Editors Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.This spring the Internal Revenue Service issued a Notice to alert taxpayers that it is “aware that certain promoters are advising taxpayers to take highly questionable, and in most cases meritless, positions . . . on current and amended returns” regarding the tax due when stock options are exercised.

In the Notice, the IRS announced that it will assess civil and even criminal penalties against taxpayers asserting “frivolous” tax positions with regard to the taxation of stock options, as well as against promoters urging taxpayers to take these positions. There are a number of lawyers, accountants and other urging taxpayers to take such positions with regard to the taxation of options. For example, a law firm in Seattle has a website soliciting taxpayers who exercised options to become clients of the firm and attempt to obtain refunds or abatements of tax. The IRS issued the Notice in response to the claims of such promoters–and in fact the Notice specifically addresses certain of the claims referred to on the website of the Seattle firm.

Many optionees have incurred or will incur large tax bills

From 1997 or 1998 through as late as 2001, many optionees who exercised options incurred large regular income tax or alternative minimum tax (AMT) bills. In some cases, especially where optionees exercised at the height of the market and didn’t (or couldn’t) liquidate their stock while prices were high, these tax bills have proved ruinous.

The statute of limitations for amending 2001 tax returns (and in a small number of cases, 2000 tax returns) and obtaining a tax refund has not yet passed. Further, as the economy improves, there are a number of taxpayers holding low-priced options granted over the last several years that now have significant value. Holders of Google options come immediately to mind, but there are many tech companies worth much more now than they were a few years ago. Holders of options in such companies may face large tax bills when and if they exercise their options. These two sets of taxpayers represent the “market” for promoters of tax positions the IRS has deemed frivolous.

Basic taxation of options

It is helpful to have a basic understanding of how stock options are taxed in order to understand what the IRS is referring to as “frivolous” positions.

There are two types of stock options. One is called an “incentive stock option” or “ISO” and the other is called a “non-statutory stock option” or “NSO” and, as the Notice states, the federal tax treatment of such options is well established. An ISO may only be granted to corporate employees and must meet a number of other tax law requirements. If an option qualifies as an ISO, the person exercising it does not recognize any tax at the time the option is granted nor any regular income tax at the time of exercise.

However, any spread between the option’s exercise price and the value of the underlying stock at the time of exercise is a so-called “preference” item for purposes of the AMT. This means that the spread is included in gross income for purposes of calculating the AMT and, if there is a large spread, say in the tens of thousands of dollars, the taxpayer is likely to have to pay AMT on the spread. Subject to rare exceptions, NSOs are also not taxed at the time of grant. However, at the time of exercise the spread between the exercise price and the value of the underlying stock is subject to regular income tax.

IRS Notice states that certain tax positions are frivolous and subject to penalties

The warning in the Notice is aimed at any frivolous or unsubstantiated position regarding the taxation of options. However, the Notice does specifically address a few arguments being pushed by promoters. One of these arguments is that the options should have been taxed at their grant date, rather than on the date of exercise. This is attractive to taxpayers because there is no spread between value at grant and exercise price in the case of an ISO (and thus no tax); very often, the same holds true for NSOs as well. However, this argument is not at all supported by the tax law, which very clearly states that ISOs are never taxed at grant, and that NSOs are only taxed at grant in very rare and specific circumstances.

Very often the stock acquired on the exercise of options is subject to restrictions; a very common restriction is a “lock up” which prevents the optionee from selling the stock for a period of time. Such restrictions have led promoters to advance another argument specifically targeted by the IRS – that the existence of these restrictions reduces the fair market value of the stock acquired on exercise of the options (and thus the amount of the tax). While this is a true argument in an economic sense, because restrictions do reduce the value of the stock, applicable tax law specifically states that such restrictions are ignored for purposes of valuing the acquired stock.

A third argument addressed by the IRS is that the purchase of stock with borrowed funds is not really a purchase if the employee later proves unable to pay the loan. Under applicable regulations, however, if the employee becomes the beneficial owner of the stock at the time he signs the note it is immaterial whether or not he eventually pays off the note; he owns the stock for tax purposes. Generally, under the tax laws if the note is at least partially “recourse” against the taxpayer, which means that the lender can go against some or all of the taxpayer’s assets other than just the stock itself to repay the loan, then beneficial ownership of the stock has transferred at the time the option is exercised and the loan is made.

The Notice, after addressing a couple of additional promoters’ arguments, goes on to cite the penalties that can be imposed on taxpayers for taking one of these frivolous positions, or any similar position, on a tax return. Potential civil penalties include accuracy-related penalties of 20 percent of the amount of the tax that should have been paid, civil fraud penalties of 75 percent of the amount of tax that should have been paid, a $500 penalty for filing a frivolous return, and penalties of up to $25,000 if any of these arguments are made in the United States Tax Court. Further, the Notice alerts taxpayers that they may face criminal prosecution if they include such positions on their tax return. Criminal penalties include fines of up to $100,000 and imprisonment for up to 5 years.

The lesson

The issuance of the Notice, and particularly the warning about criminal prosecution, indicates that the IRS is serious about stopping taxpayers from making these arguments on their tax returns. Accordingly, any taxpayer thinking of filing an original or amended return taking one of the positions specifically mentioned in the Notice should think again — even if he or she is doing it based on the advice of lawyers or accountants. In addition, if a lawyer, accountant or other advisor is suggesting to you that you take a position that is at all similar to any of the positions mentioned in the Notice, it is a very good idea for you to seek a second opinion before filing your tax return.

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, taxation and securities matters. Questions or comments can be sent to atuffin@d2vlaw.com