From the January 2008 issue of Wealth Manager Web • Subscribe!

The ISO Trap

By now, we all know the drill: The law requires individuals to calculate their tax liability two ways. First, they do the computation under the regular income tax system. Then, they must do it under the rules for the notoriously complex AMT--the Added Misery Tax. And-- surprise!--they have to pay the higher of the two results even though the AMT was originally enacted in 1969 to ensure payment of at least something by even the wealthiest Americans able to avail themselves of the most sophisticated tax breaks. But the AMT has turned into much more than a parallel system of taxation; it adds layers of complexity all by itself.

IRS National Taxpayer Advocate Nina Olson comments that a tax system must be transparent in order to be perceived as evenhanded. "Yet the complexity of the AMT is such that many, if not most, taxpayers who owe the AMT do not realize it until they prepare their returns. It adds insult to injury," she states, "when many of these taxpayers discover that they also owe a penalty for failure to pay sufficient estimated tax because they did not factor in the AMT when they computed their withholding exemptions or estimated tax payments."

AMT calculations require the use of different rules. They count more items as reportable income than does the regular method. Also, they prohibit write-offs that the regular method authorizes for everyone. The AMT hit list includes exemptions for dependents, standard deductions (those flat amounts that are based mainly on such variables as filing status and age), as well as certain itemized deductions claimed on Schedule A of the 1040 form.

The AMT regulations are especially pernicious for employees who exercise ISOs--incentive stock options. This fringe benefit has become available to a burgeoning number of employees, offering them the right to buy their employers' stocks at fixed, or exercise, prices that are usually far below the publicly traded values. In fact, there are companies that issue ISOs to all employees. And the lower the exercise price (the amount actually paid for shares), the more potentially valuable the ISOs.

Employees profit by selling shares when the stock-market price exceeds the exercise price. In rapidly rising markets, ISOs make it possible for even rank-and-filers to envision themselves as millionaires--at least on paper. Consider, for instance, Google's 2006 acquisition of You Tube. Google's purchase resulted in multimillion-dollar rewards for dozens of low-level You Tubers who had been with the video-sharing startup for less than two years, toiling away in warrens well-removed from the founders' executive suites.

Of course, the flip side of fortunes soaring swiftly is those that crumble quickly. ISOs often prove to be worthless, particularly those granted by dot-com ventures during the stock market bubble of the 1990s, when shares were cheap and companies were just throwing them around.

As for the regular rules, they pose no problems for employees. There is nothing in the tax code that compels them to declare any reportable income when ISOs are granted or exercised. Employees have no reportable income until they sell their shares. Then their profits--the excess of the sales price over the exercise price--are taxed at long-term capital gains rates of as much as 15 percent, assuming that at the time of sale they have held the shares for two years after grant and one year after exercise.

But the AMT regs contain fine print that can easily ambush theses employees. The "gotcha" is that their AMT income includes an ISO "bargain element," IRS parlance for the amount by which the stock-market price of the shares exceeds the exercise price.

Employees who exercise their ISOs reap phantom gains that can be real pains. Workers who purchase sizeable amounts of appreciated shares and hold on to them incur enormous exercise-year liabilities under the AMT. To magnify the tsoris for employees who are clueless or who receive flawed advice about the AMT, those paper profits from exercised options generate no cash to pay taxes on AMT income that may never even materialize.

Consider the difficulties experienced by recent college grad "Sydney Sheraton." She became a go-fer for Krakatoa Audio, a company whose fringes include ISOs that allow her to purchase 5,000 shares at $5 per share. By the time she exercises the ISOs, Krakatoa's shares are trading at $35, a transaction that is her maiden excursion into the stock market and--for all she knows of the AMT--an acronym for a device that dispenses dollars. Sydney's spread of $30 a share--$150,000 altogether--counts as AMT income for the exercise year. And the obligation remains even though the share price nose-dives to $5 at the close of that year.

But timing trumps everything when it comes to staying out of AMT hell. Sydney skirts liability as long as her purchase and sale of the shares take place in the same year. To lessen AMT exposure, exercising ISOs early in the year gives her more time to sell the shares if the price plummets and the profits go poof.

What gums things up is when Sydney's psychic predicts Krakatoa's share price will go gangbusters. Moreover, says the seer, she ought not to dump the stock before the close of the exercise year--the only strategy that would have immunized her from any AMT perils. Sydney should have spurned the seer's advice. Only several days into the next year, the shares suddenly plunged in value following revelations of corporate chicanery involving--what else?--backdated or otherwise manipulated option grants.

So what does the Internal Revenue Code authorize in the way of tax relief when Sydney's sole exit strategy in the post-exercise year is a stock fire sale for $2 per share? None for the exercise year under the AMT rules. Despite the meltdown of her ISO fortune, she's stuck for AMT on the $150,000 that never came into her possession. Do our lawmakers care that her AMT tax exceeds what the shares are worth after their price collapses? They couldn't care less, as Sidney and many other employees have discovered in this devastatingly expensive way.

How harshly does the law authorize the IRS to act against individuals with fat AMT tabs and no moola to pay them? The agency can garnish their wages and seize their homes, investments and other assets. Many of them are driven to declare bankruptcy.

Sydney gets some help from the regular rules for individuals with AMT income from ISOs. Her kind of AMT payment generates a narrowly prescribed tax credit--one of the non-refundable credits, meaning it cannot be refunded to the extent it exceeds the tax liability. (The child and dependent care credit is an example.) The law allows an indefinite carry-forward of the credit to offset her regular taxes in subsequent years. But even with a carry-forward, it may take many years--if ever--for Sydney to fully recoup an enormous credit for prior-year AMT. She can recoup only in a year when regular tax exceeds AMT. And the credit is easy to overlook, particularly if Sidney switches return preparers.

For example: For the post-exercise-year in issue, Sydney's unused credit is $42,000. Regular tax is $50,000 and AMT is $48,000. Those numbers authorize a credit of just $2,000. Nor will she enjoy any credit generated refund. As you would have thought, the IRS programs its computers to confiscate the refund and apply it against the unpaid AMT on the $150,000. As for the unused credit that is now $40,000, the agency allows a carry-forward to later years, but not a carry-back to previous ones. In the meantime, interest and penalties continue to mount on her outstanding AMT liability.

AMT victims with options that have gone kaput organized and asked Congress to alter the rules and accelerate the use of credits. They finally prevailed in December 2006, when Congress enacted legislation officially dubbed the Tax Relief and Health Care Act of 2006. The act authorizes some degree of relief in the form of refundable credits for some ISO recipients who have "long-term" credits not useable under the regular rules. (A refundable credit can be refunded to the extent it exceeds the tax liability. An example is the earned income credit, a tax rebate for lower-income workers.)

Our legislators crafted these special rules to help people who were unfortunate enough to be left holding options when the technology bubble burst in 2000 and 2001. AMT-caused forfeitures of deductions for, say, dependency exemptions or such itemized write-offs as state and local taxes and miscellaneous expenses, are forfeited forever.

The atrociously convoluted AMT-ISO rules apply for only a limited period. They take effect starting in 2007 and continue through 2012. How much time must elapse for unused credits to qualify as long term? More than three years, as opposed to more than just one year which is the requirement for preferential treatment of gains from sales of investments.

In the case of returns for tax year 2007, only those who paid AMT for 2003 or an earlier year are eligible for potential refunds. Therefore, Sydney garners no break if her unused credit under the regular rules is for 2004, 2005 or 2006--all years later than 2003.

Suppose she has an unused credit for 2004. Sydney will have to recover it under the regular rules or wait until she files for 2008, when her non-refundable credit will have aged enough to morph into a refundable credit under the AMT-ISO rules. For her 2009 return, Sydney's AMT payment must be for 2005 or a previous year and so on for returns for the years 2010 through 2012.

Another complication places a cap on her allowable credit for any one year. The AMT-ISO rules generally allow Sydney a refundable credit of as much as 20 percent of her "long-term unused" credits. For the first year of recovery, the ceiling on the credit is 20 percent of the AMT already paid. For each of the succeeding four years, the credit is 20 percent of the remaining balance--not 20 percent of the original amount. Thus, refundability notwithstanding, someone with a substantial amount of unused credit may not be able to recover the full amount over a period of five years.

More favorable rules allow a quicker recovery when Sydney's unused credit is less than $25,000. They permit her to claim $5,000-a-year, or the full amount of the credit, whichever is the lesser figure. Assume her unused credit is $14,000. The measure of her recovery becomes $5,000 for each of the first two years and $4,000 for the third year.

Higher-income individuals are subject to another limitation: A phase-out--a gradual reduction of their unused credits. The phase-out for 2007 and later years starts once their AGI exceeds specified amounts. These amounts are the same as those used for the phase-out of dependency exemptions, and they are indexed--that is, revised yearly to account for inflation. For 2007, eligibility begins to phase out for a married couple filing jointly when AGI surpasses $234,600 and ends when AGI surpasses $357,100. The amounts are between $156,400 and $278,900 for singles; $195,500 and $318,000 for heads of households; and $117,300 and $178,550 for married persons filing separately.

Stay tuned for IRS announcements that flesh out the fine points of who deserves to benefit and how much they should be rewarded. Expect the agency to add a few more pages to the current nine pages of instructions for Form 6251--the form that determines AMT liability. Fortunately, most tax-preparation software will take care of all the intimidating calculations without glitches.

Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners and other professionals. For information about his books, go to His Ultimate Tax-Saving Resource '08: Strategies to Increase Investable Assets is now available at

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