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IRS SNATCHES BACK ISO-AMT REFUND

May 16, 2008

Incentive Stock Options are a textbook case of grim unintended consequences from a tax break. Unlike regular "non-qualified" stock options, ISOs don't generate taxable salary income when they are exercised; if you hold on to them for one year after exercise and then sell them, any gain you have is long-term capital gain, taxed at preferential rates. This is supposed to be a tax break.

But there's a catch: the "bargain element" on the ISOs - the difference between their value and the price paid to exercise the options - IS taxable for alternative minimum tax in the year the option is exercised, even if the stock received on exercise isn't sold. If the stock becomes worthless between the exercise date and the sale date, the taxpayer pays AMT when the stock is exercised, but can only take the loss on the sale to the extent of other capital gains, plus $3,000 per year. Taxpayers have argued that there should be an AMT "net operating loss" rather than a capital loss, so that they could retroactively recover the AMT through an NOL carryback, but the Merlo decision rejected that argument.

The McLeod nightmare ISOs

This problem became all too real for many employees at McLeod Communications in Cedar Rapids -- perhaps most famously, Ronald Speltz.

Another McLeod employee, Bryce Nemitz, attempted to use the NOL carryback argument. Mr. Nemitz sold McLeod stock he had received from exercising ISOs in 2001. McLeod stock had tanked, so he had a huge loss compared to the amount he had to pay AMT on. On an amended 2001 return filed in November 2002, he computed an NOL that he carried back to 1999 and 2000. Things went well at first, as the IRS issued him carryback refunds of $53,942 for 1999 and $1,476,656 for 2000. Then the IRS realized what it had done and asked for the money back.

Did the IRS assess too late?

By the time the case reached Tax Court, the Merlo decision settled the issue of whether a loss on the sale of ISO shares could generate a net operating loss, rather than a capital loss ("no"). Mr. Nemitz tried to save the day by arguing that the IRS had asked for the money back too late, missing the three-year statute of limitations.

The IRS pointed out that assessments can be made on erroneous net operating loss carrybacks, the statute of limitations runs out three years after the filing of the return that generated the loss to be carried back - in this case, the 2001 return, under Code Sec. 6501(h).

Not really an NOL claim?

Mr. Nemitz argued that the refund was governed by Sec. 6501(a), the usual three-year statute of limitations for timely-filed returns, which would have expired for 1999 and 2000 by the time the deficiency notice was issued in 2005. He cleverly argued that since the amount carried back turned out not to qualify as an NOL under Merlo, it wasn't really an NOL, and so it didn't trigger the extended NOL statute of limitations. He also argued that the special NOL carryback statute applied only to regular NOLs, not AMT NOLs.

The Tax Court didn't go for either argument. Regarding the "it wasn't really an NOL" point, the court said:

The record establishes, and we have found, that petitioners claimed a net operating loss, and not a capital loss, for AMT purposes in the 2001 amended return and that they carried back that net operating loss for AMT purposes in the 1999 amended return and the 2000 amended return.

In other words: you claimed it as an NOL and the refund was erroneously issued as a result of the NOL claim, so the NOL statute applies.

Then the court addressed the claim that the special NOL statute only applies to "regular" losses:

As we understand it, petitioners are arguing that, because section 6501(h) refers only to a net operating loss carryback, and not to a net operating loss carryback for AMT purposes, that section does not apply to the deficiency for each of their taxable years 1999 and 2000 that is attributable to the carryback to each of those years of the net operating loss for AMT purposes that they claimed in the 2001 amended return.

Section 6501(h) applies in the case of a deficiency attributable to the application of a net operating loss carryback. The only provision in the Code that allows a net operating loss carryback is section 172(b). That section, which is entitled "Net Operating Loss Carrybacks and Carryovers", allows, inter alia, a taxpayer to carry back a net operating loss. Section 172(b) does not refer to, or distinguish between, a net operating loss for regular tax purposes and a net operating loss for AMT purposes. See Plumb v. Commissioner, 97 T.C. 632, 638 (1991). That section provides rules that apply to both the carryback of a net operating loss for regular tax purposes and the carryback of a net operating loss for AMT purposes. .

Like section 172(b), section 6501(h) does not refer to, or distinguish between, a net operating loss for regular tax purposes and a net operating loss for AMT purposes. If Congress had intended that section 6501(h) not apply with respect to the carryback of a net operating loss for AMT purposes, it would have so stated. It did not.

Bottom line: Mr. Nemitz has to pay back over $1.5 million to the IRS, in the hopes of getting some of it back over time under the relief provisions enacted in late 2006 for ISO victims.

The case has a sad note aside from the woeful consequence to the taxpayer; it was one of the last cases argued by our friend Burns Mossman, who died last year. It made me misty-eyed to see his name at the top of the opinion. If Burns couldn't pull it out, I'd say it was hopeless to start with.

Cite: Bryce E. and Michelle S. Nemitz, 130 T.C. No. 9.

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