BEWARE OF OVER-TAXATION ON INCENTIVE STOCK OPTIONS

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1 BEWARE OF OVERTAXATION ON INCENTIVE STOCK OPTIONS Fanguy, Ronnie, PhD Nicholls State University Thibodaux, LA (985) Chiasson, Michael, DBA Nicholls State University Thibodaux, LA (985) Breaux, Kevin, PhD Nicholls State University Thibodaux, LA (985) ABSTRACT Employees of many corporations are awarded Incentive Stock Options (ISO) as part of their benefit or compensation package. These Incentive Stock Options allow the employee to purchase stock of the corporation for a set price. If an ISO becomes part of the benefit package, the employee should be aware of the tax consequences associated with the exercise of the options and the later disposal of the stock acquired with the options. When the ISO is exercised, the taxpayer benefits because the difference between the ISO set price and the market price of the stock is not included in gross income for the taxable year the ISO exercise occurs. However, if the employee is substantially vested at the time of exercise, the price difference is included in the alternative minimum taxable income. Therefore, it is important for the employee to realize that the ISO can affect both the regular income tax and the alternative minimum tax (AMT). With respect to the alternative minimum tax, the employee may either not be aware of the AMT, or if aware, may not consult a professional on the applicability of the AMT. If these items are not taken into consideration the employee could be burdened with a significant unexpected tax liability when they exercise the ISO. The AMT can also have significant effects when the employee later disposes of the stock. This paper explores the tax consequences associated with the initial exercise of the ISO as well as the resulting tax consequences from the later disposal of the stock acquired with the ISO. Illustrative examples of the tax consequences will be presented along with the outcomes of recent court cases.

2 INCENTIVE STOCK OPTIONS Employees of many corporations are awarded Incentive Stock Options as part of their benefit or compensation package. These Incentive Stock Options allow them to purchase stock of the corporation for a set price. If the stock price increases, the employees may make a nice gain on the options they hold. One would expect that this gain would be subject to taxation. However, unless great care is taken, the gain will be subject to taxation above and beyond what most would consider to be reasonable and fair. THE ALTERNATIVE MINIMUM TAX Since 1970, when the Tax Reform Act of 1969 took effect, US taxpayers have been subject to the Alternative Minimum Tax (AMT) system. The AMT is a tax system with its own rules for recognition of income and deductions. Its intention was to target highincome households that took advantage of so many tax benefits under the tax code that they owed little or no federal income tax. The AMT is designed to ensure that all taxpayers pay at least some minimum amount of tax to ensure a higher degree of equity among all taxpayers. Although the AMT was originally designed to focus on a few highincome households, it has spread its reach over time and now affects many middleclass families. The AMT system runs in parallel with the regular federal income tax system that is, they must be computed separately from the regular tax system for each tax year. Then, any amount of AMT in excess of the regular federal income tax is added to the taxpayer s tax liability. In essence, taxpayers are subject to the larger of the AMT and the regular federal income tax assessment. Although the AMT was originally designed with the intention of creating equity, with respect to Incentive Stock Options, we will show that it is likely to cause great inequity. WHAT ARE THE RULES WITH REPSECT TO EXERCISING INCENTIVE STOCK OPTIONS? For regular federal income tax purposes, exercising Incentive Stock Options is not a taxable event ( 421(a)(1)). Although an employee may pay only $50,000 for $500,000 worth of stock, no regular federal income tax is levied. This adheres to the wherewithal to pay concept. Although the employee realized a gain on the transaction of $450,000, they did not receive any cash that could be used to pay the tax on the gain. The gain is, therefore, not recognized for regular federal income tax purposes. The same holds for losses, although such losses are certainly rare as it would require that the option holder exercise stock options to purchase stock for a price that is higher than the open market price. Exercising Incentive Stock Options creates very different consequences when considering the AMT ( 56(b)(3)). AMT rules require recognition of the gain realized by the employee upon exercising Incentive Stock Options despite the lack of wherewithal to pay. Under the AMT system, the $450,000 realized gain from above becomes a recognized gain which triggers AMT tax liability. Since the AMT rate is tiered at either 26% or 28%, the tax liability is potentially as high as $450,000 * 28%=$126,000. This has the effect of circumventing the benefit offered by the regular federal income tax code. As we will see as we further explore these rules, it creates a situation where taxpayers are likely to be unjustly taxed.

3 To help solidify our understanding of the tax rules that affect those utilizing ISOs, we present the following example. Let us consider John Smith. He is a middle class worker earning well below the class of individuals the AMT is intended to be imposed upon. John s employer is doing extremely well, and John is rewarded with Employee Stock Options that allow him to purchase $500,000 worth of stock for $50,000. Under the regular federal income tax rules, John has no tax liability at this time. However, the AMT rules require that he include the $450,000 ($500,000 $50,000) spread as taxable income for calculating the AMT. The AMT tax is levied, Table 1: ISO Treatment When Options Exercised and John is required to pay despite the lack of wherewithal to pay. Option Strike Price (price paid) $ 50,000 at Time of Exercise $ 500,000 It is important to realize that at the time of Spread $ 450,000 exercise, the different rules for the regular Regular Federal Income Tax $ federal income tax system and the AMT AMT Tax at Time of Exercise (28%) $ 126,000 system create a situation where there are two different tax bases for the stock acquired upon exercising Incentive Stock Options. The basis for regular federal income tax purposes is the exercise price (the price paid for the stock)$50,000 in our example. However, since AMT rules require recognition of the immediate gain that is realized upon exercising, they allow a basis that is stepped up to the fair market value at the time the options are exercised $500,000 in our example. This plays a key role in considering our next question. WHAT HAPPENS WHEN THE STOCK ACQUIRED UPON EXERCISING INCENTIVE STOCK OPTIONS IS SOLD? Although the regular federal income tax rules allow for nonrecognition of gain upon the exercise of Incentive Stock Options, it does require the recognition of gain or loss realized upon the sale of the stock acquired. The gain in this case is calculated as the difference between the sale price and the exercise price (assuming no adjustments to the basis). The gain or loss recognized under AMT rules differs, however. Since gain has already been recognized when the options were exercised, the gain or loss at the time the stock is sold is calculated using the stepped up basis the fair market value of the stock when the options were exercised (assuming no basis adjustments). Therefore, the gain or loss will be the difference between the sales price and the fair market value at the time the options are exercised. Using the stepped up basis is important to prevent doubletaxation on the spread (the difference between the exercise price and the fair market value) at the time the options are exercised. However, because the regular federal income tax and AMT systems run in parallel and because the sole function of the AMT is to increase in annual tax levied upon a taxpayer, great care must be taken to avoid the trap that these rules create. Unless taxpayers are very careful, they are very likely to be unjustly taxed upon the spread at the time the Incentive Stock Options are exercised. Taxpayers exercising Incentive Stock Options are likely to be doublytaxed on the same gain or, even worse, taxed on a temporary nonmonetary gain that never materializes. To help explain why, let us continue to consider the case of John Smith presented previously. At the time John executes the ISO, he is holding $500,000 worth of company stock; however, the direction the stock will take on the stock market is indeterminate. It will either continue to increase in

4 value, its value will remain unchanged, or it will decline in value. Either way, if John sells the acquired stock in a succeeding tax year, John will be levied more tax than seems equitable and fair to most individuals. Let us first consider the case where the stock price continues increasing. Let s say that John sells the stock when it is worth $800,000. The AMT tax rules will include income only from the appreciation since time of exercise. That is, AMT taxable income will include $800,000$500,000 or $300,000. However, the AMT tax imposed on this amount will only be levied if it is in excess of the regular federal income tax amount. The regular federal income tax rules will require recognition of not only the appreciation in value since the stock was acquired but also the immediate gain that was realized when the options were exercised (the spread of $800,000 $50,000 = $750,000). John is at a huge disadvantage because he already paid AMT tax on the spread, and he is now subject to regular federal income tax on this same gain. This double taxation is enabled by the dual basis that exists when the options are exercised. Although the AMT tax basis is stepped up to fair market value, the regular federal income tax basis is not. Therefore, John is taxed on the spread twice if his stock price has increased since the acquisition of the stock. What if there is no change in the stock price? Although this is an unlikely event, we consider it for completeness. If John sells the stock in a subsequent taxable year for $500,000 the exact amount that it is worth when he exercised the stock options the situation is disadvantaged in a manner similar to the stock appreciation case just considered. For AMT purposes, he is subject to no additional tax the sales price is equal to the basis so there is no gain or loss. For regular federal income tax purposes, he is again subject to tax on the spread despite the fact that he paid AMT tax on this gain previously. How are things different if the stock price decreases? Let s consider what happens if John sells the stock when it is only worth $200,000. In this case, a loss of $300,000 ($200,000 $500,000) will result for AMT purposes since the AMT tax basis is $500,000. The AMT loss will be of little help in providing relief to John, though, because the AMT may only increase the regular federal income tax it will never decrease it. Therefore, the loss will not offer any relief from the regular federal income tax that is to be imposed. For federal income tax purposes, John is taxed on a gain of $150,000 ($200,000 $50,000 basis). What is so unjust in this situation is that John was already taxed on $300,000 of gain at the time the options were exercised, but this gain never materialized monetarily it was only a temporary holding gain. The true overall gain to John was $150,000. However, he is taxed not only on this but also on the $300,000 spread when the options were exercised. This situation may be even more unfair to John if the value of the stock falls below $50,000 (the exercise price of the options) because, in this case, he would have a real overall loss on the ISO transaction. However, he is still taxed on the spread when the options were exercised.

5 This last case where the stock value declines introduces another interesting question: What are we allowed to do with the $300,000 AMT loss? Interestingly, the appropriate treatment of this loss is not specified in the tax code. Deducting this loss as a net operating loss was tested in Palahnuk, (006) 127 TC No. 9 in October However, the tax court did not allow such a treatment, and, furthermore, specified that the $3000 limitation on net capital losses which applies under the regular tax code applies to the AMT as well. Therefore, the deductibility of the loss is greatly limited as the losses are required to be carried forward and treated as capital losses for AMT purposes. Table 2: Treatment of ISO Stock When Sold Stock Increases in Stock Remains the Same Regular Federal Income Tax System at Time Stock is Sold $ 800, ,000 Tax Base $ 50,000 50,000 Gain/Loss Realized in Transaction $ 750, ,000 Gain/Loss Included in Taxable Income* $ 750, ,000 Tax Liability (Benefit)35% $ 262, ,500 Stock Decreases in Stock Becomes Worthless $ $ 200,000 $ $ $ 50,000 $ 50,000 $ $ 150,000 $ (50,000) $ $ 150,000 $ (3,000) $ $ 52,500 $ (1,050) AMT System at Time Stock is Sold $ 800,000 $ 500,000 $ 200,000 $ Tax Base $ 500,000 $ 500,000 $ 500,000 $ 500,000 Gain/Loss Realized in Transaction $ 300,000 $ $ (300,000) $ (500,000) Gain/Loss Included in Taxable Income* $ 300,000 $ $ (3,000) $ (3,000) Gain/Loss Carried Forward $ $ $ (297,000) $ (497,000) AMT Liability (28%) $ 84,000 $ $ $ AMT Liability in Excess of Regular Income Tax Liability $ $ $ $ * These figures apply only to the tax year in which the ISO Stock is sold. The losses assume that no other capital asset gains/losses exist. If they do exist, there would be an appropriate netting and only up to $3,000 of a net capital loss may be deducted. The remainder is carried forward. In summary, we have shown how the AMT imposes a tax upon the intermediate effects of an ISO transaction whereas the regular federal income tax system does not. The ISO transaction is completed with the sale of the ISO stock. At this point, the two tax systems separately handle the transaction the AMT considering the change in value since the stock was acquired and the regular federal income tax system considering the transaction in its entirety. The AMT taxes the ISO transaction in two distinct parts and the regular federal income tax system waits until the ISO transaction is complete and taxes it once. In either case, the entire gain/loss subject to taxation under each system is exactly the same. The difference between the two systems is when it is subject to taxation. However, this simple difference can make a huge impact on a taxpayer. SURELY, THE IRS WOULD HAVE PITY IN SUCH A CASE Most who have some measure of faith in the system would surely expect the IRS to have pity in the situation described. If we propose such an idea to Ronald and Jane Speltz, they would vehemently disagree. Ronald earned $75,000 annually working for McLeod USA Network Services a highflying telecommunications company during the dot.com bubble of the 1990s. In 2000, Ronald exercised Incentive Stock Options that he received as part of his compensation. He purchased $745,372 of McLeod

6 stock for $34,254. Unfortunately, the stock plummeted in value from $ per share to $0.80 per share by yearend. Ronald and Jane s eventually sold their $34,254 investment for $1,647. For 2000, the Speltzs were assessed $18,678 in regular federal income tax and $224,869 in AMT. The disparity was due to the differences in the rules for the two tax systems. Despite the enormous decline in the stock s value, the AMT rules required the Speltzs to report as taxable income the $711,118 spread on Ronald s Incentive Stock Options that were exercised. The Speltzs paid approximately $18,000 of the tax imposed in the 2000 tax year. After paying $92,000 of the remaining balance in 2001, they submitted an Offer in Compromise to settle the remaining tax liability explaining the unfairness of the situation and the financial hardship caused. The IRS rejected their offer. Despite Tax Court trials and appellate court reviews, the tax burden remained [Speltz vs Commissioner, 124 T.C. 165 (2005)]. This situation arose again in 2006 for Chi Wai [Chi Wai vs. Commissioner, T.C. Memo ] with identical results. With the ups and downs of the stock market in the recent years, it is sure to affect other tax payers as well. However, despite the seemingly obvious lack of fairness, no relief is in sight. It is important to keep in mind that the tax imposed upon the Speltzs (and later upon Chi Wai) was based on the temporary gain that they realized upon the exercising of Incentive Stock Options. Although this gain never materialized, the AMT tax remained. Despite the precipitous drop in the value of the stock by yearend, the AMT tax remained. Despite the loss that was realized (and recognized) subsequently, the 2000 AMT tax remained. Despite the unfairness of the situation to all reasonably minded individuals, the AMT tax remained. WHAT IS A TAXPAYER TO DO? If a taxpayer exercises Incentive Stock Options, they will include the immediate, nonmonetary gain at the time of exercise in taxable income for AMT purposes. If the stock price goes up, the taxpayer already having been taxed on the spread when the options were exercised will be subject to taxation on the spread again for regular federal income tax purposes. If the stock price goes down even to the point where the taxpayer ends up with an overall loss on the investment the AMT tax on the spread is still imposed. How can an informed taxpayer avoid these traps? There is some relief provided in 53 of the tax code to help ease the effects of being subject to the double taxation described above the AMT tax credit. Enacted to help ease the effects of temporary timing differences in the regular federal tax system and the AMT system, the AMT tax credit provides a future tax credit for AMT tax paid. This tax credit may be applied in subsequent tax years when the regular federal income tax liability exceeds the AMT liability. This tax credit is available to help in easing the tax burden associated with ISO stock transactions. The tax credit may be applied when the ISO stock options are sold as we would expect the ISO stock option transaction to generate a regular federal income tax liability that exceeds the AMT Tax liability. This does not mean that a taxpayer must wait until the ISO stock is sold to utilize the AMT Tax Credit. The credit is available starting with the tax year immediately after the tax year in which the AMT tax is paid. One potentially huge catch is that if the credit is not taken when it is available, it is lost.

7 Table 3: Summary of Taxes Paid for ISO Stock Acquisition and Disposition* Stock Increases in Stock Remains the Same Stock Decreases in Stock Becomes Worthless Tax Liability When ISO Stock Acquired AMT Tax Liability $ 126,000 $ 126,000 $ 126,000 $ 126,000 Tax Liability When ISO Stock Disposed Regular Federal Income Tax Liability $ 262,500 $ 157,500 $ 52,500 $ (1,050) AMT Tax Credit $ (126,000) $ (126,000) $ (52,500) $ Total $ 136,500 $ 31,500 $ $ (1,050) Overall Effect Total Income Tax Liability Assessed on ISO Transaction $ 262,500 $ 157,500 $ 126,000 $ 124,950 AMT Tax Credit Carried Forward $ $ $ 73,500 $ 126,000 *Considered in isolation from other transactions. Let us consider the effects of the AMT Tax Credit on John Smith s ISO transaction presented earlier in this paper as summarized in Table 3. It is important to realize that this table shows the tax effects of ISO transaction considered in isolation of other transactions. If the ISO stock increases in value or remains the same, then John Smith recovers all of the AMT liability incurred when the stock was acquired. Thereby, he will not be subject to double taxation on this transaction. However, if the stock decreases in value, the taxpayer will not be able to recover all of the AMT tax liability assessed when the ISO stock is acquired. The AMT tax credit may be carried forward indefinitely awaiting subsequent tax years in which their regular federal income tax liability exceeds their AMT liability. It may take a significant amount of time to recoup the AMT liability imposed when the ISO stock is acquired. Because of the tax effects described, those who are holding ISO stock should be particularly wary of declines in stock value. Another approach to easing the effects of taxation on ISO transactions is to dispose of the stock in the year of acquisition. In this way, the gain or loss for regular federal income tax purposes is mirrored in the AMT system, and the tax effects of the gain/loss are confined to the same tax year. Therefore, the taxpayer will not be separately subject to AMT liability on the spread in the year of acquisition hoping to subsequently recoup the tax liability by utilizing the AMT Tax Credit when the ISO stock is later disposed of. By limiting the ISO transaction to one tax year, the timing differences do not come into play. The gain at the time of acquisition is combined with (or offset by) the gain or loss at the time of disposition to yield an overall gain or loss that may be fully recognized within both the regular federal income tax system and the AMT system. CONCLUSION Care must be taken to plan for and properly account for ISO stock acquisitions and dispositions because of the differences in the rules. The AMT system views acquisition of stock via the exercise of an ISO, whereas the regular federal income tax system does not. When the acquired stock is later disposed of, both the AMT and regular tax systems impose tax liability although on varying amounts and at varying rates. In order to avoid overtaxation on these transactions, a tax preparer must have a solid understanding of the rules which govern them.