Published: Sunday, February 19, 2006
NEW YORK - When paying tax, it doesn't get much worse than racking up a tax
bill on profits you never actually receive.
But for holders of incentive stock options, that's a potential headache of
the alternative minimum tax. The reasons are complicated, but a quirk in the AMT
- the parallel tax system conceived to prevent overuse of tax deductions, but
which has instead trapped millions of middle-class taxpayers - could create a
huge tax bill on paper gains that never materialized.
The most sage advice for ISO holders is to see a tax specialist, because
there are a variety of ISO strategies that can limit the tax fallout. For
example, by being precise about how many options you exercise and when in the
tax year you do it, the tax liability can be reduced.
About one million individuals hold incentive stock options, estimates the
National Center for Employee Ownership. Holders are only subject to a 15 percent
capital gains tax if the underlying stock is sold (as long as the stock isn't
sold within a year of option exercise or within two years of the option grant
date).
But there's another colossal caveat. For alternative minimum tax purposes,
the spread between the option price and the stock's fair market value at the
time of exercise is added to your income - even if you haven't sold the stock.
That could push some taxpayers into AMT territory that might have dodged it
otherwise. And back to the worst-case scenario: Should the stock dive,
individuals could owe a potentially enormous tax bill on phantom gains that
simply vaporized.
First, a quick AMT recap. This parallel tax system was installed in 1969 to
ensure the wealthiest Americans were paying their fair share of taxes by
reducing the amount of deductions they can take. However, it was never indexed
for inflation and has increasingly trapped more middle-class taxpayers.
To determine AMT tax liability, two calculations are necessary: One under the
traditional tax system and another under the AMT system, where various
deductions - such as state and local income taxes, property taxes, miscellaneous
deductions and personal exemptions and others - are added back (ISO spread
income is also added). You must pay the greater of the two. Though the AMT rate
is either 26 percent or 28 percent - a lower rate than the highest marginal tax
bracket of 35 percent - it's applied to a wider base of income, making that tax
bill more costly.
That's why the resounding lesson is thoughtful planning, because a clever
strategy can make the best of this complicated tax scenario.
"When you exercise ISOs it may put you in AMT, and one of the strategies is
to look at your income for the year, and maybe you exercise just enough to stay
out of AMT," said Bernie Kent, personal finance partner with
PricewaterhouseCoopers Private Company Services. He said those in the $150,000
to $382,000 income range (for married couples filing jointly in 2005) are more
susceptible to AMT. Ironically, the likelihood of AMT starts dropping once
ordinary income hits about $400,000.