CHANGING TIDES.

Real Taxes on Virtual Income: The ISO Dilemma

UP AND DOWN. UP AND DOWN.

The last few years have been a roller coaster for employees who have held stock options, especially those in California's technology sector. While some have accumulated significant wealth, others have watched potential fortunes evaporate. Stock options' volatility introduces complexity when providing tax and financial planning services. Without a crytal ball to predict future stock prices, it is challenging to know the best timing for option exercise and stock sale. However, it is possible to counsel clients on strategies to help them achieve their goals and minimize risk.

Last year demonstrated how profoundly stock prices can affect strategies for dealing with incentive stock options. At the beginning of 2000, technology industry employees with stock options were optimistic about their companies and future stock prices. By year-end. every other Internet stock was worth less than $5 and one of every five was literally a penny a stock. according to Pegasus Research International. Thus, employees' optimism about the stock price proved unfounded for most Internet and many established technology companies.

The result is a tax problem that is magnified by (but not unique to) California's high-tech firms. A recent letter to Maryland Congressman Wayne T. Gilchrest, from an outraged constituent, "Mary," illustrates the alternative minimum tax conundrum that shocks unsuspecting taxpayers:

I was granted incentive stock options which I exercised (and held) throughout 2000. ... the price for these shares ranged from a high of $43.17 Jan. 4 to a low of about $5 by the end of 2000. They are now practically worthless. This strange and unfair law has resulted in a total tax liability of $112,000 for the year 2000. That is, $40,000 in regular income taxes on real income I actually earned, and another $72,000 in AMT that is on income I never actually received, and income I may never actually receive given the stock price. Thus, I find myself having to scramble to coma up with $65,000 in cash to cover the additional ANT.

In retrospect, it is easy to see that Mary would have profited if she had sold the stock at its peak, immediately after exercising the ISOs. Alternatively, she would have avoided the loss of most of her exercise price and all of the AMT tax debt if she had simply never exercised the options. Unfortunately, the tax law motivated Mary to shun both of these strategies. If she sold her ISO stock within one year of exercise, she would sacrifice the 20 percent long-term capital gain tax rate. If she anticipated continued stock appreciation, then she would increase her AMT gain by delaying exercise. AMT gain is equal to the spread (stock FMV minus ISO exercise price) on the date of exercise. The tax law encourages taxpayers to exercise early and hold the shares for at least one year. When a stock tanks, that tax smart strategy compounds the taxpayer's problems.

DEALING WITH AMT

To preserve capital gain treatment on stock disposition, and avoid compensation income on the spread (FMV minus strike price), ISO stock must be disposed of no earlier than two years from when the option is granted, and one year from exercise (IRC Sec. 422). For individuals who do not hold their stock for the requisite holding periods, the transaction is considered a "disqualifying disposition" and the lower of the bargain element on date of exercise or the gain on sale is treated as compensation income. There is no AMT gain if the stock is sold in the year of exercise.

A possible solution for Mary is to recoup the ANT. However, this depends on the relationship between regular taxable income and ANT income. All or most of the AMT from a stock option exercise is creditable in subsequent years to the extent that the regular tax exceeds the tentative minimum tax, although the excess may never materialize.

Mary's AMT basis matches the high FMV on the exercise date and if she sells the stock for peanuts in 2001, the transaction will produce minimal if any regular tax (low basis, low sales price) and a large AMT capital loss (high basis, low sales price). The ANT capital loss is limited to $3,000 per year (assuming no other ANT capital gains), limiting the excess of the regular tax over the tentative minimum tax. The AMT loss and AMT credit can be carried over to subsequent years, subject to the same limitation.

Potentially, the employee may be pushed into bankruptcy or insolvency as a result of the exercise-year tax liability. In recognition of the frequency of high-tech employee insolvency, the Franchise Tax Board has established a special team to deal with ISO ANT-related offers in compromise.

How can we help our clients avoid this type of disaster? The adviser has the most opportunity to influence the outcome in the year the option is exercised. Even if the tax year has closed, there are still planning approaches available for clients in these predicaments.

PRE-EXERCISE STRATEGIES

Before a client exercises ISOs, numerous approaches should be contemplated:

* The most conservative strategy is to exercise the option when the employee is prepared to sell the stock, which eliminates exposure to loss of the exercise price. Although potential ANT gain increases as time goes by, if the stock increases in value, as long as ISO exercise coincides with the stock sale, the employee avoids Mary's dilemma--a real tax liability on virtual income. Additionally, the cash from the stock sales proceeds can be used to cover both the option price as well as the regular income tax liability on the spread at exercise. The downside to this approach is that failure to hold the stock for one year after exercise (a disqualifying disposition) defeats the very tax benefit that ISOs confer (in contrast to nonqualified stock options)-capital gain on the spread upon sale.

* Encourage clients to diversify now to limit their exposure from the stock dropping in value rather than focusing on tax savings. The likelihood of a permanent loss in value is much greater for a single stock than an investment in the broad market. Ideally, your clients should develop financial plans and build diversification strategies that will help them lock in enough wealth from their options to meet their goals.

* A tax-smart middle ground is to exercise enough ISOs each year to equalize tentative minimum tax with the regular tax.

* The more risk-tolerant employee may seek to exercise early (and hold the stock) to lock in the low ANT gain and start the clock running on long-term capital gain. That employee must understand that the ANT is locked-in if they fail to sell the stock before year-end. Lack of investment diversity subjects the employee to a high-risk investment strategy. At pre-IPO companies, this strategy may create minimal or no ANT but the investment risk is very high.

* To minimize ANT impact in the year of exercise, sell holdings in the form of stock previously exercised or as same day sales of ISO stock. This strategy reduces ANT by pulling up the regular tax. The client/employee must understand that this strategy is designed to prevent the ANT credit from being wasted in future years, but is not really a tax saver in the current year.

* Consider exercising options with the use of existing stock. Properly done, this eliminates the cash cost on exercise and results in a tax-deferred exchange under Code Sec. 1036. However, this does not eliminate the ANT that is owed from the ISO exercise.

* Run scenarios to show the client the impact of a stock price decline so the client is fully aware of the risks from incurring ANT. Advise clients to limit the ANT they incur to an amount they can afford to risk and to set aside funds up front to cover ANT.

AFTER EXERCISE

Once clients have exercised their options, you still have tax planning flexibility.

* If the stock drops substantially, e.g., more than one-third, consider disqualifying dispositions prior to the tax year-end. Although the client is subject to regular tax on what is now compensation income, AMT is eliminated and the total tax is lowered because the regular tax is imposed based on the sales price, not the value at exercise, Code Sec. 422(c)(2). To eliminate AMT, the client should sell enough stock before year-end to cause the regular tax to equal, but not exceed, tentative minimum tax. Clients may be reluctant to sell, hoping the stock will recover, but it is important for them to understand the implications of a large AMT burden.

* Even if the stock has not dropped, it may make sense for clients who did not previously review their financial goals, and who have overextended themselves in terms of AMT liability, to consider disqualifying.

* Beware of the Wash Sales Trap (see sidebar, Page 18).

STRATEGIES FOLLOWING THE YEAR OF EXERCISE

Once the tax year in which the ISO exercise occurred is closed, the die is cast, and the taxpayer will incur the AMT liability based on the original value at exercise, regardless of the stock's current value. If the AMT credit is fully used, the taxpayer eventually will be "whole," as they did not pay any incremental tax from AMT, although they would incur an opportunity cost from paying the AMT up front. When the stock has dropped precipitously, the larger planning issue, full recovery of the AMT credit, becomes a significant challenge.

* If available, sell stock with a large regular tax (and AMT) capital gain in the same year as selling the ISO shares. The AMT gain is offset by the AMT capital loss on the sale of the ISO shares. The sale of the ISO shares produces little if any regular tax capital loss. This increases the spread between the regular tax and tentative minimum tax--the portion eligible for offset by the AMT credit. Even if the entire realized AMT capital loss cannot be utilized, it can be carried over to future years.

* Consider disqualifying dispositions of the ISO shares exercised in the prior year subjecting the sale to regular tax on compensation income. After factoring in the effect of using additional AMT credit, the actual tax paid may be equal to a qualifying disposition at capital gains rates, with less AMT credit remaining. However, if the client had a sufficiently large AMT credit left over, trying to maximize the AMT credit is irrelevant since it could take decades or a lifetime to fully use it. This strategy might be neutral in terms of tax paid and provide an opportunity for the client to eliminate the risk from continuing to hold the stock.

HELP FOR EMPLOYEES

Where taxes owed exceed stock value, employers, without conflicting concerns, may take the sting out by:

* Rescinding the stock within the year of exercise, effectively canceling out the transaction;

* Forgiving loans made to employees to fund the cost of the exercise or payment of taxes; or

* Issuing more options.

Karen Goodfriend, CPA, PFS, is a partner in the Menlo Park office of Goldstein Enright Financial Advisers and is co-chair of CalCPA's Personal Financial Planning Committee. She can be reached at [e-mail].

Gary R. McBride, JD, LLM, CPA, is a professor in the graduate tax program at CSU Hayward and a consultant to Froshman, Billings & Williams. He can be reached at [e-mail].

Wash Sales Trap

The wash sales trap potentially applies to any disqualifying disposition in which an employee, within 30 days--before or after the stock sale--repurchases company shares. Code Sec. Sec. 422(c)(2)(B) limits the disqualifying disposition ordinary income to the stock sales price (rather than the value on exercise), if and only if, the "disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized to such individual." The wash sale rules of IRC Sec. 1091 would deny loss recognition if identical stock is purchased within 30 days before or after.

For example, assume a client exercised ISOs (for 1,000 shares of stock) with a large bargain element--ISO strike price $20 and stock FMV of $200--in March 2000. But the stock value dipped to $25 by December. The client sold the stock Dec. 10 for $25 and repurchased identical shares in the open market within 30 days for $25. AMT on the bargain element at exercise is eliminated by virtue of Code Sec. 56(b)(3), and the client expects to owe regular tax on $5,000 of ordinary income [($25 minus $20) multiplied by 1000].

The IRS will argue that the taxpayer owes regular tax on ordinary income of $180,000 [($200 minus $20) multiplied by 1000)]. Proposed regulations confirm the above outcome. [See Prop. Reg. 1.422A-1(b)(3), Example (6)]. Proposed regulations are not authoritative, but dismissing the regulations' position is dangerous.

The taxpayer will argue that the statutory language, which declares that the "loss (if sustained) must be recognized," is not intended to address a hypothetical loss, but in fact only applies when a loss really is sustained; for example, in the above scenario, if the sales price were $19 or less. However, legislative history reflected in the technical explanation to the Revenue Act of 1963, supports the Treasury's interpretation that "(if sustained)" refers to a hypothetical loss [see IRS Cumulative Bulletin 1964-1 (Part 2), pg. 319, Example (2)].

The IRS may interpret repurchase quite broadly to include additional option exercises. If the company is aware of the wash sale and seeks a compensation expense deduction, it will feel obligated to report W-2 income to the employee to secure its deduction [Reg. 1.83-6(a)(2)]. However, the employee may be reluctant to report the wash sale, or more likely, not be aware of the issue.

Employees who disqualify their options should be advised to steer clear of repurchases within the 30-day period. As an alternative, they can purchase and hold a similar security such as a company in the industry, sector mutual fund, or index during the 30-day period.