment program, the dividend is taxable when
paid. If the plan lets you buy shares at a discount, your taxable dividend
and basis for figuring gain or loss when you sell the new shares is the
fair market value of the dividend date. There's no immediate tax on the
discount; instead, it's taxed as capital gain when you sell.
-
Dividends paid in another
class of shares (such as preferred stock) are taxable when paid.
-
Dividends paid in the stock of
another company, such as tracking stock, shares in a subsidiary, or shares
in a sibling company in a controlled group, are taxable when paid.
-
If the corporation paying the
dividend lets you choose between
taking cash or taking stock, the dividend is taxable when paid. Your
holding period in the new shares begins the day after the distribution;
your Basis for figuring
Capital Gain is the value of the distribution.
Gain and Loss on Sale
-
Profit or loss when you sell
your shares is Capital Gain when you sell.
-
Commissions you pay when you
buy and sell are included in your Basis
for calculating Capital Gain.
-
If you hold stocks in a
Separate Account or fee-based account
(one with a single fee for an unlimited number of trades), there's no
specific commission to assign to each transaction. Instead, deduct the
annual fee as an
Investment Expense, up to net investment earnings, subject to the
2% floor on
Miscellaneous
Itemized Deductions.
You probably already know that
different stock investment styles give you different results. Small,
growth stocks can rocket up and down with the day's headlines, while
stodgier utility stocks give smoother, more predictable returns. However,
stock investment styles also affect your tax bills. Value stocks generally
pay more of their total return in dividends, taxed today at your highest
rates. Growth stocks generally pay more in capital appreciation, taxed
when you sell at potentially lower long-term growth rates.
Stock
Options
Stock options give you the right--but
not the obligation--to buy or sell an asset at an agreed price (the
strike price) by a specified time (the expiration date). You can buy
"listed" options that trade on an established exchange, or you can receive
stock options from your employer as part of your compensation package.
Listed Options
Buying a call--going long, in
Wall Street parlance--gives you the right to buy someone else's asset.
Writing, or selling, a call--going short--gives the option buyer the right
to buy your asset. Buying a put gives you the right to sell your
asset, while selling a put gives the put buyer the right to sell you
their asset. If you write an option to sell something you already own,
you're said to be covered. If you write an option to sell something you
don't already own, you're said to be naked. This isn't nearly as sexy
as it sounds. It's a good way to lose a ton of money in a heartbeat. (I
have to confess here that the first time I traded options--in this case,
going long an OEX put? I lost 40% of my position in the time it took to
eat a hamburger for lunch. I should have at least had a cocktail or two!)
Example:
Microsplat trades today at $110. You pay $400 for a call option giving you
the right to buy 100 shares within the next 90 days at $120 per share. If
the share price remains below $120, your call expires worthless and you
lose the price of the option. If the share price rises to $130 and you
exercise the option and buy the stock, your gain equals $600: $10 per
share (the difference between the $120 option price and fair market
value), minus the $400 option price.
Gains and losses from stock
options and equity options--those based on an underlying stock or group of
stocks--are taxed as short- or long-term gain and loss, depending on how
long you hold the position. Gains from options on individual stocks are
treated as short- or long-term gains depending on how long you hold the
contract. Gains from non-equity options--those that trade on a national
securities exchange or commodity futures exchange (options on regulated
futures contracts and index options) are taxed as "Section 1256"
contracts. If you hold a non-equity option long on the last day of the
year, the mark-to-market rules require you to pay tax for that year as if
you had sold your position that day. 60% of your gain or loss will be
treated as short-term gain or loss; the remaining 40% will be treated as
long-term gain or loss. This long-term treatment gives you a small break.
For taxpayers in the 28% bracket, it cuts your actual tax from 28% to
24.8%; for taxpayers in the 39.6% bracket, it cuts your actual tax from
39.6% to 31.76%.
Here are three specific
options strategies for tax-efficient investors:
-
You can use put options to
protect stock profits without selling and paying tax on your gain. Let's
say you have $100,000 worth of Microsplat with a cost basis of just
$20,000. If you sell, you'll owe up to $16,000 in federal income tax
alone. You can buy a put that will rise in value and protect your gain if
the price of Microsplat drops. Hold the stock as long as you like, secure
in knowing the option "insures" your stock against a fall. You can sell
the stock in pieces, or you can borrow against its value. Of course, the
insurance has a cost. But the premium you pay for the option can be far
less than the tax you would pay if you sold.
-
You can write covered calls to
earn tax-advantaged extra income. Covered call writing is selling options
to buy stock that you already hold. You collect the premium as extra
income when you write the option. Your main risk is that the price of your
stock will rise and it will be called away from you. However, if you're
not willing to actually sell the stock, you can always buy back the option
(at a presumably higher price due to the rise in the underlying stock). If
the option expires unexercised, your premium is taxable as short-term
capital gain in the year the option expires. This can let you collect a
premium this year and delay recognizing taxable income until next year. If
the option is exercised and you deliver the underlying stock, the premium
is added to the sale price and taxed as short or long-term gain depending
on your holding period for the underlying stock. This can let you convert
the option premium into long-term gain depending on your holding period.
-
Long-term Equity Anticipation
Securities, or "LEAPS," are long-term are long-term options traded on the
American Stock Exchange. These let you lock in a buy or sell price for as
long as three years, far longer than the bulk of options. And they let you
control more shares for less money. Of course, the premium you pay to buy
these options is naturally higher.
Employer Stock Options
In today's competitive job
market, more than one in ten private sector employers use employer stock
options and stock incentives to attract and retain talented employees.
Options, along with stock incentives such as stock appreciation rights,
discounted stock, and restricted stock, let your employer pay you today
with tomorrow's stock appreciation. And they let you hitch their pay to
your company's rising star. Most employers require you to complete a
certain period of service, such as four years, before your options vest.
Most company-granted options run for 10 years; this lets you enjoy 10
years of growth without risking your own capital or paying tax. To
"exercise" the option, you pay the "option price" (the stock's market
value on the date of the grant), then take delivery of the specified
number of shares. Your gain is the difference between the option price and
the market value when you exercise the option--also called the "spread."
It shouldn't surprise you that
clever accountants and compensation experts have created several types of
stock incentives. Here's how they work:
-
Incentive stock options, or
ISOs, may offer the most powerful tax advantages. You don't pay tax when
the company grants the option. And you don't owe ordinary income tax when
you exercise the option and buy the stock. You don't pay tax until you
actually sell the shares you acquire with the option. You'll pay long-term
capital gain rates on the spread if you hold the shares at least two years
from the grant date or one year from the option date (whichever is
greater). Any further appreciation is taxed as short- or long-term capital
gain, depending on how long you hold the shares after you exercise the
option. BUT--and this is a crucial but--the difference between the option
price and the stock's fair market value at the time of exercise is
considered a preference item for the
Alternative Minimum Tax.
If you're not careful, you can wind up owing tax on paper gains. If the
stock price falls after you exercise your options, you can even wind up
owing tax on losses. In this case, your best solution may be to sell your
shares and pay tax (at ordinary rates) on whatever gain you can still
salvage. This is a common, if terrifying, predicament for thousands of
dot-com millionaires who saw their overnight profits evaporate with the
2000 dot-com crash.
Example:
On January 1, 2000, you exercise 100,000 shares at $1 per share. The stock
is actually worth $10 per share, giving you a $900,000 gain and a $900,000
preference for the AMT. By December 31, the stock price falls to just $2
per share. Your gain has shrunk to $100,000, yet you still face AMT on
$900,000 of gain. Your only solution is to sell your shares at the fair
market value of $200,000 and pay tax at ordinary rates on your remaining
$100,000 of gain.
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Nonqualified stock options, or
NQSOs, are more flexible, but less powerful. As with ISOs, you pay no tax
when the company grants the option. But, unlike with ISOs, you pay tax at
ordinary income rates on the spread when you exercise the option. There's
more flexibility to sell immediately because there's no holding period
requirement. But there's no chance to profit from lower long-term capital
gain rates. As with ISOs, any further appreciation is taxed as short- or
long-term capital gains, depending on how long you hold the shares after
you exercise the options.
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Stock appreciation rights, or
SARs, are a cash bonus tied to the company's stock price. With SARs, you
owe tax on the value of the SAR when you exercise the rights or when you
become entitled to the maximum bonus under the plan. (If you somehow
forget to exercise your options, you'll still be taxed as if you had
exercised them immediately before expiration.)
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Some companies let employees
buy stock at a discount. In this case, the discount is taxed as ordinary
income when you buy the stock. Any further appreciation is taxed as short-
or long-term capital gains, depending on how long you hold the shares
after you exercise the options.
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Finally, some companies offer
restricted stock to key executives. Restricted stock isn't taxed when you
receive the award. Instead, it?' taxed in the year it's substantially
vested--the year in which you can actually sell it or there's no longer
substantial risk of forfeiture. You'll owe tax at that time on the
difference between what it's worth, and what you pay to buy it (if
anything). (You can also elect to pay tax when you receive the award on
the stock's value at that time. This avoids tax the year the stock vests.
When you finally sell the stock, the gain above its value at the time of
the award is taxed as short- or long-term capital gain. This strategy has
the effect of converting gain from the date of the award to the date of
vesting from ordinary income to capital gain. To make this election,
you'll need to notify the IRS within 30 days of the award.)
Exercising nonqualified stock
options can be an expensive proposition if you need to produce a large
down payment. That's because you'll need cash to pay for the stock as well
as cash to pay for the tax. Fortunately, the IRS has ruled that you can
use existing stock that you already own in full or partial payment for
option shares without paying tax on any gain in the old shares.
Example:
You own 1,000 shares in your employer, Conglomerate.com, that you bought
for $20 per share. Those shares are now worth $30 each. You have just been
granted option to buy 2,000 shares at $15 each. You can transfer your
existing 1,000 shares to the company in payment for the 2,000 option
shares. Your gain on the transaction is the $30,000 difference between the
option price and fair market value. You defer tax on the gain on your
original 1,000 shares until you sell the option shares.
You could always sell part of
the stock to finance your purchase. Or you can keep it all in hopes that
the price will climb even more. At this point, it might be smart to
consider an old Wall Street adage: "Bulls make money; bears make money;
but pigs get slaughtered." You might also want to consider how much of
your net worth you want to tie to your employer's stock. This is
especially true because a business disaster could cost you your job as
well as your stock. Concentrating your wealth in a single company can be a
great way to get rich--but a lousy way to stay rich.
Deciding when to exercise
options or sell stock should be an investment decision. The longer you
wait, the more chance you have of to wait and see how the stock performs
without committing your own capital. Unfortunately, you can't decide to
exercise without considering whether options gains will phase out your
itemized deductions, push you into a higher tax bracket, or subject you to
the AMT. The main challenge is to defer the day of reckoning when you owe
tax on the spread. There are several tools to help accomplish this,
although they carry their own legal and investment risks. Consult your CPA
or financial planner to consider these advanced strategies:
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You can ask your employer to
hold your options in trust, as with a nonqualified deferred compensation
plan. However, your employer can't diversify out of company stock without
creating a tax liability of its own. And your shares remain subject to
claims of your employer's creditors.
-
Section 83(b) of the tax code
lets you report NQSO income and pay tax on the spread before the option
vests. Why pay tax early? Because the spread--and therefore, the amount
taxed at ordinary income rates--is likely to be lower than if you wait. The
theory here is that taxing less of your gain at ordinary income rates
justifies paying early. This may be especially valuable if your employer
is about to go public and you expect the stock's price to take off. But
this strategy carries dangers. First, if the stock price drops, you'll
have paid more tax than if you had waited. And second, if you leave your
employer before your options eventually vest, you'll have paid tax on
compensation you never actually receive.
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You might also consider
selling your options to your family, or a trust, family limited
partnership (FLP), or family limited liability company (FLLC). This lets
you shift future appreciation to the buyer, while letting you participate
in the gains as beneficiary of the trust, FLP, or FLLC. This move is
definitely not for do-it-yourselfers, so see your CPA or attorney.
Stop-Smoking Programs
Deductible
Medical Expense subject
to the 7.5% floor.
Student Loan Interest
Student loan interest is
deductible as an adjustment to income under the following rules:
-
You can deduct up to $2,500 of
interest you pay on "qualified education loans"--loans you take to pay for
tuition, room and board, and related expenses.
-
The deduction is phased out
for taxpayers with "modified adjusted gross incomes" between $55,000 and
$70,000 ($115,000 and 145,000 for joint filers). "Modified adjusted gross income"
generally equals regular adjusted gross income plus interest on
U.S. Savings Bonds
redeemed to pay tuition, employer-provided
Adoption Assistance, and
foreign earned income and allowances.
-
You can't claim the deduction
if you can still be claimed as dependent on someone else's return.
Subscriptions
You can deduct single-copy
purchases as well as subscriptions.
Summer Camp
(See Dependent Care
Credit)
Swap Fund
(See Tax-Engineered Products)
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