AMT
Credit Relief — Commentary
Relief provision is controversial
By
Kaye A. Thomas
Posted December 11, 2006
Is this new law fair?
The new relief provision for people with old unused AMT
credit is already controversial. Some people are calling it
justified relief from an unfair tax on phantom income. Others
see it as a boon to people who got greedy with their options.
Neither characterization is accurate. It's a poorly designed,
overly generous, overly complicated, long overdue provision that
refunds taxes to some people who deserved relief long ago,
ignores many others who arguably deserve similar relief, and
lavishes tax dollars on still others who have no reasonable
claim for tax relief.
We're talking here primarily about people who exercised
incentive stock options and held the stock. Some of those people
had disastrous tax results when the stock price collapsed. Some
of them had wonderful results when the stock price went
up. Both groups will get tax refunds under the new law.
Phantom income?
The central argument made in support of this provision is
that people who pay AMT when they exercise incentive stock
options are paying tax on phantom income. That's nonsense. When
you receive fully vested shares of stock that are worth more
than you paid, you have income, and it isn't phantom income.
We couldn't conceivably have an income tax that treated cash
as income while allowing compensation paid in stock to go
untaxed. Imagine the outcry if executives who receive tens of
millions of dollars in stock compensation were allowed to report
only the much smaller cash portion of their compensation as
income.
If this is phantom income, why are we giving relief to people
who lost out when holding stock from incentive stock options,
but not to people who lost out when holding stock from
nonqualified stock options? Is it phantom income when the AMT
applies, but real income when the regular income tax applies?
This is a phantom argument.
Investment loss
People who claim to have had phantom income actually had real
income followed by an investment loss. It seems unfair to them
that they can't use the investment loss to eliminate tax on the
income. Yet they actually received better treatment than other
taxpayers, not worse. Let's compare two situations.
- You exercised a nonqualified stock option, paying
$100,000 to buy stock worth $1,100,000. You could have
cashed in your $1,000,000 profit but chose to hold the
stock. It declined in value and you ended up selling it for
$100,000, the same amount you had when you started.
- Exactly the same, except this time it's an incentive
stock option.
In the first case you pay tax on $1,000,000 of compensation
income and get to claim a capital loss of $1,000,000, which is
subject to a $3,000 annual limit. You're in a world of hurt,
because you have no economic profit and somewhere you have to
come up with money to pay tax on $997,000 of income.
In the second case you have two advantages over the first
one. One is that you could have avoided the bad result if you
sold the stock in the same year you exercised the option, even
if the stock price collapsed before you sold it. You didn't have
that opportunity in the first case. With nonquals, your tax cost
is locked in as soon as you exercise the option; with ISOs you
can bail out later in the year.
Even after you blew that opportunity to escape the AMT, you
ended up with a better result than the first case because your
option income was taxed at the lower rates that apply under the
AMT, instead of regular income tax. In the years when the worst
disasters occurred, the regular tax rates went to 39.6%, but AMT
on a large incentive stock option profit was about 28%.
The new tax law provides no relief to people who had
disastrous results from holding stock after exercising
nonqualified stock options. It provides relief to people who had
disastrous results from holding stock after exercising incentive
stock options, even though those people had an added opportunity
to avoid the disaster and also ended up paying about 30% less
tax than people with nonquals.
What AMT is supposed to do
By now it is well known that the alternative minimum tax
doesn't work the way it was originally intended. The idea was to
impose a minimum amount of tax on people with very high levels
of income if they otherwise would pay very little tax because
they receive unusually large benefits from preferential rules in
the tax law. For various reasons the AMT now applies to many
people who are not its original targets: upper middle income
taxpayers who claim larger than average deductions for personal
exemptions and state and local taxes. The AMT is such a mess
that many people advocate repeal of the entire tax.
When it comes to incentive stock options, though, the AMT
comes reasonably close to doing what it was originally intended
to do. It applies only if you seek preferential tax treatment by
holding the stock after exercising the option. If it didn't
apply to ISO profits, many people with incentive stock options
would receive millions of dollars in compensation income that
was either converted entirely to long-term capital gain
(nowadays taxed at just 15%) or avoided taxation altogether in
any of various ways, such as offsetting the gain against
investment losses, donating the stock to charity, or holding the
stock until death.
The new law seems to be premised on the notion that if you
paid AMT, you should eventually get it back in the form of a
credit. That idea undercuts the purpose of the AMT. Someone who
fully recovers the AMT credit has lost the use of the money for
a number of years but is otherwise back in the position of
someone who never paid the tax in the first place. That makes
sense only if we agree the tax law should permit corporate
executives and other holders of incentive stock options to
convert millions of dollars in stock option profits to long-term
capital gain or, in some cases, tax-free income.
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Contrary to a widespread misconception, the AMT
credit was not designed to let people recover a tax prepayment. It
was designed to prevent double taxation when AMT and the regular
income tax apply to the same income in different years. With the
limitations that were in place before this new law, it accomplished
that purpose. |
Who gets relief?
The new law provides relief to everyone that has old
unused AMT credits. Let's compare some different situations. In
each case you exercised an ISO with $1,000,000 of profit and
ended up with unused AMT credit. I'm working with the tax rates
in effect back in 2000 because that's when most of the
heartbreak occurred.
- You held all the stock, so you had to pay $280,000 AMT
in the year of exercise. You ended up selling the stock over
a year later but by that time your profit had dwindled to
$100,000. You use very little of the AMT credit upon sale of
the stock. You're up the proverbial creek, with a $280,000
tax bill and no resources to pay the tax. This was bad
planning coupled with bad luck.
- You sold 40% of the stock immediately and held the other
60%. Now you owe regular tax on the stock you sold and still
have to pay around $120,000 of AMT. That's excellent
planning for three reasons. You've reduced your risk on this
one stock. You have sale proceeds you can set aside to cover
your tax liability. And you have a reasonable prospect of
recovering all your AMT as a credit: if the stock price
holds up, you'll have a $600,000 capital gain, and at the
20% rate we had back then, the tax would be around $120,000,
just enough to soak up the $120,000 AMT credit. But instead
the stock price went down, you sold the remaining stock for
a nominal profit of $60,000. Good planning and bad luck.
Disappointing but not a disaster because you set aside money
from the first stock sale to cover the tax. Overall you came
out ahead (though not anywhere near the original $1,000,000)
and you still have over $100,000 in unrecovered AMT credit.
- You held all the stock, so you had to pay $280,000 AMT
in the year of exercise. You were lucky, though: your
company prospered, and you sold the stock a year later for a
nominal profit of $2,000,000 (double the profit when you
exercised the option). Good luck overcame your bad planning,
sort of like a poker player drawing to an inside straight
and making it. The way the AMT credit works, you still don't
recover the full amount. You get an amount roughly equal to
the original profit multiplied by the capital gains rate
(20% back in 2000, 15% now). You're sitting pretty, but you
still have unrecovered AMT credit.
- You held all the stock, so you had to pay $280,000 AMT
in the year of exercise. Six years later you still
hold the stock, which is now worth $10,000,000. You have
$280,000 of old unused AMT credit.
Some form of tax relief makes sense for people in the first
situation. In many cases they ended up with tax bills that
exceeded the profit that remained when the sold the stock. That
situation was created in part by their own bad planning, but it
was just about impossible back in 2000 to find a financial
advisor or tax pro that understood incentive stock options well
enough to explain how to construct a good strategy for ISOs.
(The first edition of my book Consider Your Options came
out early in 2000 but a really good explanation of strategies
didn't appear until later editions.) The IRS bears some
responsibility for the confusion. They offer tax publications on
just about every conceivable subject, but not on the AMT. The
new law doesn't provide the kind of relief I would have
designed, but arguably it provides a kind of rough justice for
people caught in an AMT whipsaw when the price of their stock
collapsed.
People in the second situation also suffered a whipsaw but
avoided a disaster through sound planning. I don't see a crying
need for relief here, but if we give relief to people in the
first situation and not the second we're rewarding bad planning
and punishing good planning. It makes sense to let them ride
along on this relief provision.
People in the third situation never suffered a whipsaw and
have unused AMT credit only because they took maximum advantage
of a special tax benefit that converts ordinary income to
long-term capital gain. They are precisely the kind of people
who should be paying AMT. Why are we returning the credit to
those people?
People in the fourth situation also never suffered a whipsaw,
and if they recover the entire credit will find themselves in a
situation where they hold millions of dollars worth of stock
from compensatory options without having paid any tax at all.
Nice!
Bottom line
For people caught in an AMT whipsaw during the bear market
that started in 2000, the new law provides relief that is long
overdue. Many of those people tried to find good advice on how
to handle their options and were unable to find any. They made
their best guess about what made sense and ended up with severe
consequences. I'm happy to see them obtain a measure of relief.
The law is poorly designed, though. Some people are still
paying off AMT they owe from 2000. The law allows them to
recover some of that tax, but they don't even start to get it
back until 2008 (when they file their tax returns for 2007) and
in the meantime the IRS presumably will continue collection
activity on the old tax.
At the same time, the new law squanders tax relief on people
who never lost a dime on their option stock, never suffered a
whipsaw, and could still be sitting on stock worth millions.
Considering that people have spent more than five years trying
to craft some form of relief from the AMT disasters that struck
in the 2001 filing season, this is a poorly designed law.
Click here for a detailed
explanation of the relief provision
Related
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