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YET ANOTHER TAXPAYER AMT-INCENTIVE STOCK OPTION DEFEAT

October 12, 2006

The Tax Court shot down yet another theory for avoiding alternative minimum tax on incentive stock options that go bust.

Incentive stock options, or ISOs, are employee stock options with a special tax feature. When you exercise ordinary employee stock options, the excess of their value over the price you pay to exercise the shares is taxed as ordinary wage income at rates up to 35%. In contrast, if you exercise ISOs and hold the stock for one year after exercise, there is no ordinary wage income. Instead, the excess of your sales price over your option price is capital gain, currently taxed at only 15%.

The catch? In computing AMT, the "bargain element" of ISOs is taxed at the time of exercise. That means you have to pay tax up front and hope that the stock is still worth something a year later. It's still a good deal if the stock price goes up, because you get a credit against your regular capital gain tax for the AMT paid when you sell the stock. If the stock tanks, though, it's a bad, bad deal.

Many telecom employees with ISO shares ended up paying large AMT bills on stock that became worthless not long after exercise. Iowa's Ron Speltz, who got clobbered on his McLeod ISOs, is a type specimen. Taxpayers have tried a number of ingenious arguments to avoid the ISO AMT on worthless telecom shares, but to no avail.

ARE AMT CAPITAL LOSSES DIFFERENT?

The Tax Court shot down the latest attempt yesterday. Jonathan Palahnuk exercised ISO in his emplooyer, Metromedia Fiber Network. He paid $99,949 to exercise shares worth $2,185,959. He had no regular taxable income on the exercise, but $2,086,009 in AMT income. As a result he ended up paying $586,066 of AMT in 2000.

Things didn't go so well for Metromedia in the next year, and he sold his shares in 2001 for $248,410. For regular tax purposes, he had a capital gain of $148,461 on the stock that had already cost him $586,066 in taxes. For AMT purposes, he had a $1,937,547 capital loss.

The catch? Capital losses are only deductible up to the amount of your capital gains, plus $3,000. The taxpayer tried to convince the Tax Court that the $3,000 loss limit shouldn't apply in computing AMT. The Tax Court didn't buy it. That means the taxpayer can take $3,000 of AMT capital losses against his AMT ordinary income for the next 646 or so years.

The Moral? I see two. For taxpayers, if you exercise ISOs, and you can't pay the AMT if the stock goes bust, sell enough shares right away to cover your taxes. You'll convert some potential capital gain into ordinary income, but at least you'll stay solvent.

For policymakers, it shows how unintended consequences can turn tax breaks, like ISOs, into tax nightmares.

Cite: Palahnuk, 127 T.C. No. 9.

Related Tax Update Coverage:

ANOTHER BAD DAY FOR AMT-ISO VICTIMS

DES MOINES REGISTER TAKES UP SPELTZ CAUSE

TAX COURT TO ISO-AMT VICTIMS: YOU'RE STILL SCREWED

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