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ISOs and the AMT.

While incentive stock options may seem like an ideal corporate perquisite, they can also trigger alternative minimum tax consequences that can minimize their advantages. This article examines the interplay between ISOs and the AMT and offers planning strategies.

Companies are offering a number of incentive packages as a means of attracting and retaining key employees in today's tough market. One type of incentive plan allows employees to share in the benefits of company ownership. There are many plan variations available to companies seeking to offer their employees this type of opportunity, including employee stock purchase plans, stock appreciation rights, options to purchase stock at a set price in the future and many others. Each plan type carries unique tax consequences for the employee and employer.

SOPs can have some unique twists. In a basic SOP, an employee is granted options to purchase company stock at a fixed price in the future. The taxation of the option grant, option exercise and the subsequent sale of the stock depends on whether the option is an NQSO or a statutory ISO.

NQSOs vs. ISOs

NQSOs

ISOs are afforded special tax treatment under Sec. 422. NQSOs are stock options that are not ISOs. The main differences between ISOs and NQSOs are the statutory restrictions placed on ISOs and their favorable tax treatment. Under Sec. 422(a), for an option to qualify as an ISO, the grantee must be an employee of the company, its parent or subsidiary, or of a corporation that assumes responsibility for the options as a result of certain reorganizations, mergers, consolidations, acquisitions or liquidations described in Sec. 424(a). Under Secs. 422(b)(2), (3) and (d), an ISO plan cannot continue for more than 10 years from the earlier of plan adoption or the date the plan receives shareholder approval; further, the value (determined at the time of grant) of the stock that can be exercised for the first time during any year by an employee cannot exceed $100,000.

Generally, there are no tax consequences at the grant date for either ISOs or NQSOs. However, if an NQSO has a readily obtainable FMV at the grant date, there may be immediate tax consequences, according to Regs. Sec. 1.83-7(a).

When NQSOs are exercised, the spread between the FMV of the stock at the exercise date and the option exercise price is compensation income to the employee and a deduction to the employer. The stock basis is the FMV on the exercise date. An employee must pay withholding tax when the options are exercised.[1] An employee can instruct the plan administrator to exercise options and sell the stock to pay the tax, a "cashless" exercise. The stock sale proceeds are used to pay the exercise price and the taxes, with the employee receiving the excess. An employee can also exercise options, sell sufficient stock to cover the exercise price and taxes and hold the remaining stock. Another alternative is for the employee to pay the exercise price and taxes and hold all of the stock. The subsequent disposition of the stock will yield a capital gain or loss under Sec. 1221.

Planning for the exercise and disposition of NQSOs includes addressing cashflow issues and the stock's expected appreciation. The assumption is that the stock will appreciate from the date of option grant to the date of exercise, because an employee will not exercise options if the stock's FMV is less than the exercise price.[2] If an employee wants to obtain company stock at a depreciated price, he can buy it on the market; the same is true with ISOs.

ISOs

The taxation of ISOs may seem simple, but there are hidden complexities that could catch an unenlightened employee. For an employee, the advantage is that there are no regular tax consequences on option exercise, according to Secs. 422(a) and 421(a)(1); however, the employer does not get a deduction. Under Sec. 1011, the basis of the stock is the exercise price. On stock disposition, the spread between the FMV of the stock at sale and the exercise price triggers capital gain or loss under Secs. 1001(a) and 1221. If an employee disposes of the stock prior to (1) two years from the grant date or (2) one year from exercise date (a disqualifying disposition), the tax treatment under Sec. 422(a)(1) is similar to that of NQSOs. In the disposition year, the spread between the FMV of the stock on the exercise date and the exercise price is compensation income under Sec. 421(b).

The AMT Quandary

ISOs carry AMT consequences.[3] The exercise of an ISO triggers an AMT adjustment under Sec. 56(b)(3) for the spread between the FMV at exercise and the exercise price, if the exercise is not a disqualifying disposition. The adjustment is an increase to AMTI as a deferral adjustment item under Sec. 56. When AMT is calculated, the adjustment is not capital gain, according to Sec. 56(b)(3). Thus, AMT on the adjustment is calculated at either 26% or 28%, depending on AMTI. Under Sec. 55(b)(2), this adjustment is coupled with other AMT adjustments to determine whether the taxpayer has to pay AMT.

If a disqualifying disposition occurs, the AMT consequences are mitigated. If it occurs in the year of exercise, the spread between the FMV at exercise and the exercise price will be compensation income for both regular tax and AMT purposes. The stock basis used to calculate gain or loss on the disposition will be the same for regular tax and AMT purposes. If a disqualifying disposition occurs in a year other than the exercise year, the compensation income resulting from the disposition included in regular taxable income will be disregarded for AMT purposes. The AMT stock basis used to calculate AMT gain or loss from the disposition will include prior years' AMT adjustments. All of these issues (including the fact that the Sec. 55(d) AMT exemption is not indexed for inflation) means that it is relatively easy to trigger AMT. ISO adjustments can quickly create AMT for a taxpayer.

The stock basis for AMT purposes is the FMV of the stock at exercise, according to Sec. 56(b)(3). The fact that the adjustment is a deferral is important; AMT paid on deferral adjustments creates AMT credits for future years, according to Sec. 53(b) and (d)(1)(B). When the stock is sold, the taxpayer should get an AMT credit for the AMT paid in the previous years on option exercise. The adjustment is taxed at either 26% or 28%. The increase in the AMT basis of the stock results in a negative gain or loss adjustment for AMT purposes; thus, the capital gain on the stock sale will generally be less for AMT purposes, to the extent of the original increase in AMTI in the exercise year. While this effectively reverses the original increase in AMTI, the tax benefit for the decreased capital gain for AMTI purposes is computed at capital gain rates.

Basically, the tax on the positive adjustment for option exercise is calculated at 26% or 28%, but the tax on the negative adjustment on sale of the stock is computed at only 20%, according to Secs. 55(b)(1), (b)(3) and 56(b)(3). Depending on the amount of the adjustment, as well as other AMT and income issues, the result may be an inability to take the entire credit in the year of sale and a prolonged number of years before the taxpayer enjoys the benefit of the credit. The credit may not only be eroded by the time value of money in this situation, but there is also a risk of erosion due to exclusion items (under Sec. 53(d)(1)(B)).

If a client informs his tax adviser that he has a SOP at work, the tax adviser should request the plan document from the client and review it carefully to understand the type of plan involved. If it involves ISOs, proper tax planning is critical to minimize tax consequences and make cash available to pay any tax. The adviser should educate the client about the tax consequences resulting from equity and/or income resulting from the plan. Clients may be surprised to learn of the potential additional tax liability and complexity. Tax professionals need to consider the costs and benefits of additional planning and make clients aware of them.

Examples 1-4 in this article demonstrate the AMT consequences and use of the AMT credit in different situations. Each situation needs to be evaluated based on its facts and circumstances. If the client is new, the tax adviser must determine the possible need for amended prior-year returns and any potential AMT credit carryforward.

Example 1: X is married and files jointly; the only income is $100,000 in wages. X and his spouse take a standard deduction. In year 1, X exercises an ISO, triggering a $40,000 AMT adjustment; X has a net AMT of $6,019 in year 1 and generates a credit in that amount available for future years. In year 2, X sells the ISO stock at a regular tax capital gain of $90,000; the AMT capital gain is $50,000. X takes a standard deduction in year 2 because his only itemized deduction, state taxes from year 1, is smaller than the standard deduction. X can use his entire AMT credit in year 2; see Exhibit 1 on p. 251.
Exhibit 1: Full use of AMT credit

AMT

 Year 1 Year 2 Year 3

Taxable income $87,050 $176,600 $80,983

P&A:
Standard deduction 7,350 7,600 0
Personal exemptions 5,600 5,800 5,800
Taxes 0 0 13,217
Itemized deduction floor 0 0 0
Regular tax capital gain/(loss) 0 (90,000) 0
AMT capital gain/(loss) 0 50,000 0

ISO deferral adjustment 40,000 0 0

AMTI 140,000 150,000 100,000
AMT exemption (45,000) (45,000) (45,000)

Taxable excess $95,000 $105,000 $55,000

AMT 24,700 27,300 14,300
AMT capital gain tax N/A 24,300 N/A
TMT 24,700 24,300 14,300

Regular tax (18,681) (36,372) (16,799)

AMT $6,019 $0 $0

MTC

 Year 1 Year 2 Year 3

Taxable income $87,050 $176,600 $80,983

Exclusion P&A 12,950 13,400 19,017

Total exclusion P&A 12,950 13,400 19,017

AMTI with only exclusion P&A $100,000 $190,000 $100,000
AMT exemption (45,000) (35,000) (45,000)

Taxable excess 55,000 155,000 55,000

AMT 14,300 40,300 14,300
AMT capital gain tax N/A 34,900 N/A
TMT with only exclusion P&A 14,300 34,900 14,300
Regular tax (18,681) (36,372) (16,799)

Net minimum tax with only
exclusion P&A 0 0 0

Net minimum tax $6,019 $0 $0

Exclusion P&A 0 0 0

Credit generated $6,019 $0 $0

Prior year's credit 0 6,019 0
Allowed in current year 0 6,019 0

Carried to future years $6,019 $0 $0


Example 2: The facts are the same as in Example 1, except that the ISO exercise generates a $300,000 AMTI adjustment in year 1 and a $400,000 regular tax capital gain and $100,000 AMT capital gain in year 2. Exhibit 2 on p. 254 demonstrates that although a significant portion of an AMT credit is used in the sale year, the credit itself begins to lose value (because of partial erosion through AMT exclusion adjustments and the number of years it will take to fully use). The AMT in year 1 is $89,819, generating an AMT credit in that amount. In year 2, credit use is limited to the amount by which regular tax exceeds AMT. If AMTI could have been reduced in year 2 by an adjustment (rather than a reduction of capital gain), use of the credit in year 2 would have been increased by approximately $4,000. In year 3, there is no credit use, because the payment of state taxes due for year 2 creates AMT in year 3.
Exhibit 2: AMT credit erosion

AMT

 Year 1 Year 2 Year 3

Taxable income $87,050 $492,400 $58,353

P&A:
Standard deduction 7,350 7,600 0
Personal exemptions 5,600 0 5,800
Taxes 0 0 35,847
Itemized deduction floor 0 0 0

Regular tax capital gain/(loss) 0 (400,000) 0
AMT capital gain/(loss) 0 100,000 0

ISO deferral adjustment 300,000 0 0

AMTI 400,000 200,000 100,000
AMT exemption 0 (32,500) (45,000)

Taxable excess $400,000 $167,500 $55,000

AMT 108,500 43,550 14,300
AMT capital gain tax N/A 37,550 N/A
TMT 108,500 37,550 14,300

Regular tax (18,681) (99,996) (10,463)

AMT $89,819 $0 $3,837

MTC

 Year 1 Year 2 Year 3

Taxable income $87,050 $492,400 $58,353

Exclusion P&A 12,950 7,600 41,647

Total exclusion P&A 12,950 7,600 41,647

AMTI with only exclusion P&A $100,000 $500,000 $100,000
AMT exemption (45,000) 0 (45,000)

Taxable excess 55,000 500,000 55,000

AMT 14,300 136,500 14,300
AMT capital gain tax N/A 106,000 N/A
TMT with only exclusion P&A 14,300 106,000 14,300
Regular tax (18,681) (99,996) (10,463)

Net minimum tax with only
exclusion P&A 0 6,004 3,837

Net minimum tax $89,819 $0 $3,837

Exclusion P&A 0 6,004 3,837

Credit generated $89,819 $(6,004) $0

Prior years' credit 0 89,819 21,369
Allowed in current year 0 62,446 0

Carried to future years $89,819 $21,369 $21,369


Example 3: The facts are the same as in Example 2, except that X pays the state taxes for year 2 in year 2 to get a deduction on his Federal return. Exhibit 3 on p. 255 demonstrates further erosion of the credit due to exclusion items. State tax is an exclusion item that has reduced the amount of the credit available in year 2 and future years. The degree of erosion hinges on the time value of money, other exclusion items, and X's total tax picture.
Exhibit 3: Prepayment of state taxes

AMT

 Year 1 Year 2 Year 3

Taxable income $87,050 $468,437 $86,600

P&A:
Standard deduction 7,350 0 7,600
Personal exemptions 5,600 0 5,800
Taxes 0 42,576 0
Itemized deduction floor 0 (11,013) 0
Regular tax capital gain/(loss) 0 (400,000) 0
AMT capital gain/(loss) 0 100,000 0

ISO deferral adjustment 300,000 0 0

AMTI 400,000 200,000 100,000
AMT exemption 0 (32,500) (45,000)

Taxable excess $400,000 $167,500 $55,000

AMT 108,500 43,550 14,300
AMT capital gain tax N/A 37,550 N/A
TMT 108,500 37,550 14,300
Regular tax (18,681) (93,286) (18,372)

AMT $89,819 $0 $0

MTC

 Year 1 Year 2 Year 3

Taxable income $87,050 $468,437 $86,600

Exclusion P&A 12,950 31,563 13,400

Total exclusion P&A 12,950 31,563 13,400

AMTI with only exclusion P&A $100,000 $500,000 $100,000
AMT exemption (45,000) 0 (45,000)

Taxable excess 55,000 500,000 55,000

AMT 14,300 136,500 14,300
AMT capital gain tax N/A 106,000 N/A
TMT with only exclusion P&A 14,300 106,000 14,300
Regular tax (18,681) (93,286) (18,372)

Net minimum tax with only
exclusion P&A 0 12,714 0

Net minimum tax $89,819 $0 $0

Exclusion P&A 0 12,714 0

Credit generated $89,819 $(12,714) $0
Prior years' credit 0 89,819 21,369
Allowed in current year 0 55,736 4,072

Carried to future years $89,819 $21,369 $17,297


Examples 1-3 assume that years 1-3 are 2000-2002 and that year 3 uses the same standard deduction and personal exemptions used in year 2. Examples 1 and 2 assume that the entire state (Maryland) tax liability is paid when the return is due. The tax adviser should evaluate whether a client should prepay part or all of this liability. Prepaying state tax in a year in which the taxpayer owes AMT will not reduce the amount of tax due that year, but may affect the credit to be carried forward. The adviser should also analyze the costs and benefits of interest and penalties if the safe-harbor amount is not paid timely due to AMT.

Another obstacle to AMT credit use occurs if the stock loses value from the date of exercise until the date of sale. If this occurs, but value has nevertheless increased from the option price, a taxpayer will have a capital gain for regular tax purposes, but a capital loss for AMT purposes. Unless a taxpayer can generate AMT capital gain that can be absorbed by the AMT capital loss, use of the credit will be spread over countless years; the AMT capital loss will be limited by Sec. 1211(b) to $3,000 in excess of AMT capital gain per year.

Example 4: The facts are the same as in Example 2, except that the year 2 stock sale produces a capital gain of $200,000 for regular tax purposes and a capital loss of $100,000 for AMT purposes. Exhibit 4 on p. 256 demonstrates the effect of the AMT capital loss on credit use. The capital loss for AMT purposes is limited to $3,000 per year. X may not be able to use the AMT credit for years. The issue is further complicated if options are exercised in multiple years and X pays AMT for several years.
Exhibit 4: Effect of AMT capital loss on credit use

AMT

 Year 1 Year 2 Year 3

Taxable income $87,050 $291,356 $72,953

P&A:
Standard deduction 7,350 7,600 0
Personal exemptions 5,600 1,044 5,800
Taxes 0 0 21,247
Itemized deduction floor 0 0 0

Regular tax capital gain/(loss) 0 (200,000) 0
AMT capital gain/(loss) 0 (3,000) (3,000)

ISO deferral adjustment 300,000 0 0

AMTI 400,000 97,000 97,000
AMT exemption 0 (45,000) (45,000)

Taxable excess $400,000 $52,000 $52,000

AMT
 exclusion P&A 108,500 13,520 13,520
AMT capital gain tax N/A N/A N/A
TMT 108,500 13,520 13,520
Regular tax (18,681) (59,704) (14,551)

AMT $89,819 $0 $0

MTC

 Year 1 Year 2 Year 3

Taxable income $87,050 $291,356 $72,953

Exclusion P&A 12,950 8,644 27,047

Total exclusion P&A 12,950 8,644 27,047

AMTI with only exclusion P&A $100,000 $300,000 $100,000
AMT exemption (45,000) (7,500) (45,000)

Taxable excess 55,000 292,500 55,000

AMT 14,300 78,400 14,300
AMT capital gain tax N/A 64,050 N/A
TMT with only exclusion P&A 14,300 64,050 14,300
Regular tax (18,681) (59,704) (14,551)
Net minimum tax with only
 exclusion P&A $0 $4,346 $0

Net minimum tax 89,819 0 0

Exclusion P&A 0 4,346 0

Credit generated $89,819 $(4,346) $0

Prior years' credit 0 89,819 39,289
Allowed in current year 0 46,184 1,031

Carried to future years $89,819 $39,289 $38,258


Planning

The ISO AMT predicament creates numerous planning opportunities. A client needs to consider the number of options to exercise and timing. When a client has substantial value in options, proper planning is critical to ensure proper cashflow, financial security and tax minimization. It is important to remember the client's financial goals and objectives and his present and future cash needs. Tax planning should be based on the client's financial goals, not vice versa; the entire portfolio and other income are also important.

Minimal Exercise

Several planning techniques can help mitigate the AMT consequences of ISOs. One strategy is to exercise just enough options to keep a client out of the AMT. However, it may take many years to exercise all of a client's options this way; there is risk associated with holding options and they can expire. This technique may be appropriate for clients who do not expect to have additional options vest in future years or who do not have a significant number of or value of options.

Accelerate Income

One idea might be to create or accelerate ordinary income into the year after exercise to take more rapid advantage of the available credit. This may seem logical, but as regular taxable income increases, so does AMTI, which in turn phases out the AMT exemption and increases the AMT, decreasing the credit allowable in that year. The advantage of creating or accelerating ordinary income is potentially to reduce erosion of the credit by exclusion items. The numbers need to be reviewed to evaluate the viability of creating ordinary income. Some methods of bringing ordinary income into the year desired include acceleration of bonuses, deferral of Schedule C, E or F expenses, deferral of Schedule A deductions and exercise of NQSOs.

Use Company Stock

Another alternative for exercising ISOs (but not alleviating AMT) is to use company stock the client already owns. The tax adviser should verify that the plan provides for exercise of ISOs via a Sec. 422(c)(4) stock swap. The client gives the employer stock in the amount of the option price and receives the same amount of stock he would have received had he paid cash. When stock is used as the exercise price, the regular tax basis in the lot of shares received equals the basis of the lot transferred.[4] This type of stock swap may assist a client in portfolio diversification, by decreasing the client's percentage of total holdings in the employer's stock (assuming the client holds other stock and options in his portfolio). Further, cash that would have been used to exercise the options may possibly be available to purchase other investments. The tax adviser needs to be aware of the holding period requirements for the stock transferred and/or any restrictions on such stock.

Timing Issues

The timing of ISO exercise and subsequent sale of the stock is crucial for proper tax planning. If a client exercises ISOs in year one, but does not have the cash to pay the tax in year two, he may have to liquidate the stock before the qualifying period, losing tax benefits. One strategy is to exercise ISOs early in year one (i.e., before April) and sell the stock just before April 15 of year two, in time to pay the AMT tax from the year one exercise. The client will have cash to pay the tax, receive ISO treatment on the option and, in the year of sale, will most likely be able to use a significant portion of the credit created by the AMT payment. Awareness of a client's objectives is paramount. If a client intends to hold the stock for the long term, the tax adviser needs to create ways for him to generate the cash needed to pay the tax. For example, if credit or margin is available, the funds to pay the tax could be obtained by borrowing.

Awareness of the stock's potential is also key. Holding the stock for any amount of time carries risk. When planning exercise and sale timing, the tax planner must consider the number of years the client may face "AMT purgatory" due to vesting and exercising of options over multiple years and the availability and erosion of the credit in future years. The client's entire portfolio must be taken into account. The stock sale year may be an appropriate time to dispose of portfolio losers.

Required Information

To adequately complete ISO tax planning, the tax planner needs to see the SOP and vesting schedule. The client may have a myriad of SOPs available along with ISOs; each has unique tax consequences. The plan needs to be reviewed for the status of unexercised options on termination of employment. Are there "black out" periods when the client will not be able to dispose of the stock? The plan may require approval to take certain option actions. The employer's financial condition, status and plans should be reviewed. For example, if the employer is planning a merger, this may affect the period the client is willing to hold the stock. The client's prior three years' tax returns, entire financial and income position and future projected income for several years have to be reviewed. Moreover, in certain states, ISO exercise is considered compensation for state tax purposes, which can limit the opportunity to plan when to pay state taxes.

Conclusion

Congress has not completely ignored the AMT quagmire. There has been some discussion about overall AMT relief and a bill that would give tax deferral to certain NQSOs under stringently restricted plans. The adviser needs to be aware of proposed tax law changes.

Tax professionals can play an integral part in planning strategies for clients to maximize the benefits of stock options. The key is to be aware of the total picture at all times. Tax complexities create planning opportunities and a chance to render invaluable assistance to clients.

Abbreviations used in this article:

AMT = alternative minimum tax

AMTI = alternative minimum taxable income

FMV = fair market value

ISO = incentive stock option

MTC = minimum tax credit

NQSO = nonqualified stock option

P&A = AMT preferences and adjustments

SOP = stock option plan

TMT= tentative minimum tax

EXECUTIVE SUMMARY

* Employers can offer NQSOs or ISOs, but the latter offer more favorable tax treatment.

* Tax professionals can play an integral part in planning strategies for clients to maximize the benefits of their stock options.

* When a client has substantial value in options, proper planning can ensure proper cashflow, financial security and tax minimization.

[1] Rev. Rul. 67-257, 1967-2 CB 359.

[2] Now that the stock market has gone down dramatically, a big issue (outside of the scope of this article) is--how does one pay the income taxes (regular or AMT) on the income recognized (ordinary or AMT) on option exercise?

[3] For a discussion of the AMT, see Everett and O'Neil, "AMT Planning Strategies," 31 The Tax Adviser 788 (November 2000).

[4] Rev. Rul. 80-244, 1980-2 CB 234.

For more information about this article, contact Ms. Rosenzweig at CSR@hertzbach.com

Mark R. Topolski, CPA Partner Hertzbach & Company, P.A. Owings Mills, MD

Joseph M. Aleshire, CPA Partner Hertzbach & Company, P.A. Owings Mills, MD

Cindie S. Rosenzweig, CPA, MS Tax Manager Hertzbach & Company, P.A. Owings Mills, MD
COPYRIGHT 2001 American Institute of CPA's
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Article Details
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Title Annotation:incentive stock options and alternative minimum tax
Author:Rosenzweig, Cindie S.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Apr 1, 2001
Words:4540
Previous Article:Tax planning for expatriates.
Next Article:Current corporate income tax developments.
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