Does the IRS Cash In When I Exercise My Options?

Also, child tax credits, excess IRA contributions and education tax credits.
Publish date:

The Tax Forum tackles child tax credit issues this week, as well as excess IRA contributions and disqualifying incentive stock options. And we've also got more on those pesky

education credits.

Any other questions? Send them to, and please include your full name.

Disqualified ISOs

Here's a funny situation. Incentive stock options are exercised in 1998 and the stock is sold the same day through a brokerage account. The company that issued the ISOs is required to report the income on the employee's W-2, but the broker reports the same income on a 1099. How do you correct this double reporting? Subtract the income from the W-2 and attach a letter of explanation with supporting documentation? -- Stephen Hudson


It's not really double reporting. By selling the stock on the same day you exercised your incentive stock options, or ISOs, you created what tax folks call a "disqualified disposition." That means you gave up the long-term capital treatment on the sale.

Rande Spiegelman, personal financial services manager at


, walked me through the logistics.

Typically, if the options are ISOs, there is no income recognizable when the options are exercised, according to

Section 422 of the tax code. Capital gains or losses are generated only when the shares of stock are sold, and they're reported on

Schedule D

- Capital Gains and Losses

. (Be aware that ISOs can create alternative minimum tax issues for you too.)

To qualify for the long-term capital gains rate, you must hold the ISOs for one year after the exercise date


two years after the date of grant.

In your case, you did not hold the stock for one year after the date of exercise, so you can't claim the lower long-term capital gains rate.

The difference between your exercise price and the fair market value on the date of exercise will show up on your

Form W-2

- Wage and Tax Statement

. You will pay tax on that money at your ordinary income rate, which could be as high as 39.6%. The long-term capital gains rate is only 20%.

As for the

Form 1099B

- Proceeds from Broker and Barter Exchange Transactions

, I am assuming there is no reported capital gain because you sold the shares the same day you exercised. So the form is just reporting the actual sale.

So what does your

Schedule D

- Capital Gains and Losses

look like? For illustration, let's assume you exercised your ISOs and sold everything on Feb. 1 and the fair market value of the stock was $20 that day.

Feb. 1 will be the date of purchase and date of sale in columns b and c on Part I of Schedule D. The sale proceeds from your Form 1099B will go in column d. The basis, or your original cost, will go in column e and is the fair market value of the shares the day you exercised. So those two amounts will be the same. As a result, your gain or loss in column f should be zero.

You don't need to attach any additional statements or schedules.

Excess IRA Contributions

What happens if I make an extra $2,000 IRA contribution and don't claim it? My objective would be to increase my tax-sheltered capital. -- Art Micallef



reported last week that every time you make an IRA contribution, the company holding your IRA -- your broker or mutual fund company -- has to report the amount to the IRS. So if you don't report the contribution, the company will anyway.

Regardless, any contributions you make over the $2,000 limitation are subject to a 6% penalty tax. And you will be charged that 6% every year until you take that money out of the account, says Martin Nissenbaum, national director of personal income tax planning at

Ernst & Young


You can avoid this penalty by withdrawing any excess contributions by the time you file your tax return. You also must withdraw any related earnings.

Your custodian should be keeping track of your contributions and should alert you if you hit your max. But if the custodian allows you to make an excess contribution anyway, you're still stuck with the penalty.

President Clinton

is trying to crack down on people like you who want to beef up their tax-sheltered savings. He has proposed raising the penalty to 10%, notes Nissenbaum.

Child Care Credit for Traders

My wife works full-time and I trade stocks full-time. Are we eligible for the child-care tax credit? -- C. J. Lang

C. J.,

You have combined two different credits! One is the Child Care and Dependent Care Credit for qualifying childcare expenses. The other is the child tax credit that is new for 1998. With this, you can take a credit of up to $400, providing you meet the adjusted gross income limitations. Since I'm not sure which credit you are referring to, I will address both.

To qualify for the Child Care and Dependent Care Credit, you have to meet eight tests, which are outlined in

Publication 17

- Your Federal Income Tax

, says Christina Tomeo, a tax manager at


in New York.

But one of these requirements says that both you and your spouse must have earned income during the year, notes Tomeo. Earned income is defined as wages, salaries, tips, and other employee compensation, plus the amount of the taxpayer's net earnings from self-employment for the taxable year, according to

Section 32 of the tax code.

As a trader, you're not paying self-employment taxes. You're not eligible for this credit, therefore you and your wife can't claim it. The government wants you to be paying in to its system to get any credits back, says Tomeo.

You can claim a Child Tax Credit of $400 ($500 in tax years beginning after 1998) for each dependent child under age 17, says Tomeo. The credit phases out if your modified adjusted gross income is above $110,000 for joint filers, $75,000 for unmarried individuals, and $55,000 for those married and filing separately.

There is a worksheet in the

instructions to

Form 1040


Form 1040-A

to help you compute this credit.

Child Tax Credit and the Roth

I just did my taxes this weekend with TurboTax, and it told me I was ineligible for the Child Tax Credit ($400) because my adjusted gross income was too high. However, the reason it passed the limit was due to the conversion of all my traditional IRAs to Roth IRAs in 1998. I thought that the added income due to conversion was not supposed to affect other deductions. For example, I know they eliminate the conversion amount when determining if you are eligible to convert in the first place. How come the conversion amount was included in calculating other tax breaks? -- Joe Celentano


You're right that the conversion amount is not included in the determination of your qualification in the first place. But after that, it counts for just about everything.

Potentially you can lose all your credits because of your Roth IRA conversion, notes Nissenbaum. That applies to any credit that is phased out as you hit certain adjusted income limitations, including the Child Tax Credit, student loan deductions and education credits.

In addition, your miscellaneous itemized deduction phase out may be affected, says Bill Fleming, director of personal financial services for



And if you opted to spread your IRA conversion over the next four years, you'll have to deal with these issues three more times.

New on Form 1040

If you haven't yet thought about your tax return, don't worry: You've got time. But before you pick up a

Form 1040

- U.S. Income Tax Return

and panic when you see a bunch of new items, be sure to revisit our

story highlighting some of the new changes. It could make your tax-filing experience less stressful.

Education Credit Tips

After our

story on the difficulty colleges and students are having with

Form 1098-T

- Tuition Payments Statement

, reader

Ed Cheng

, a professional tax return preparer, wrote to say that he's dealt with close to 100 of these forms so far. And he's seen clients forgetting the following things:

  • Parents can claim the Lifetime Learning Credit for any courses they took last year along with their children's credits.
  • If the student took out a loan to pay tuition and fees, the parent cannot claim the credit, even if the student is a dependent.
  • Students who are college sophomores before June 30, 1998, and juniors after July 1, 1998, qualify for both the Hope Scholarship and the Lifetime Learning Credit. But these students -- or their parents -- will have to decide which one to take. They can't take both in the same year. The Hope Scholarship is generally more beneficial.
  • Your student loan interest may be deductible.