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ISOs and AMT: improving the odds when gambling with the IRS.

In a well-known song, "The Gambler," Kenny Rogers advises, "[k]now when to hold 'em, know when to fold 'em, know when to walk away, and know when to run." Although intended for card players, this advice should also be heeded by holders of incentive stock options (ISOs). ISOs can be a huge trap, because they appear to offer a wager that seems too good to pass up--the opportunity to convert ordinary income (generally taxed at 35%) into long-term capital gain (generally taxed at 15%).With an apparent 20% payoff, the wager seems enticing.

Under current law, however, the casino (i.e., the IRS) has two big advantages: (1) under Sec. 422, taxpayers must hold the shares for one year after exercise (or, if later, two years from the date the option was granted); and (2) under Secs. 55 (b)(2), 56(b)(3) and 83(a), for alternative minimum tax (AMT) purposes, the "spread" (i.e., the difference between the amount paid to exercise the ISO and the stock's fair market value (FMV)) is taxable at ordinary income rates in the year in which the option is exercised. Thus, almost all taxpayers who exercise ISOs will be subject to the AMT. Why is that a problem? After all, AMT is just a timing difference (i.e., a prepayment of tax that will be credited back to the taxpayer when he or she later sells the stock that gave rise to the AMT in the first place), right? Not necessarily. In many instances, ISO taxpayers are unable to recover the full AMT credit, especially when the price of the stock later declines.


Consider, for example, the case of Robert J. Merlo. During 1999 and 2000, he was employed by Service Metrics, Inc. (SMI). On July 2, 1999, he was named its vice president of marketing. On July 14, 1999, SMI granted him options to purchase 275,000 shares of its common stock with an exercise price of 10 cents per share. The options qualified as ISOs under Sec. 422. On Nov. 23, 1999, Exodus Communications, Inc. (Exodus) acquired SMI and converted Merlo's options to purchase SMI common stock into options to purchase Exodus common stock.

Insider trading: Exodus had an insider trading policy that provided, in pertinent part:

It is illegal for any Director, officer or employee of Exodus Communications, Inc. (the "Company"), to trade in the securities of the Company while in the possession of material nonpublic information about the Company ... Violation of this policy or federal or state insider trading or tipping laws by any Director, officer or employee may subject a Director to dismissal proceedings and an officer or employee to disciplinary action by [Exodus] up to and including termination for cause" (Emphasis in original.)

The insider trading policy did not require Exodus stock to be returned if a shareholder attempted to sell his or her stock in violation of the policy.

ISO exercise: On Dec. 21, 2000, Merlo exercised ISOs to purchase 46,125 shares of Exodus common stock at 20 cents per share, for a total exercise price of $9,225. The price of the optioned stock on the National Association of Securities Dealers Automated Quotation System (NASDAQ) on Dec. 21, 2000, was $23.3125 per share, for a total $1,075,289 FMV on the exercise date. Exodus filed for bankruptcy on Sept. 26, 2001, rendering Merlo's shares worthless.

On his 2000 Federal income tax return, the taxpayer did not use the stock's FMV on the Dec. 21, 2000, ISO exercise date. Instead, he included in his alternative taxable income for AMT purposes $452,025, the excess of the price for Exodus common stock reported on the NASDAQ on April 15, 2001, over the price he paid. He also filed Form 8275-R, Regulation Disclosure Statement, disclosing that he relied on then-pending proposed legislation (HR 2794, 107th Cong., 2d Sess. (2001)) that would have allowed taxpayers to use the difference between the amount paid for the shares purchased via the ISO exercise during 2000 and the FMV of such shares on April 15, 2001, for purposes of computing AMT. Unfortunately, the proposed legislation was never enacted.

Deficiency notice: On Nov. 13, 2003, the IRS sent the taxpayer a deficiency notice, seeking $169,510 in additional tax. On Dec. 4, 2003, prior to filing a petition for redetermination of the notice, Merlo filed a 2000 amended return, reducing his taxable income for AMT purposes by $452,025, the excess of the price for Exodus common stock reported on the NASDAQ on April 15, 2001, over the price he paid, thereby eliminating the $116,973 of AMT reported on his 2000 return and claiming a $149,757 refund. Under Part II, Explanation of Changes to Income, Deductions, and Credits, of the 2000 amended return, the taxpayer stated: "Return adjusted to reflect shares subject to substantial risk of forfeiture and non-transferable."

Merlo I

In his first Tax Court appearance (TC Memo 2005-178), Merlo argued that his shares of Exodus stock were subject to a substantial risk of forfeiture and not freely transferable, because they were blacked out from trading under Exodus's insider trading policy. He relied on Robinson, 805 F2d 38 (1st Cir. 1986), rev'g 82 TC 444 (1984), in which the First Circuit held that a taxpayer's shares were subject to a substantial risk of forfeiture until a one-year sellback provision lapsed, because the employer could have compelled its employee to sell the shares of stock back at the price the employee paid at the time he exercised the option if the employee attempted to sell the shares within a year of exercising the option. The Tax Court distinguished the Merlo facts, because the remedy Exodus chose to enforce its insider trading policy was not a forfeiture of the shares, but disciplinary proceedings against the offending employee, up to and including involuntary termination of employment.

Merlo II

In his second Tax Court appearance (126 TC No. 10 (2006)), Merlo presented the following arguments: (1) his AMT capital-loss deduction on the worthlessness of the stock was not subject to the $3,000 annual limit on capital losses and, thus, he was entitled to an AMT net operating loss (AMTNOL) deduction that could be carried back to 2000; (2) the AMT treatment of his situation was contrary to Congressional intent; and (3) the AMT treatment of his situation was inequitable. The Tax Court rejected all three arguments.

In response to the first argument, the Tax Court acknowledged that the Code does not explicitly address the treatment of capital losses for AMT purposes. However, it looked to Regs. Sec. 1.55-1(a), which states: "Except as otherwise provided by statute, regulations, or other published guidance issued by the Commissioner, all Internal Revenue Code provisions that apply in determining the regular taxable income of a taxpayer also apply in determining the alternative minimum taxable income of the taxpayer." As the Tax Court found that no statute, regulation or other published guidance purported to change the treatment of capital losses for AMT purposes, it held that the Secs. 1211 and 1212 capital-loss limits apply in calculating a taxpayer's alternative minimum taxable income (AMTI).

No AMTNOL: The court also ruled that the AMT capital loss realized in 2001 did not create an AMTNOL that could be carried back to 2000. Under Sec. 172(d)(2)(A) and Regs. Sec. 1.172-3(a)(2), net capital losses are excluded from the NOL computation. Secs. 56(a)(4) and (d)(1) provide that the AMTNOL is determined by adjusting the regular NOL, as adjusted by the items enumerated under Secs. 56-58. As none of the adjustments under those sections modify the exclusion of net capital losses, the court ruled that the taxpayer's net AMT capital loss was excluded for purposes of calculating his AMTNOL deduction. As a result, his AMT capital loss realized in 2001 did not create an AMTNOL that could be carried back to 2000.

Other rejected arguments: The taxpayer alternatively asserted that "the intent of Congress in imposing an AMT tax on deferral preferences [including ISOs] was to accelerate the taxation of economic income without creating an additional tax liability." He attempted to rely on the provisions of the Senate report to the Tax Reform Act of 1986 (S Rep't No. 99-313, 99th Cong., 2d Sess. (1986), 1986-3 CB (Vol. 3) 1) to support his position; however, the Tax Court found that the Senate report contained neither direct support for the taxpayer's interpretation of Congressional intent, nor language supporting an inference of such intent.

Finally, Merlo advanced several "policy and legal considerations," arguing that, under equity principles, he should be allowed to carry back his AMT capital loss to reduce his AMTI, because applying the Secs. 1211 and 1212 capital-loss limits to the calculation of his AMTI resulted in harsh and unfair tax consequences. Not surprisingly, the Tax Court's response to this argument was as follows:

The unfortunate consequences of the AMT in various circumstances have been litigated since shortly after the adoption of the AMT. In many different contexts, literal application of the AMT has led to a perceived hardship, but challenges based on equity have been uniformly rejected ... it is not a feasible judicial undertaking to achieve global equity in taxation ... And if it were a feasible judicial undertaking, it still would not be a proper one, equity in taxation being a political rather than a jural concept ... the solution must be with Congress.


Legislation to "fix" the ISO AMT problem has been repeatedly introduced in Congress. Perhaps Merlo's biggest miscalculation was in assuming that Congress would remedy the hardships caused by this problem (recall that he had referred to such legislation on the Form 8275-R filed as part of his 2000 return). Unfortunately, such legislation has not been enacted. Most recently, the AMT Credit Fairness Act of 2005 (HR 3385) was introduced by Representative Sam Johnson (R-TX) on July 21, 2005. The bill would entitle taxpayers with outstanding AMT credits (four years or older) to claim the greater of either 20% of the stored-up credits or $5,000 per year in refund relief. It would also require corporations that provide ISOs as compensation to furnish workers who exercise the options with a Form 1099-like declaration of their expected tax liability by January 31 of the following year.

Incredible as it may seem, employers have not been required to report ISO exercises to the IRS since 1979, when then-Sec. 6039(a) was repealed (it had required that every corporation make a return in connection with the transfer of stock acquired by any person pursuant to the exercise of a qualified stock option or a restricted stock option). Since 1979, ISO reporting has effectively become voluntarily. In fact, the current requirement of Sec. 6039(a)(1)--that every corporation that transfers a share of stock to an employee on exercise of an ISO must provide him or her with a written statement reporting the amount of the ISO income by January 31 of the year following the calendar year in which the ISO was exercised--was not enacted until 1998. Thus, the $1.1 million AMT adjustment associated with Merlo's exercise of his Exodus options was reported to the IRS only by the taxpayer himself when he filed his return. One cannot help but wonder whether (1) he is happy for the ISO taxpayers who (either through ignorance or intentional disregard of the Sec. 6039(a)(1) statement) have not voluntarily disclosed their ISO transactions to the IRS and, thus, have not been forced to pay the inequitable AMT; or (2) outraged that the lack of reporting permits such disparate treatment of similarly situated taxpayers.


Although ISOs were intended to provide a tax benefit to employees, when the post-exercise price declines, optionees can find themselves subject to huge AMT tax liabilities attributable to sometimes worthless stock. The following are some general rules to assist optionees in optimizing ISO treatment.

Understand the game's rules: Some commentators have pointed out that if Merlo had waited two more weeks (until 2001) to exercise his options, his AMT tax liability would have been wiped out when the shares became worthless (see discussion of Sec. 56(b)(3) below); however, as Merlo's employment with Exodus terminated on Dec. 31, 2000, it may not have been possible for him to wait until 2001. Although Sec. 422(a)(2) permits ISOs to be exercised for up to 90 days following termination of employment, employers may impose more restrictive terms. Optionees need to be familiar with the terms of their stock option plans and to plan accordingly, especially if they are considering terminating employment. In addition, optionees need to be familiar with the terms of their employers' insider trading policies--especially the blackout periods. If it can properly be inferred from the record that December 2000 was part of a black-out period imposed by Exodus's insider trading policy, by the time December came around, Merlo's only alternatives may have been to (1) let the options expire unexercised or (2) exercise the options and hold the stock.

Carefully time the placing of bets: If possible, optionees should exercise ISOs early in the year, especially if there is a significant spread between the option price and the stock's FMV. When an employee disposes of stock acquired through an ISO before the expiration of the ISO holding period (two years from grant/one year from exercise), Sec. 422(c)(2) limits the compensation income the employee must include as a result of the disqualifying disposition, to the excess (if any) of the amount realized on the disposition over the stock's adjusted basis. Sec. 56(b)(3) provides that the Sec. 422(c)(2) rule also applies for AMT purposes, but only if the inclusion and disposition are within the same tax year. Thus, if a taxpayer acquires stock by exercising an ISO and disposes of it in the same tax year, the treatment under the regular tax and the AMT will be the same. This provision gives an optionee the ability to cancel a wager with the IRS and avoid the AMT liability that would otherwise attach on December 31. Exercising early in the year minimizes the amount of time that the optionee will be exposed to the ISO AMT liability without the ability to rescind the wager if the stock price declines. In addition, it allows the taxpayer to satisfy the one-year holding period prior to April 15th of the following year, when any tax liability may be due.

Assess the payoff of the wager: Optionees should prepare careful projections to determine the actual tax savings that may be achieved by holding onto the ISO stock for the required holding period. In most cases, when a deep-in-the-money ISO is exercised, optionees will find that the complex interaction between the regular tax and the AMT effectively provide a tax ,benefit for only a portion of the shares, because many will not be able to recover the full AMT credit when they sell their shares. In such cases, holding additional shares merely exposes the optionee to additional risk, without providing any additional reward.

Carefully monitor the stock price and the trading windows, after exercising the ISOs: When the post-exercise stock price has declined (or when it appears that a decline is likely), the ISO stock should be sold in the same year in which the ISOs were exercised. Although, under IRS rules, the benefits of Secs. 422(c)(2) and 56(b)(3) are available for sales executed through December 31 of the year in which the options were exercised, if a company's insider trading policy prohibits all sales during the month of December, then the effective deadline for selling the stock may be November 30.

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Title Annotation:incentive stock options, alternative minimum tax
Author:Takacs, Natalie Bell
Publication:The Tax Adviser
Date:Aug 1, 2006
Previous Article:Gains on sales of QSB stock in light of secs. 1045 and 1202.
Next Article:Highlights of the sec. 199 final regs.

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