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DES MOINES REGISTER TAKES UP SPELTZ CAUSE

July 25, 2006

The Des Moines Register yesterday weighed in on the plight of the Speltz family from Eastern Iowa. Ron Speltz was a McLeod Communication employee who participated in the McLeod "incentive stock option" plan and ended up owing hundreds of thousands of dollars of tax on stock that became worthless. From the editorial:

Here’s how it happened: In 1992, Ron took a job with McLeodUSA, then a small telecommunications start-up. Compensation included stock options, which he saved for a family nest egg. In 2000, he and June consulted a financial adviser on the best way to cash out the stock. The adviser told them to exercise the stock options and hold the stock for a year to take advantage of low tax rates on capital gains.

Then the stock price fell. What was once worth about $700,000 became worth about $2,000. Yet, they owed more than $250,000 in state and federal taxes due to a quirk in the Alternative Minimum Tax law that targets Incentive Stock Options (ISO-AMT).

It's not exactly correct to call the AMT issue a "quirk." It's a devil's bargain that has been in the tax code for 20 years. To get the tax benefits of ISOs - long-term capital gain tax on what would otherwise be ordinary compensation - you have to pay AMT when you exercise ISOs. You also have to hold on to the shares for a year to get the capital gain rates. If you sell the ISO shares before the year is up, the "bargain element" - the spread between the exercise price and the value at exercise - is ordinary income.

The editorial says Senator Grassley is trying to get some AMT-ISO relief in the pension reform bill now in conference committee.

The "financial advisor" issue is a new wrinkle, to me. If Mr. Speltz paid for financial advice, the advisor's malpractice insurance company must be sweating. If you are exercising ISOs, you should remember what Mr. Speltz learned the hard way: if you exercise ISOs, you should consider whether you could pay the resulting AMT if the stock becomes worthless before your taxes are due. If not, you should sell enough shares to make sure you stay solvent if the company doesn't - even if you have to pay ordinary income taxes in the bargain.

The correct solution to the ISO problem is to simply repeal the ISO provisions entirely - both the benefits and the AMT downside. Economically, you almost never exercise a stock option until you are ready to cash out. The ISO holding-period rule encourages behavior that would otherwise be economically irrational.

Hat tip: State 29.

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