Tax Treatment of Stock Options The lowered capital gains tax rates provided by the 1997 Taxpayer Relief Act makes stock based pay more desirable than ever. But unless one knows the rules governing capital gains treatment such as alternative minimum tax and the disposition of stock options, much of the tax benefit could be lost. Stock options give employees the right to purchase company stock at a specified "exercise" price over a specified time period, "the option term." (Usually the exercise price is the market price of the stock at the time of the option grant.) There are two types of stock options that are usually granted. They are known as incentive stock options (ISOs) or non-qualified stock options(NQOs). At the date of grant there is no tax regardless of whether the option is an ISO or an NQO. When an individual exercises the option, however, he or she is taxed on the excess of the fair market value on the date of exercise over the exercise price paid. This excess is known as the "bargain element" and depending on whether the option is an ISO or an NQO, the taxation may differ significantly. The bargain element of an NQO option is considered compensation and is subject to regular income tax at rates as high as 39.6%. But if the option is an ISO, assuming the ISO holding periods are satisfied, it may be subject to regular income tax and it must be included as an alternative minimum tax adjustment to regular taxable income. The alternative minimum tax rate is 26% on the first $175,000 of AMT income and 28% on any excess. The tax consequences of a sale of option stock also differ markedly depending on whether the option was an ISO or an NQO. When NQO stock is sold, only the appreciation beyond the date of exercise is considered a capital gain since the appreciation between the date of grant and exercise was taxed as ordinary income in the year of exercise. Conversely, when ISO stock is sold, the entire appreciation from the date of grant, including the bargain element at the date of exercise, is eligible for capital gain treatment provided the ISO holding periods are satisfied. Since capital gain tax rates were lowered last year, the bargain element is subject to these lower rates. In addition, there is the other advantage that these taxes need not be paid until the stock is sold, rather than when the option is exercised. To obtain this benefit, employees cannot dispose of ISO stock within 1 year of the exercise date and within 2 years of the grant date. The tax rate that applies to capital gain income relating to an NQO or an ISO depends on the holding period after the option exercise date. The gain on shares held up to 12 months is taxed at the seller's ordinary marginal income tax rate like ordinary income. Gain on shares held over 12 months but not more than 18 months is taxed at Federal income tax rates not to exceed 28%, and gain on shares held over 18 months is taxed at rates not to exceed 20%. While it is a common rule of thumb to wait until the end of the exercise period before exercising stock options to defer taxes as long as possible, the interplay of the lower capital gain tax rates, the AMT and other factors may require a different strategy. Many executives who find the rules overly complicated consult us for help in determining the best strategy for the exercise of stock options and sale of option stock. Payroll Tax Update The IRS has announced that beginning July 1, the return period liability thresh-old that triggers employment tax deposits is being increased from $500 to $1,000 quarterly. Employers whose FICA - FITW liability for a quarter was less that $500 did not have to make deposits within the quarter, but were instead permitted to pay the tax along with their Form 941 "Employer's Quarterly Federal Tax Return." This procedure is now sanctioned for up to $1,000 of FICA - FITW tax liability relieving an additional roughly 500,000 small firms from the requirement to make payroll tax deposits. The Social Security Administration says that it is overwhelmed because about 1 in 10 W-2 forms it receives contains an error. It cautions that it plans to start rejecting a much larger number of the forms submitted on magnetic media. If you submit forms with mistakes, you may well get the entire batch back with a notice to fix them by a specified date. Delays beyond the period will result in significant penalties. In order to avoid a major problem next winter, we recommend that clients start reviewing their records for hyphenated names to be certain they contain no errors, and purge the files of titles and suffixes such as Ph. D. or CPA. You can also request to see your workers' social security cards and require that new cards be obtained if there have been name changes and the employee has not received a new card. Also, use the Social Security Administration's Enumeration Verification Service. It is free and lets you match the names and numbers on your payroll records against the Administration's files. This can be done directly with the Social Security Administration over the phone by calling 800-772-1213. For the third time, the IRS had delayed its plan to require small businesses to start electronic payment of payroll taxes. The deadline for firms with at least $50,000 per year in withheld Federal income and employment tax deposits had been set for Jan. 1, 1999 and has been extended to June 30, 1999. Accordingly, until the new deadline, the IRS will not impose a 10% penalty on firms that continue to use paper forms to make their payroll tax deposits