Reducing corporate AMT on an employee's stock option exercise.

Sec. 421(a)(2) and (b) provide that a corporation issuing an incentive stock option (ISO) may not deduct compensation attributable to its exercise, unless the employee makes a disqualifying disposition of the ISO stock. Alternatively, if the corporation issues a nonqualified stock option (NSO), the corporation issuing the NSO can deduct its value as compensation attributable to its exercise when the option's value is included in the employee's gross income either at the time of grant (if the NSO has a readily ascertainable fair market value) or at the time of exercise. However, in the latter instance, income recognition and the corresponding deduction may be delayed if the underlying property (the stock) is not transferable and is subject to a substantial risk of forfeiture (if a Sec. 83(b) election is not made).

Sec. 56(b)(3) provides that, for alternative minimum tax (AMT) purposes, Sec. 421 does not apply to noncorporate taxpayers on the transfer of stock acquired pursuant to the exercise of an ISO. Thus, Sec. 83 governs the treatment of ISOs for individual AMT purposes. Because there is no corresponding statutory corporate adjustment, it is presently unknown whether a corporate employer obtains a Sec. 83(h) deduction. Although the legislative history states that "the rules of section 83 will apply to the stock in determining the individual's alternative minimum taxable income" [emphasis added], it seems fair that such a deduction also be allowed.

The AMT adjusted current earnings (ACE) adjustment relies on income tax principles, particularly earnings and profits (E&P) concepts, for its computation. Under Sec. 56(g)(3),ACE generally is defined as the corporation's AMT income (AMTI) for the tax year determined with the adjustments specified in Sec. 56(g)(4). Under Sec. 56(g)(4)(C)(i) and Regs. Sec. 1.56(g)-1 (d)(1), no deduction generally is allowed for any item if such item would not be deductible for any tax year in computing E&P.

Luckman, 418 F2d 381 (7th Cir. 1969), rev'g and rem'g 50 TC 619 (1968), and Divine, 500 F2d 1041 (2d Cir. 1974), rev'g and rem'g 59 TC 152 (1972), involved the treatment for E&P purposes of the bargain element on employees' exercise of restricted stock options. These cases held that, when the exercise of a stock option gives rise to a compensation deduction to the employer corporation for income tax purposes (as with NSOs or disqualifying dispositions of ISOs), the same deduction should also be allowed for E&P purposes. In both cases, the courts discussed the importance of maintaining the greatest possible symmetry between taxable income and E&P. By using a cash equivalent approach, the courts held that the deduction should be permitted to maintain this conformity. Under this approach, the exercise of an option was viewed as if the corporation had paid the employee cash compensation equal to the stock's value, which was then used by the employee to purchase the stock. Therefore, the courts held that E&P was reduced when the employees exercised their restricted stock options.

Consequently, if no deduction is allowable on an ISO's exercise in computing corporate AMTI, a negative ACE adjustment should be permitted. Alternatively, if such a deduction is allowable, no "add back" should be required in computing ACE.