Although we think the risk of holding ISO shares after an exercise often isn't justified by the tax savings when the holding requirements are met, some people decide to go for the "brass ring". It's difficult to recoup the AMT credit when the stock is sold after the holding period requirements are met, so the federal tax rate for the spread at the exercise date ends up being 28% (the AMT tax rate, compared to about 32% regular tax after the tax benefit of the state tax deduction in a state like California).

Recent tax legislation may help you eventually recover some of the AMT credit. See the explanation below.

If you decide to hold the stock, it usually is best to exercise the option early in the year. Assuming the exercise is made more than one year after the grant date, only the second requirement of holding the stock more than one year after the exercise date must be met to realize the tax savings.

There are two advantages of exercising early in the year. These advantages only apply if the stock is publicly traded or the stock can otherwise be sold at the end of the year and during the next year.

1.      If you have a lower income tax for the tax year before the year of exercise, you can make estimated tax payments or have withholding based on the previous year's tax (110% of last year's tax if your adjusted gross income for last tax year was more than $150,000), so most of the tax due relating to the option exercise may not be due until April 15 after the year of exercise. By that date, you should have met the holding period requirements so the stock can be sold to generate the cash to pay the tax.

2.      If the market price for the stock has fallen at the end of the year, you can sell the stock before the end of the year of exercise. You pay tax on ordinary income, being the excess of the sales price of the stock over the option price. The alternative minimum tax adjustment for the exercise date is eliminated. I call this the "escape hatch". In order to qualify, the transaction has to qualify for reporting a loss (if a loss was realized). This means you can't sell or gift the stock to a related party and that you have to avoid the wash sale rules. You can't purchase the same type of stock within 30 days before or 30 days after the sale (including other ISO, ESPP or NQO exercises).

Federal tax changes happen frequently and seem to always be on the increase. If you would like to review the changes that went into effect for 2006 & 2007 click here.

For those of you who live in Pennsylvania, there are several changes for 2006 as well. One change in Pennsylvania of special note is the allowed deduction of tuition plan contributions.

Contributions to any qualified tuition program as defined in section 529 of the Internal Revenue Code, including those offered by other states, will be deductible from taxable income.  The amount deducted for each designated beneficiary cannot exceed the annual limitation on gifts permitted by the Internal Revenue Code for purposes of federal estate and gift tax, which is currently $12,000. The deduction cannot result in taxable income being less than zero.

Distribution rules have also changed. Distributions used for qualified higher education expenses, as well as undistributed earnings in the accounts, will not be taxable. Federally qualified rollovers between accounts and beneficiary changes will also not be taxable events for Pennsylvania purposes. Distributions that are not used for qualified higher education expenses will be subject to tax.

These changes will apply to tax years beginning after December 31, 2005.

Pennsylvania is being very progressive in allowing the deduction as detailed above.

 WHY YOU NEED A WILL, ESTATE PLANNING 101

It's amazing how many people don't have a written will.

When people are wealthy, having a good estate plan makes an enormous difference to the survivors.

Remember when Howard Hughes passed away? He had many wills floating around. His estate was tied up for years, with the states arguing which one had jurisdiction over Hughes' assets and was entitled to the inheritance taxes.

In contrast, J. Paul Getty had a very orderly estate plan that was designed to keep its administration out of the public spotlight and was probably handled quickly and with minimal expense.

If an individual doesn't have a written will, the state of which he or she is a resident provides a will for him or her. The rules for the state-provided will are the laws of intestacy. Are the laws of intestacy for your state acceptable to you for administration of your estate? Maybe you should find out.

The only way you can be "in the driver's seat" for many important decisions after your death is to have a written will, perhaps together with a trust.

What are some of these decisions?

1.      Who will be the executor of your estate? You can prepare a trusted friend or family member, or a professional fiduciary you know, for handling the administration of your estate. It may be there are personal conflicts or an inability to handle financial matters that make a particular family member inappropriate as an executor. Just exclude that person from your list of potential executors.

2.      Who do you think should care for your minor children? Every person with minor children should have a will to make their wishes known about this critical decision.

3.      If the assets are to be used for the support of your minor children, how will they be managed? In most states, minor children can't own and manage their assets directly. The assets must be managed by a conservator/custodian, in trust, or in a uniform gifts to minors account. Some forms require court approval to use the funds for the benefit of the minor. This is another critical decision that should be made with legal guidance.

4.      Who do you want to inherit your property? You might want some of your property to go to a favorite charity. The only way to give it to someone outside the family is through a will, trust, or beneficiary designation.

What if there are no family members left? If you don't specify your wishes, your property may go to the state. Is that what you want?

Are there family members, such as aged parents or a disabled child, for which special provisions must be made?

5.      Do you wish to use tax advantages that are available for your family? Many important elections must be made in a will or trust. For example, leaving property outright to a surviving spouse "wastes" the amount that can be given federal estate tax free by a decedent. Property may be put in a special type of trust, called a QTIP (qualified terminable interest property) trust, to qualify for an election to claim the marital deduction, and yet designate who will receive the property after the death of the surviving spouse. This helps insulate the property in the event the surviving spouse remarries, so the property won't go for the benefit of the new spouse or the new spouse's children or grandchildren.

Each person may transfer, directly or in trust, up to $1 million for the benefit of their grandchildren and avoid the "generation skipping tax" of an additional 55%. Special provisions should be made in the will or trust to exploit this election.

6.      The person writing the will can provide flexibility for their family in making decisions after death by providing disclaimer options in the will. Discuss this with your attorney.

7.      If you have a living trust, you should also have a will so that any property, except personal property and possibly your residence, that you didn't transfer to the trust during your lifetime goes into the trust at your death. This is called a "pour over will".

8.      Even when your property is held as community property or in joint tenancy, you should have a will to provide for the event that both spouses or joint tenants pass away in a common accident or within a short time of each other.

9.      Which of your beneficiaries do you wish to be responsible for paying for the estate and inheritance taxes, funeral expenses and administration expenses out of their share of the estate? You may make specific bequests of assets or amounts and residuary bequests of what's left. Should the persons who receive specific bequests be required to reimburse the estate for a share of the taxes and expenses?

This list is necessarily incomplete. I hope you can appreciate that the process of writing a will is a complex task which should be done with the help of a competent attorney.  I am very active in this area and have estate attorneys that I frequently rely on to help my clients.

Since the tax and probate laws are constantly changing, as well as your family and financial situation, you should also review and update your will and estate plan periodically, at least every five years. Also, be sure to update your will when you marry or divorce or when you have a new child.

If you don't have an estate plan in place, now is the time to take action and get started! Call me if you want my help getting started.

1398 Wilmington Pike ∙ West Chester, PA 19382 ∙ Fax (610)399-4978

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