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How the refundable AMT credit works

October 06, 2008

A reader asks a question that identifies a tricky issue in dealing with ISOs and the minimum tax credit under the new rules enacted last week. I have changed some of his numbers so it works better as an example.

I exercised some ISO's early in Jan at $180 but the stock has fallen to $80 now. My original intent was to hold until next year for capital gains benefit but knew I had the option of selling them by end of year to make the income regular and avoid AMT calc. With the change in ISO-AMT rules, does this mean that if I paid $420k in AMT for tax year 2008 that I can claim $210k cash back on my 2009 return?

The reader leaves out some important facts, so I will make some up. We will assume that the reader has ISOs for 10,000 shares, and that his exercise price was $30. If he holds the ISO stock for a year, he will have no 2008 regular taxable income on his exercise of incentive stock options, but he will have $150 per share added to his income in computing alternative minimum tax, - $1,500,000 in total. We will assume that this increases his AMT by $420,000: 28% of $1,500,000. This should generate a $420,000 minimum tax credit that may offset future regular tax, but not AMT.

The new tax law makes 50% of long-term unused minimum tax credits refundable, the same as if it were from wage withholding. "Long-term" unused credits are those over three years old. That means any credits generated by 2008 tax won't become "long-term" until 2012. So the taxpayer will not be able to get 50% back as a refundable credit until 2012; it will only be available to reduce regular tax, but only to the level of AMT. As the rule allowing refunds of long-term minimum tax credit expires after 2012, the remaining 1/2 would never generate a cash refund; it would only offset regular tax. That may not happen for many years.

If the taxpayer's $420,000 AMT credit had originated in 2003 instead, it would be "long-term" in 2008, and he would, under the new law, be refunded $210,000 in 2008 and $210,000 in 2009.

Disqualifying disposition: opting out of ISO treatment

If the reader sells the stock in 2008 at $80, the results differ. If he sells shares acquired by exercising an ISO within 12 months of exercise of the option, he in effect elects out of ISO treatment and the resulting AMT problems. He will have $1,500,000 of ordinary compensation income per share ($180 value - $30 exercise price = $150 x 10,000 shares = $1,500,000). Assuming a 35% rate, that means he will owe $525,000 to the IRS on the shares for 2008. He will also have a capital loss of $700,000, the difference between the $1,500,000 exercise price and the $800,000 sales price at $80 per share. But very importantly, he will have $800,000 cash available to pay the $525,000 tax. If he holds on to the shares that have already fallen in value from $180 to $80, he will be in a pickle if the shares decline more - and further stock declines are certainly possible in today's economy.

The ISO tax benefit benefit our reader would get by holding onto the shares for a year after exercise is that any gain would then be taxed then at capital gain rates. If the stock stays at $80, the reader will have $500,000 capital gain taxable at 15%, unless the next president and Congress raise capital gain rates for 2009. That would reduce his regular federal tax on the ISO income to $75,000. But he would still probably be unable to use much of the minimum tax credit generated by his 2008 exercise of the ISOs for a number of years, with the big benefit not available 2012.

The bottom line? Our reader has to do some thinking on whether the savings of having capital gain treatment of ISOs is worth both the market risk on his stock and the high possibility of having to wait until 2012 to recover taxes due in 2008 if he retains ISO treatment. If the stock goes to zero before he sells it, he has a $420,000 AMT liability and no cash.

Oh, and one more thing: Congress should fix the problem going forward by repealing the ISO rules entirely. They create a dangerous AMT trap for the unwary, and they encourage behavior - holding stock after exercising an option - that would normally not make economic sense.

UPDATE, 10/10/08: more at Long-term minimum tax credits: what are they?

Tags: AMT.ISOs.