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April 26, 2006

screw.jpgThe Tax Court shot down another attempt by an unhappy alternative minimum tax-payer to avoid the disastrous tax consequences incentive stock options.

This sad tax problem got national press when eastern Iowan Ronald Speltz was hit with a $206,000 tax bill for exercising McCleod ISOs that were nearly worthless by the time the tax bill came due.

When you exercise an incentive stock option, you get favorable tax treatment. You have no income for the "spread" -- the excess of the stock price over the amount paid to exercise the option -- and you have capital gain on the eventual sale of the shares. This contrasts with the more-common "non-qualified" options, which generate ordinary income immediately on exercise:


There are two big catches in the favorable treatment of ISOs:

1. You have to hold on to the shares for a year after exercise to qualify, and

2. the favorable treatment doesn't apply when computing AMT; you report the spread is all ordinary wage income on Form 6251. This becomes a huge problem if the stock craters between the time you exercise the options and tax day.

Robert Merlo exercised options for 46,125 shares of Exodus Communications, Inc. on December 21, 2000. His exercise price was 20 cents per share, and the stock value at exercise was $23.3125. This gave him a "spread" of $1,066,064.

When the taxes came due the next April 15, the stock value had gone down to about $10.18. At this point, selling his shares would have still netted Mr. Merlo enough cash to pay his tax. He took another path.


When he filed his 2000 return, he reported the bargain element as the difference between the exercise price and the value on April 15, 2001, rather than the exercise date. He held onto his shares and rode them down until Exodus made its, well, exodus by declaring bankruptcy on September 26, 2001.

The IRS noted that the tax law requires the bargain element to be measured on the date the option is exercised, not the subsequent tax return due date, and assessed him additonal AMT of about $170,000. Mr. Merlo didn't care for this. He apparently realized his initial return position wasn't going to work, so he raised a number of other issues:

1. He wasn't "vested" in his ISO shares under Code Section 83, and therefore had no income.

2. His AMT capital loss deduction on the worthlessness of the stock was not subject to the $3,000 annual limit on capital losses, so he had a net operating loss to carry back and get an offsetting tax refund.

3. The AMT treatment was just wrong, somehow.

The court disposed of the "vesting" argument last July, holding that the shares weren't subject to risk of forfeiture. Mr. Merlo had argued that he might lose his job because selling the shares was against the company's insider trading policy. The court said that even if that were true, it didn't matter, as long has he wouldn't have to forfeit share proceeds:

The evidence in the instant case shows that petitioner had no substantial risk of losing the rights to his shares of Exodus stock. There is no evidence that Exodus could have ever compelled petitioner to return his shares after he exercised his ISO; no sellback provision is present; nor is there any evidence that Exodus could have compelled petitioner to forfeit his shares of stock.

The court had no trouble ruling that the annual capital loss limitation applies for AMT purposes as well:

This Court has never addressed whether the capital loss limitations of sections 1211 and 1212 apply for purposes of calculating a taxpayer's AMTI. However, section 1.55-1(a), Income Tax Regs., states:

        Except as otherwise provided by statute, regulations, 
        or other published guidance issued by the Commissioner, 
        all Internal Revenue Code provisions that apply in 
        determining the regular taxable income of a taxpayer 
        also apply in determining the alternative minimum 
        taxable income of the taxpayer.

We find no statute, regulation, or other published guidance that purports to change the treatment of capital losses for AMT purposes.

Not a surprising result. AMT is mostly the regular tax system with a few specific changes. If the tax law doesn't specify that something is computed differently for AMT, regular rules apply.

The "just wrong" defense didn't get very far, either:

Petitioner also advances several "policy and legal considerations". Essentially, petitioner is arguing that, under principles of equity, he should be allowed to carry back his AMT capital loss to reduce his AMTI. Petitioner feels that applying the capital loss limitations of sections 1211 and 1212 to the calculation of his AMTI results in harsh and unfair tax consequences.

This Court has previously stated:

        The unfortunate consequences of the AMT in 
        various circumstances have been litigated since 
        shortly after the adoption of the AMT. In many 
        different contexts, literal application of the 
        AMT has led to a perceived hardship, but challenges 
        based on equity have been uniformly rejected. * * *
        * * * "it is not a feasible judicial undertaking 
        to achieve global equity in taxation * * *. And if 
        it were a feasible judicial undertaking, it still 
        would not be a proper one, equity in taxation being 
        a political rather than a jural concept." * * * the 
        solution must be with Congress.

Congress broke it; only Congress can fix it.

The moral? ISOs are a dangerous bargain. They carry a lure of future regular tax savings at the cost of current AMT. If the shares tank, you just get the AMT. If you can't afford the AMT if the shares become worthless, sell enough shares when you exercise the options to make sure you'll be solvent at tax time.

Cite: Merlo, 126 T.C. No. 10.





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