Planning for an AMTNOL when ISO exercise price exceeds current market value.

Due to current market conditions, many taxpayers have significant holding losses for alternative minimum tax (AMT) purposes on stock acquired from exercising an incentive stock option (ISO). Many taxpayers paid substantial AMT after exercising ISOs. The difference between the fair market value of the stock received on the date of exercise and the option price paid is an AMT adjustment (Sec. 56(b)(3)). This adjustment is added to the AMT basis of the stock.

ISOs that are exercised and sold within a year are taxed at ordinary income rates. ISOs that are exercised and held for at least one year are taxed at capital gain rates. Therefore, the taxpayer holds the ISO stock in anticipation it will appreciate and the resulting gain can be converted from ordinary income to capital gain income.

The AMT paid as a result of exercising an ISO generates a minimum tax credit (MTC) that can offset a regular tax liability in future years. The MTC may not be carried back and may not offset AMT liabilities in future years. The MTC credit offsets the regular tax liability when there is no AMT tax liability (i.e., the regular tax is greater than the AMT). Any unused MTC is carried forward.

Because market prices have declined, the taxpayer may have little or no gain for regular tax purposes, but may have a holding loss for AMT purposes. Should the AMT loss be triggered?

When the stock is sold, the difference between the gain for regular tax and the AMT gain is the "adjusted gain or loss." If the adjusted gain or loss generates an AMT net operating loss (NOL), the NOL must be carried back two years (Sec. 172(b)) and AMT paid in prior years may be recoverable (unless an election to forgo the carry-back is filed).

Example:

Year 2000. T exercised ISOs for 80,000 shares at $50 per share with a cost of $0.05 per share in 2000. T has regular taxable income of $212,741 and reports a tax preference item of $3,996,000 ((80,000 shares x $50) - (80,000 shares x $0.05)). The total tax is $1,175,760 and there is an MTC of $1,123,325 to carry forward.

Year 2001. Assume T has a holding loss of $301 per share. Also assume that 80,000 shares of ISOs are sold at $20 per share. T has other taxable income of $225,900. There is a regular tax gain of $1,596,000 ((80,000 shares x $20) -- option cost of $4,000) and an AMT loss of $2,400,000 ((80,000 shares x $20) -- AMT adjustment of $3,996,000 + option cost of $4,000). The adjusted gain or loss for AMT is a loss of $3,996,000 ($1,596,000 regular tax gain + AMT loss of $2,400,000). T claims an MTC of $375,846, as a result of AMT paid in 2000. The unused credit of $745,845 may be carried forward. The MTC is reduced by exclusion preferences totaling $1,634.

The AMT adjusted loss generates an AMTNOL of $2,166,500 (adjusted gross income of $1,829,500 -- adjusted loss of $3,996,000). T may elect to forgo the two-year carryback period.

Year 2002. Assume T did not sell in 2001 but sells the stock in 2002. T elects to carry back the AMTNOL and file an amended return for year 2000. The original return reported a total tax of $1,174,965, including AMT of $1,123,325. T recomputes the AMT, deducting an AMTNOL of $2,166,500. T reports adjusted tax of $569,140 (including AMT of $516,705) and claims a refund of $606,620 on the amended return. There is an unused MTC of $516,705 to be carried forward to 2001.

By selling ISOs with holding losses in 2002, T is able to file a carryback claim and file for a refund of taxes paid in 2000 totaling $606,620. If T sells ISOs with holding losses in 2001, he claims an MTC of $375,846. By timing the realization of holding losses within two years of exercise, T recoups $230,774 more by amending and claiming a refund than by selling at a loss in a year when no carryback opportunity exists. Although there is no limitation period on the MTC carryforward, it may take many years to recoup, unless the stock appreciates and AMT holding losses are eliminated.

Planning for an AMTNOL requires careful analysis and may not apply in every circumstance. The tax adviser must evaluate the facts and circumstances as they apply to an individual taxpayer to determine whether creating an AMT loss can result in a refund claim.

FROM SARAH G. AVERY, CPA, EHRENKRANTZ STERLING & CO., LLC, LIVINGSTON, NJ