finance: closeup - Class tax is now mass tax

BY CAROLYN SCHUK

Consider this for a tax policy design: Don't index for inflation -- so that as inflation pushes incomes up, the number of people hit for tax geometrically increases. Then eliminate familiar deductions like those for state and local taxes and the child tax credit. Next, make people calculate their taxes twice using two different formulas. And then force them to pay the higher amount, whichever it is.

Pretty unfair, don't you think? Yet this is an accurate description of the alternative minimum tax or AMT -- the "stealth" tax that experts agree is swimming upstream piranha-like to bite more and more Americans.

The AMT received a lot of press in Silicon Valley a few years ago. While some tech workers struck it rich with stock options, others exercised their options only to watch a plummeting stock market erase their gains. But not only was their stock nearly worthless, they also discovered that they owed hundreds of thousands of dollars more, due to an obscure tax, the AMT.

Since the dust from the dot.com bust settled, not much has been heard about the AMT. But with Google Inc.'s IPO minting new millionaires, the subject is back in the news. And the news isn't good.

The AMT was enacted in 1969 to keep wealthy taxpayers from using tax avoidance transactions to escape tax liability. As well as disallowing many exemptions, deductions, exclusions and credits, the AMT contains unique rules governing income recognition and the timing of deductions and credits.

But its concealed weapon is that it is not indexed to inflation-adjusted income growth -- unlike the regular tax code. In other words, you determine whether you must pay the AMT in 2004 by those 1969 numbers. The result is that every year, inflation pushes more and more taxpayers into the AMT "bracket."

How serious is this "bracket" creep? Consider the following projections from the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institute. In 2005, AMT will affect 12.7 million taxpayers. By 2010 the number will reach 32 million. By the Tax Policy Center calculations, in 2010 the AMT will take back about 34 percent of the administration's 2001 tax cuts.

Then add incentive stock options to the fray.

Elissa Wellikson knows the ins and outs of stock option plans better than most people -- she was in charge of stock plan administration when she was general counsel at San Jose-based Redback Networks Inc. during the dot com boom and bust. Many people end up taking a tax double whammy on their options, Wellikson said.

"Capital gains tax rates are more favorable than regular income tax rates, but the investment has to be held for at least a year," she said. "And in the year the option is exercised, the tax is calculated on the difference between the value of the options -- the strike price -- and the stock's market price on the day the options are purchased -- regardless of the stock's current value or the fact the these are only paper gains."

People count on selling the stock at a higher price and using the proceeds to pay the taxes, she said. However, if the price goes down during the time you hold the stock, you are still liable for the tax due as the result of exercising the stock -- even if gains are still paper profits. And because of the amounts involved, these profits are often subject to the AMT.

That makes for risky business when dealing with volatile stocks.

"Many of the people who received options never had a reason to consult a financial planner before," Wellikson said. "So they didn't realize that exercising stock options put them into a whole new category. Despite recommendations in stock plans to get tax advice, they didn't know the AMT applied to them."

Desley Oliphant was one of these people. She worked at a startup she declined to name shortly before it went public and received a sizable number of options.

"I had a high-powered financial advisor," Oliphant says. "On his advice I held the stock after I exercised the options. The price of the stock went down but when I got my tax bill the following April, I discovered that I was still liable for tax on the paper profits. I almost passed out."

She had no choice but to sell the stock at the low price just to cover the tax bill.

She was one of the lucky ones. Some never realized any gains at all and are still faced with huge tax bills.

Financial planner Mark Neath advises his clients that they are better off with simultaneous execution of options -- buying and selling at the same time.

"Even though they pay ordinary income tax rates, they reduce their risk exposure," said Neath, who works for JK Harris & Company in Charleston, South Carolina.

Jay Cena exercised stock options at Sunnyvale-based Network Appliance Inc. in 2000 only to see the value of his holdings plummet. Like Oliphant, Cena paid the entire amount of his profits in AMT. He now stays busy lobbying to reform the tax through a lobby group he founded, ReformAMT.

Reform efforts are nothing new (see sidebar.) The Bush administration has asked the Treasury Department to propose a long-term fix for the AMT, but this report is not due until January 2005. The bottom line: Relief is not coming any time soon.

How to avoid AMT and how it's being fought

The mechanics of the alternative minimum tax are so complex, many taxpayers don't realize they are subject to it. In simple terms, a large number of itemized deductions is often all it takes to trigger the AMT. The AMT is so complex that the head of the Internal Revenue Service was among those taxpayers who received an AMT surprise hit in 2003, according to WebCPA.

Many items can cause or contribute to AMT liability, including:

- State and local taxes

- Interest on second mortgages

- Incentive stock options

- Long-term capital gains

- Tax-exempt interest

- Tax shelters

A history of AMT reform

Legislative changes were made in 1978 and 1986. In 2001, the Joint Committee on Taxation proposed that Congress repeal the AMT and local congresswoman, Zoe Lofgren, introduced bipartisan legislation to reform the AMT treatment of incentive stock options. Due to the distractions of 9/11 and the subsequent budget deficit, the bill never made it through the Ways and Means committee, said Cena.

Congress applied a short-term fix by increasing the AMT exemption in 2003 and 2004. In May of this year, the House passed a bill extending this exemption into 2005. This was never voted on in the Senate.

An amendment offered by Rep. Charles Rangel of New York in May 2004 -- and supported by another Silicon Valley congressman, Mike Honda -- would have eliminated the AMT for single taxpayers earning under $125,000 and married taxpayers earning under $250,000. That bill was defeated. Significantly, all the bills dealing with the AMT currently being considered still only seek modifications. Wholesale abolition or reform in the short term is not even on the table.

According to the Congressional Budget Office, repealing the AMT would cost as much as $900 billion over the next 10 years -- about $10 billion less than it would cost to repeal the regular income tax. Add that to current budget deficits and the dimensions of the problem become huge.

-- Carolyn Schuk


	Class tax is now mass tax Alternative minimum tax or AMT is now affecting more and more Americans

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