Taxes on incentive stock options are coming back to haunt some workers

by Staff Writer Shelly K. Schwartz

CNNfn, December 19, 2000

NEW YORK (CNNfn) – The clock’s ticking for thousands of employees — particularly in the sector — who exercised incentive stock options earlier this year and have since seen their holdings plunge in value. And the worst part is, many of them don’t even know it.

That’s because they will be stuck paying the potentially painful alternative minimum tax (AMT) on the “virtual profit” they made — unless those taxpayers dump the shares before the end of the year.

That “profit” is calculated based on the difference between the strike price — the price at which they were allowed to buy the stock — and the fair market value of the shares at the time they exercised the options. The tax liability remains the same regardless of what has happened to the stock price since.

“I’m seeing really big numbers for people getting stung,” said Claudia Hill, an enrolled agent and chair of the government relations committee for the National Association of Enrolled Agents in Cupertino, Calif. “They can find themselves in a big jam right now if they are still holding stock options that they exercised earlier this year [and have since plunged in value].”

Who’s hit?

The disaster, as some tax professionals are calling it, refers only to incentive stock options, or ISOs. Many companies and startup firms use ISOs as a form of compensation to reel in new recruits, often in lieu of higher salaries.

The AMT is a tax system that runs parallel to the regular income tax. When your AMT is higher than your regular tax, you pay AMT.

For regular tax purposes, incentive stock options are not taxed when they are granted, nor on the date of exercise, but they are taxed as capital gains when sold. However, because of their tax-advantaged status, Congress requires anyone who exercises and holds ISOs to claim the as-yet unrealized profit as AMT income.

The difference between the fair market value of those shares on the date of exercise and the option’s strike price — the price at which you were allowed to buy them — is treated as an item of adjustment for AMT purposes.

Nonqualified stock options, more common among well-established, profitable companies, are always taxed when they are exercised. Any additional gain or loss is also taxed at either short- or long-term capital gain rates, depending upon how long the stock is held. Those who own this type of option are unaffected by any additional AMT tax hit.

Joyce Franklin, a Certified Financial Planner and CPA in San Francisco, said many of her clients who work for high-tech firms and startups and are facing jaw-dropping AMT taxes this year on their exercised options, even though the value of the stocks they still hold has tanked.

“I’m seeing a lot more people this year than in other years who’ve taken an AMT tax hit who now hold stock worth less than they paid for it, ” she said. “It’s very common.”

Case study

Here’s an example of how it works:

Say you exercised 200 of your incentive stock options in January at $5 a share and the fair market value of the stock that day was $60 per share. You haven’t yet sold the shares so you don’t owe capital gains taxes yet, but you still have to claim $11,000 ($55 X 200) as an item of adjustment on your AMT forms. The adjustment may push you into AMT, if your AMT income is higher than your regular tax income.

“We are telling our clients to please sell before year-end. If you really think that the stock will appreciate in the future, sell it now and immediately buy it back.”
– Nancy Goedecke, EA

Now, let’s say your company’s stock price hit the skids this fall in the tech stock sell-off that ravaged the markets. The stock now trades at $20 per share, but because you haven’t yet sold the shares you still owe AMT on that $55 per share gain. Consider it a type of prepayment on your future gains.

“They can’t change the AMT tax consequences of that $55 that they made in virtual income when they exercised and they will pay taxes on that extra money if they still hold those shares on Dec. 31st of this year,” Hill said, noting the Internal Revenue Service is essentially just calling their bluff.

“The taxpayer could’ve sold their shares and didn’t because they were betting that the stock would go up even higher and that they would avoid paying regular income taxes on their profit and pay the lower long-term capital gains taxes [by holding it for more than a year],” she said.

The only way to avoid the AMT, as it pertains to ISOs, is to sell those stocks in the same calendar year in which you bought them — by Dec. 31. That transaction is known as a disqualifying disposition and in many cases it is viewed as the lesser of two evils.

“By selling the stock in the same year that effectively causes the ISO shares to be treated like nonqualified options,” Hill said, noting regular income tax and AMT would be treated the same.

Keep in mind, though, that any stocks sold less than a year after purchase do not qualify for the more favorable long-term capital gains tax rate of 20 percent. Instead, the profit is treated as a short-term capital gain and taxes as ordinary income. If you’re in the higher tax brackets of 31 percent to 39.6 percent, that can really take a bite out of your profit.

If the worker in the example cited earlier decides it’s worth paying the higher short-term capital gains rate to avoid the AMT tax hit and sells his shares this year, he would owe regular income taxes on $3,000 — since the 200 shares he bought at $5 each are now trading at $20. ($15 X 200 = $3,000.)

“We’ve talked with several clients in recent weeks because they may have exercised ISOs in January or February when the stock price was high and now the bottom has fallen out,” said Nancy Goedecke, an enrolled agent in Hudson, Mass. “They need to think about whether they should hold them and prepay the AMT or sell them now and pay the higher ordinary income tax.”

There’s a lot at stake, she notes. One of her clients has $198,000 generated by ISO shares he still holds to add to his taxable income under the AMT this year. That will add nearly $59,000 to the $48,000 he already owes to Uncle Sam, bringing his total tax liability to $107,000 this year. He’s now trying to decide whether it makes sense to dispose of those shares he bought earlier in the spring.

“We are telling our clients to please sell before year-end,” Goedecke said. “They need to be looking at whether it makes sense to hold these stocks and [pay the AMT] or sell them and pay the ordinary income, or short-term gains.”

Doing the math

So how do you know whether it makes sense to sell?

“If the stock price has dropped more than 30 percent from the date of exercise then you really need to sit down and push a pencil and think about selling those options.”
– Nancy Goedecke, EA

Goedecke said she tells clients to look at the fair market value of the stock today, compared with its trading price at the time you exercised your options.

“If the stock price has dropped more than 30 percent from the date of exercise then you really need to sit down and push a pencil and think about selling those options,” she notes.

Franklin adds it’s a good idea to assess your stock options and holdings at year-end anyway.

“A lot of what I see is that people are concentrated in one or two companies where they worked and they have these high expectations for where they think the stock should be,” she said. “But sometimes people’s expectations are influenced by what they hear within the company from the CEO or chief financial officer. What they say may or may not be true. They may be saying it just to retain employees so [taxpayers] should really be thinking about their long-term goals and not be greedy.”

If it hurts to sell off some of your stock options that you feel are subject to rise, it might help numb some of the pain to find another, related stock in the sector or otherwise that would likely rise alongside your company’s stock. That way, you’ll still enjoy the benefit of a market trending upwards.

What is the AMT?

When it was first passed in 1978 the alternative minimum tax was designed to keep wealthy taxpayers from sheltering too much of their income from the federal government. Since then, however, taxpayer advocates say middle-income workers are increasingly getting stuck with the bill.

“The AMT hasn’t really been adjusted [for inflation and cost of living increases] since it was founded,” Goedecke said. “More and more middle class families are now subject to this additional tax.”

According to estimates, some 828,000 more Americans paid the AMT in 1998 — a 40 percent increase over 1997. About 27 percent of taxpayers who paid the AMT in 1998 had combined household incomes of less than $100,000 and by 2010, government figures show 17 million people will pay the AMT — unless Congress increases the salary threshold.

In addition to ISOs, items that can trigger the AMT include large deductions for medical expenses, certain tax shelters, unusually high state and local property/ income taxes and even exemptions for your kids and spouse.

Under the AMT, the tentative minimum tax rates on ordinary income are 26 percent and 28 percent. For capital gains, the maximum capital gains rates for the regular tax are used.

You may have to pay the AMT if you are single with an income of at least $33,750, married filing jointly with an income of at least $45,000 or married filing separately with an incomes of $22,500. You are required by law to calculate your taxes twice – once using the standard forms and once using the AMT formula. You pay taxes on whichever number is higher.

A portion of what makes up the tax base for the AMT stems from virtual gains generated by exercised incentive stock options — if you fail to sell them in the same year you bought them. In addition to that, you are still required to pay capital gains taxes on your profit from those options in the year you ultimately sell them.

But the good news is, taxpayers receive a credit from their AMT tax payments — also called a bargain element — that can be used to help offset the tax bite on any gains they realize when they actually sell the stock.

The bargain element, used to determine the size of the credit you’ll receive, is the difference between the fair market value of your stock on the day of exercise and the option price, or strike price at which you bought it.

Planners stress, however, that if you sell your ISO shares in the same year you exercised, you won’t have to worry about tax credits and bargain elements.

“If you exercise your options and hold them, and then sell at the end of the year, you don’t have to take anything into the AMT,” Franklin said.

© 2002 Cable News Network LP, LLLP. An AOL Time Warner Company ALL RIGHTS RESERVED.

Preserving the Wealth of Successful High-Tech Community Members
Preserving the Wealth of Successful High-Tech Community Members
The BE WISE Planning Strategy
The BE WISE Planning Strategy