ROANOKE TIMES

                         Roanoke Times
                 Copyright (c) 1995, Landmark Communications, Inc.

DATE: MONDAY, April 3, 1995                   TAG: 9504030003
SECTION: MONEY                    PAGE: 6   EDITION: METRO 
SOURCE: 
DATELINE:                                 LENGTH: Long


TAX RAMIFICATIONS OF COMPANY STOCK

Q: My employer gave me an option to sell 200 shares of company stock. The option was given at $48.25 per share. I paid nothing for the stock. I exercised the option at $55 per share for a taxable gain of $1,289. Total tax withheld was $533.65, which includes Social Security tax of $98.61. Should Social Security tax be withheld? I assume federal and state tax made up the total of $533.65.

A: From a tax standpoint, there are two types of company stock options: incentive stock options and nonqualified stock options. The tax consequences of each are dramatically different.

Incentive stock options have the more favorable tax treatment, but must meet stringent requirements to qualify. The major requirement is that the option price be greater than or equal to the stock's fair market value when the option is granted.

If this is the case and the other incentive stock option requirements are met, you do not have to recognize gain until you ultimately sell the stock. The gain is not considered wage income and therefore not subject to Social Security and Medicare taxes. In addition, if you hold the stock for one year after you exercise the option and two full years after the company originally grants you the option, then you will receive capital gain treatment.

There is one potential drawback to an incentive stock option. If you think the stock is going to continue to appreciate and you hold it past the year that you exercise the option, the difference between the option price and the fair market value of the stock at date of exercise is included in alternative minimum taxable income. This may or may not result in additional tax depending on other elements of your tax situation.

Nonqualified stock options are options that do not meet the requirements of incentive options. These nonqualified options have less favorable tax treatment than incentive stock options, but are more popular with employees bcause the company can grant the option at a value far below the current trading price.

Gains on nonqualified options are recognized when you exercise the option (purchase the stock). Be careful if the options themselves are actively traded; then the gain is triggered immediately when the option is first granted and you will have to pay tax on the paper gain.

Nonqualified stock options are considered wage income and are subject to Social Security and Medicare taxes. Your company is required to withhold federal and state taxes. This means you would have to pay these taxes and withholdings in addition to the cost of the option when it is exercised. Gain on nonqualified stock options is taxed as ordinary income and does not qualify for capital gain treatment.

It is clear your company is treating your stock award as a nonqualified option, which the company can do at its discretion. As such, it is required to withhold federal, state, Social Security and Medicare taxes. In your situation, you simultaneously exercised the option and sold the stock. Your company withheld these taxes from your gain and should report both the $1,284 gain and the $534 withholdings on your W-2 statement.

-Answered by C.J. King of Cole and King.\ Q: I'd like to know what the current rules are regarding Sub-Chapter S corporations which, for tax purposes, have not shown a profit for the last few years. I've heard that if the corporation loses money three years in a row, IRS will classify that corporation as a hobby. Is that true? What does that mean? If classified as a hobby:

Does the reclassified corporation no longer pay Virginia state taxes on revenues?

Can the corporation exist at all if it's a hobby? Do SEC incorporation fees apply? Do business license fees apply?

Corporations give their shareholders limited liability. If a hobby, is that limited liability still in force?

Is the only change such that the hobby's loss cannot be entered on the stockholders' 1040 against other income? If/when the hobby makes money, does it go on the 1040?

Does the hobby pay income taxes? To what extent? How?

What are the other problems (or benefits) which might surface if the corporation is reclassified as a hobby?

A: The Internal Revenue Code states that "in the case of an activity engaged in by an individual or S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed," with certain exceptions as detailed in the code.

The code does, however, give a test whereby if an activity generates taxable income for three or more taxable years in a five-year consecutive period, ending with the tax year in question, there is a presumption that the activity is engaged in for profit. In the case of certain activities involving horses, the test is two years out of a consecutive seven-year period.

Whether an activity is engaged in for profit is determined by taking into account "all facts and circumstances." The facts and circumstances standard has led to many disagreements between the Internal Revenue Service and taxpayers which, in turn, have generated many court cases.

The regulations enumerate nine factors to be looked at in determining if a profit motive exists. They are (1) the manner in which the taxpayer conducts the activity, (2) expertise of the taxpayer or his advisers, (3) time and effort the taxpayer spends on the activity, (4) expectation whether the assets used in the activity may appreciate in value, (5) taxpayer's success in similar activities, (6) taxpayer's history of income or losses with respect to the activity, (7) the amount of profits, (8) taxpayer's finances and (9) any elements of personal pleasure or recreation.

If it is determined that an S corporation's activity is not engaged in for-profit business, the code mandates that the deduction of the expenses concerning the activity be limited at the corporate level. In essence, expenses will be allowed to the extent of gross income generated by the activity and no loss or income will be shown on the shareholder's K-1.

There will be no federal or Virginia income tax benefit or liability generated by the activity in a year in which limited expenses exceed gross income. There is an ordering rule that determines which expenses are considered to be deducted and which expenses are disallowed. Any losses disallowed by the hobby loss rules are lost forever. There is no provision for a carryover of the excess expenses to a year showing a profit.

The Internal Revenue Code section that sets forth the hobby loss rules does not negate the existence of the corporation. This and other similar questions are determine under state or local law. An attorney would be better suited to answer such questions.

-Answered by Allen Spell of Brown, Edwards & Company.



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