In this Episode, Steve and Cliff discuss common tax issues with Stock Options. This discussion is aimed at the employee who receives stock options as part of their compensation. Discussion of Tax Strategies for ESOP, RSUs, and ISOs. 83b elections, tax timing and rules and common tax preparation mistakes.
Listen to the full episode to learn more!
Episode Transcript
Intro:
You're listening to the Practical Tax podcast with tax attorney Steve Moskowitz. The Practical Tax podcast is brought to you by Moskowitz LLP, a tax law firm.
Steve Moskowitz:
Welcome back, folks. This is Steve Moskowitz and Cliff Capdevielle, and we wanna show you how we can save you some taxes. I'm the head of the firm, I am a tax attorney, and before I was a tax attorney I was a CPA. I started life off in a big firm, and then opened up my own practice many years ago.
My friend and colleague, Cliff Capdevielle, is also a tax attorney and accountant. He also came out of a big firm. And there's so much here that we wanna talk to you about. A lot of times when you go to work someplace, they say, "Well, your salary is so much, "but we're gonna give you extra benefits "like stock options." And one of the things that you say, "Well, okay, that's good, "but I wanna do what the wealthy do, "I wanna go ahead and make all kinds of money, "and take all kinds of tax advantages of this."
So you have a stock option. There's something that you should know about called an 83 election. And basically what an 83 election will do for you, is greatly reduce the amount of taxes which you have to pay on that stock option. And you say, "What's 83 , Steve?" Well, that one refers to 83 in the Internal Revenue Code. But Cliff, tell us about what's an 83 election.
Cliff Capdevielle:
Sure, so what you wanna do when you're planning for employee stock options, is make sure that to the extent possible, you are capturing any gains as long-term capital gains versus short-term capital gains.
Steve Moskowitz:
What's the advantage between capital gains and ordinary income tax, Cliff
Cliff Capdevielle:
And it's huge, it is huge, Steve. It's almost double. So ordinary rate for most people is 30 to 37%, guess what, if you can convert ordinary income to capital gains, you can reduce that rate to 20% or below. So you're essentially cutting your tax in half if you do that, Steve.
Steve Moskowitz:
Well, I like cutting the tax in half, and I would be willing to venture, Cliff, that everybody watching this or listening to this would like to cut their tax in half too. So, okay, this is great. Tell me how do I cut my tax in half?
Cliff Capdevielle:
Yeah, so with an 83 election, you essentially notify the government that you're picking up an income, a very small amount, which is the the fair market value on the date that the options are granted to you and you pick that up, and that starts the running of the holding period for capital gains rate. So in other words, if you hold that stock more than a year, you've converted what would typically be ordinary income tax at ordinary income rates to capital gains rates. So it makes a huge difference. And we see a lot of mistakes, Steve, unfortunately.
Steve Moskowitz:
Whole lots of mistakes here.
Cliff Capdevielle:
With the startups in Silicon Valley and even with mature companies, we see major mistakes when people go to their local CPA firm or their local tax preparer, not making these basis adjustments, not calculating the capital gain rates, it's unfortunate these laws are pretty complicated, and if you don't know how they work, you can end up paying a lot more tax than you need to.
I'll give you an example, with non-qualified stock options. These are typically called RSUs, sometimes ESPP. These options are actually included in the gross income part of wages, so these are actually included in W-2 wages. Guess what? Oftentimes the broker dealer will report these without the basis adjustment. In other words, they will leave off from the cost basis the amount that's been included in W-2 wages. And what does that mean? That means people are paying double tax in many cases on these stocks.
Steve Moskowitz:
Nobody likes double tax, Cliff.
Cliff Capdevielle:
Nobody likes to pay best tax twice.
Steve Moskowitz:
I don't like any single tax.
Cliff Capdevielle:
On the same money, right. But we see that all the time, every single day, people come in, they've gone to their local tax prepare or CPA, the local tax preparer or CPA is trying hard. They take the numbers right off that 1099 from Schwab, or E-Trade, or whatever they plop it on the tax return. And these high tech employees who are super smart can't figure out how they pay so much in tax. And the reason is Steve, because most tax repairers are not familiar with these roles. They aren't making the proper basis adjustments. And as a result these people are paying much more in tax than they need to.
Steve Moskowitz:
That's so true. And another example that I wanna talk about that's so vitally important, is the importance of tax planning. And to give you a personal example, when I set foot into law school in day one, as a student I already had a bachelor's and a master's degree in accounting. I was already a CPA practicing in tax, but I went to law school to become a tax attorney. I didn't wanna do accident cases or divorces. I wanted to be the person to tell clients, look, you can do this and this and this like the big boys and save all kinds of money.
And let me give you an example with the 83 election, you listening and say, "This is terrific, "and I got the stock options and you know what, "next year, when I go to my tax return preparer, "I'm gonna show him how smart I am." And I say, "You know what, take that 83 election for me, "and here's what you're gonna find out, "whoops, you're too late." 'Cause when you get an 83 election there's some strict rules. One of them is, you have to notify the IRS within 30 days of the award. That's not even 30 days of getting it. So when the board says, we're gonna go ahead and award this to Mary Jones, Mary has to or her representative has to notify the IRS, and say, "Mary went ahead and got some stock options, and we're electing 83," if you don't do it, if you wait until you file your return too late. And the beauty of this is it not only creates a capital game but it saves you taxes even while you're holding it. So what happens is, if you don't do an 83 election when the restriction, what happens with a stock option, the company gives you something, but there's some strings attached. We're gonna give this to you today but you're gonna have to do something. You're gonna have to achieve a certain sales goal or stay within some period of time or do something. And if you don't do it, then this is of no value to you. But if you do do it, then it's of value. When the restriction lifts if you haven't done the 83 election, you have to report it at income when the restriction lists.
So if you decide you're not gonna sell it then you have what's called Phantom income. That means you pay tax on something that you haven't gotten the money for, who likes to do that. And again, that means you have to have the cash from some other source. Whereas if you've done the 83 election, when the restriction lifts, you have nothing to do no tax to pay, and then eventually when you sell it, you turn what Otherwise would've been ordinary income into capital gains or more simply you only pay half the tax. So again, a little bit of knowledge there's a tremendous tax savings here. So that's just one of the things that we're excited to tell you that. And cliff, tell us some more about something else.
Cliff Capdevielle:
Yeah, a couple other things I wanted to cover. One is incentive stock option, and before everybody's eyes lays over.
Steve Moskowitz:
ISOs.
Cliff Capdevielle:
Yeah, the ISOs have even more complications in the way they're treated Steve. And this is opportunity for tax preparer to make even more serious mistakes, and we see this every single day. The reason ISOs are so complicated is because typically until you sell a stock, you don't have what's called regular income tax. You do have alternative minimum tax, which is entirely. Yeah, it sounds as painful as it is. It is another tax, which in many cases will affect those incentive stock option owners. And that tax is paid even before you sell the stock. When you sell the stock this is typically where we see the mistake. You are entitled to an AMT basis adjustment on those shares. We see this missed all the time. On high tech employees with incentive stock options essentially pay double tax. When they sell the stock, it's a real unfortunate situation.
Steve Moskowitz:
We don't like that double tax, Cliff.
Cliff Capdevielle:
Absolutely not. So that's something to keep an eye out for, make sure that your tax preparer is very familiar with incentive stock options, AMT and AMT basis adjustments. You know, Steve, you get this question all the time. These Silicon valley billionaires are living in luxury mansions in up here incline village and all over Tahoe. You just came back from Hawaii. There are Silicon valley billionaires buying up Hawaii right, left.
Steve Moskowitz:
Along with celebrities and athletes. And you know, I'm here based in San Francisco, but you see that more and more people especially with the remote working, they're buying properties all over and you have all kinds of opportunities for all types of savings, but go ahead cliff.
Cliff Capdevielle:
So a couple issues with that I wanted to talk about. One is, how is it that the Silicon valley billionaires buy all this real estate, and yet they don't pay any tax each year, and that's because typically what they're doing is they're borrowing against their stock. And this is perfectly legal. You can borrow a bunch of money from your stock against your stock.
